ESOP Valuation

3rd ed. (October 2005). 218 pp. (6" x 9"), softcover; $25 for NCEO members; $35 for nonmembers.

This book brings together the best articles we have published on employee stock ownership plan (ESOP) valuation--that is, the valuation of a company for purposes of an ESOP. Where needed, these articles have been updated for this book. Valuation is a crucial issue for closely held ESOP companies and engenders some of the most heated debate in the field. For a booklet introducing company owners and managers to the topic, see Understanding ESOP Valuation, which is included as a chapter in our book Selling to an ESOP.

An Introduction to ESOP Valuation
Valuation Issues in Multi-Investor ESOP LBOs
ESOP Accounting Rules
An ESOP Valuation Case Study
Repurchase Economics and Valuation Effects
ESOP Valuation and Financial Advisory Analysis Due Diligence Checklist
ESOP Valuation for Banks and Bank Holding Companies
Valuing S Corporation ESOP Companies
Marketability Discounts and ESOP Acquisitions of Minority Share Interests
Shifting Control in an ESOP Context
Valuation Issues for ESOP Fiduciaries
Valuation Ethics
How to Appraise an Appraiser

Excerpts

From Chapter 5, "Repurchase Economics and Valuation Effects"

When an ESOP is the buyer of a company and the purchase is accomplished with debt, the post-transaction value of the company’s equity is reduced by an amount that is represented by the face value of the debt. The debt is related to a distribution of cash to selling shareholders, and the number of shares outstanding remains the same both pre- and post-transaction. Contributions to the ESOP during the loan amortization period may exceed the level of benefits considered normal for the industry. After the loan is amortized, the ESOP company will have continuing contributions to meet the repurchase obligation if shares are being recirculated (as discussed below). There is an underlying assumption that the ESOP contributions for these recirculated shares represent normal levels of benefit expense. Once the debt is repaid, the impact of the continuing contributions for repurchases is frequently ignored. To the extent that the continuing contributions are not reflected in the compensation expense of the company, the effect is to miss an element of the cost structure of the company and to potentially overvalue the company (figure 1) (i.e., if ongoing ESOP expense is not considered or adequately quantified, then the company may be overvalued). The difficulty is estimating the amount of future ESOP contributions that are dependent on future ESOP stock prices.

From Chapter 8, "Valuing S Corporation ESOP Companies"

There is no question that the absence of taxes represents true cash savings to a company. It follows, then, that the cash savings should translate into some form of enhanced value.

From the most global perspective, value is enhanced via the increase in cash flows available to the company. The source of these cash flows is the cash that would otherwise have gone to pay corporate federal income taxes. As discussed above, the magnitude of the savings depends on the percentage of the company owned by the ESOP. This value enhancement is realized in one of two ways: either through reinvestment of cash flows or through the payment of regular dividends. The reinvestment of the added cash flows into productive assets earning a return in excess of the company’s cost of capital enhances value over time as those assets become productive and generate additional cash flows and higher levels of growth than would otherwise be the case. When the cash flows are paid out in the form of dividends, the owner of the ESOP common stock earns a portion of its total return in the form of dividends. In this case, the value is captured either in a capitalization of dividends approach or in the increased marketability (or conversely lower marketability discount) of the security due to its higher income return. The capital gains portion of the value is less than if the company reinvested the added cash flows, but the income portion is higher.

If the company merely retains the added cash flows in the form of cash and marketable securities, which do not earn a return in excess of the company’s cost of capital, the S corporation election may not be value enhancing. The mere avoidance of taxes does not enhance value. The cash savings associated with the S corporation status must be put to productive use.

From Chapter 10, "Shifting Control in an ESOP Context"

Substantial empirical data supports the application of a control premium in an initial transaction of the nature described above. In order to better understand such empirical data, it is helpful to understand that there are actually varying degrees of control that an investor might possess through stock ownership. For example, an investor owning 100% of the stock of an entity possesses complete control of that entity and its cash flows. On the other hand, an investor owning 51% of the stock of an entity does not possess complete control of that entity, even if only a majority vote is required to pass any action requiring a vote. This is because that investor has, at the very least, certain fiduciary responsibilities under applicable corporate law to the remaining 49% shareholder(s). This fiduciary responsibility limits what the investor owning 51% of the stock of the entity can do regarding the assets and cash flow of that entity. In many, if not all, states throughout the United States, a majority shareholder(s) has a fiduciary responsibility not to oppress the minority shareholder(s) and has a duty of loyalty to such shareholder(s). Furthermore, a 50% interest possesses, in essence, veto power, but it does not possess total control. For example, a 50% interest is below the 80% or 90% level required to “squeeze-out” minority shareholders in several states. Finally, of course, an investor owning less than 50% of the stock of an entity certainly does not possess complete control of that entity and may not possess any elements of control.

To definitively answer whether an ESOT may pay a control premium in a properly structured and negotiated initial ESOT stock purchase transaction that is part of a multi-stage transaction in which the ESOT will execute a binding written contract at the time of the initial ESOT transaction to ensure that the ESOT will own, at its discretion, a controlling interest in the corporation within a reasonable period of time after the initial transaction, FMV Opinions, Inc., performed an analytical study (the "FMV Control Premium Study") involving approximately 150 transactions initiated and completed from 1993 through July 1999 in which an entity acquired a non-controlling interest in a publicly traded company (the “target” or “targets”) and later acquired a controlling interest in the target.

From Chapter 13, "How to Appraise an Appraiser"

When considering an ESOP for a closely held company, either for a client or for your own company, you undoubtedly will contact, or be approached by, a number of ESOP consultants who hope to provide you with their services. They will offer advice on many different issues. For example, should the attorney or the benefits consultant draft the plan documents? Should a repurchase obligation study be performed? Which vesting schedule is more appropriate? Whatever their respective specialties, however, one issue on which all of these consultants will agree is the pivotal importance of the selection of the business valuation consultant, also known as the business appraiser. In an ESOP, the business appraiser determines the "fair market value" of the company’s stock, thus effectively calculating the value of what may be the life’s work of an entrepreneur.

Further, if the value is ever challenged, whether by an employee or by either of the two federal agencies that has enforcement responsibility for ESOPs, the Internal Revenue Service (IRS) and the U.S. Department of Labor (DOL), the appraiser may be called upon to defend the value. If you are the entrepreneur, how do you evaluate the ability of such a person? If you are an advisor to an entrepreneur who seeks your counsel on this matter, such as an attorney or an accountant, what is the basis of your recommendation?

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