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The Employee Ownership Report

NewsletterConcisely written for leaders in employee ownership companies and for service providers in the field, the NCEO's bimonthly newsletter, the Employee Ownership Report, is the most efficient way to stay informed about legal issues, current events, best practices, breaking research, management approaches, and communications ideas for employee ownership companies.

Available exclusively to NCEO members, the Employee Ownership Report is delivered in hard copy and all issues back to 1997 are available in the members-only area of the Web site.

Nonmembers are invited to read the sample article below from the current issue of the newsletter. Every time a new issue appears, the sample article on this page will be replaced by one from the new issue. Join online for only $90 to receive the Employee Ownership Report and all our other membership benefits.

Read a sample issue of the entire newsletter (September-October 2015).

Sample Article from the July-August 2019 Issue:

Control Premiums in ESOPs

Historically, when an ESOP bought a minority interest in a company it paid for shares at a price that was discounted because those shares lacked control. The theory was that a hypothetical willing buyer would pay more per share for the right to control how assets are deployed in a company, much in the same way that ownership of shares in a public company (which almost by definition is on a minority basis) often goes up in value when there is a takeover offer. If the ESOP acquired more than 50% of the shares, however, there would be a control premium, the value of which varied based on the specific facts.

In recent years, the concept of control value and how to calculate it has become more nuanced, constructed more from a set of calculations. Appraisers have shifted to a new model that never pays for control per se, but rather applies multiples to earnings based on a variety of company attributes that provide what they persuasively contend provide a more accurate way of thinking about what ESOP shares are really worth. If the ESOP does not have governing control, this number is discounted based on the elements of control it lacks. Even when the ESOP owns a majority of the stock, however, control may be subject to contingencies on loans or practical constraints on how the ESOP trustee can exercise control, all of which can also result in discounts. Control elements are not priced on a general assumption, but a calculation.

The NCEO surveyed 18 leading ESOP appraisal firms to learn more about current practices. The results point to a growing, if not universal, consensus on how valuation is approached.

Income Analysis

Valuations in ESOP companies include asset value, comparable company analysis, and the income approach, which (to somewhat oversimplify) analyzes multiples of cash flow (measured as EBITDA) that willing buyers would pay willing sellers. The income approach usually gets the lion's share of the weighting. Appraisers typically rely on normalized projected future earnings over the coming five years or a capitalization of prior earnings. These earnings are then discounted by the weighted average cost of capital (WACC), which measures the cost of equity capital, the risk-free investment rate, beta (a measure of the equity risk premium), the size premium, and the company-specific risk premium. This produces a number, frequently 12% to 20% (but with variations), that indicates a rate of return that is acceptable to a hypothetical investor. So if the WACC is 15%, an investor will pay 6.7 times EBITDA for the earnings, plus an amount reflecting the "residual value," the amount remaining at the end of the five-year period the investor can capture. This analysis, however, is company-specific in terms of its earnings projections or trajectory, capital structure, and other issues. This number is adjusted as needed based on asset and comparable company models, as well as discounts as needed for liquidity and repurchase obligation.

In the past, appraisers might then take the value this creates (after adjusting for comparable company and asset value), then apply a minority discount if the ESOP owned less than 50% and a control premium if the transaction bought it above 50%. The approach was based on market guideline company studies based on acquirers having a synergistic value when they acquire control. In fact, multiples from public companies and private companies for which there are data arguably reflect financial control levels, meaning the assets are already being deployed in an optimal or near-optimal way. If not, there would be a lot more acquisitions to unlock value. True synergistic opportunities are not the norm, this argument goes. As a result, this financial control model is now more often used to determine enterprise value in ESOP companies. The resulting enterprise value would then be adjusted, if needed, for lack of liquidity, repurchase obligations (if needed), and minority discounts, if applicable.

Many respondents made further adjustments based on constraints that may exist on how the company can use future revenues. These may include limitations on new investments, board seats (sometimes for the seller), compensation paid to the seller other than the note itself, and restrictions on dividends and bonuses, among other things. These constraints in theory might impair the optimal use of revenues from a financial control standpoint, resulting in a somewhat lower number.

While this approach is the most common, some appraisers still use control and non-control approaches more directly, albeit with caution. These approaches may be justified based on facts and circumstances, and this more traditional model does not per se produce a systematically different result than the emerging model.

Interactive Effects

The valuation models that now prevail do vary from firm to firm, and board members, fiduciaries, and trustees need to understand how they work and why. It should be noted, however, that valuation is an iterative process. If your company's stock is valued at, say, 5% less than it might be with a more aggressive approach, that means you need that much less money to buy out existing owners and/or departing employees. And that means, other things being equal, your EBITDA goes up over time—so your value will go up with it.

For a good overview of the theory behind the new models based on financial control, see Chris Mercer, What Determines the Level of Value in Business Valuation.