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.
Table of Contents
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
How to Appraise an Appraiser
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.