This issue brief is designed to help a broad range of readers. It provides internal ESOP trustees and other internal fiduciaries with (1) a better understanding of the various pieces and inputs into the valuation report and (2) the corresponding ability to confidently review, question, and discuss the report (as well as document all of the foregoing) with the appraiser before the report is finalized. It also provides service providers to closely held ESOP companies with a framework for helping internal fiduciaries understand the valuation report and how to review, question, and discuss it. Finally, it helps readers communicate relevant valuation information to employees. A thorough understanding of the valuation process is crucial because the ESOP trustee is a plan fiduciary and cannot simply rubber-stamp the numbers and conclusions in the valuation report. The trustee has a duty to exercise proper due diligence and fully document a complete review of the report before making its final determination of value.
Table of Contents
Why Use an Appraiser?
ESOP Appraiser Independence
Statutory and Regulatory Background
Application to Specific Contexts
Contents of a Valuation Report
Three Approaches to Valuation
Detailed Discussion: The Market Approach
Detailed Discussion: The Income Approach
Weighting Valuation Approaches
Determining Company Enterprise Value
Unique ESOP Valuation Considerations
Treatment of ESOP Debt
S Corporation Tax Shield
Discount for Lack of Marketability (DLM)
Shareholder's Equity vs. Enterprise Value
Need for an Updated Valuation
Communicating the Valuation to Employees
Construct a Report Summary
The Home Appraisal or Rental Income Analogy
The Elements of Free Cash Flow
Impact of Guideline Multiples
Eliminating Communication Surprises
From "ESOP Appraiser Independence" (footnotes omitted)
What if the appraiser has done prior valuations for the company for only non-ESOP purposes? Does it depend on how many and when last performed? One view is that any prior appraisal relationship with the company voids the independence criteria. The other view is that "old and cold" isolated valuations for the company would not necessarily compromise the independence of a current transaction appraisal and opinion.
Given the above, can the appraiser's engagement for a prospective ESOP be structured so appraiser independence is maintained but transaction costs are still minimized? For example, an appraiser could be engaged to perform a preliminary valuation for the ESOP feasibility study not by the company or by the potential seller but instead by a newly appointed exploratory ESOP committee (i.e., the exploratory plan administrator). In this case, the same appraiser can be used by the ESOP trustee in the purchase transaction because independence has been maintained.
This approach is often used because it is cost-effective and makes sense for the same appraiser to perform both the feasibility study and the subsequent adequate consideration opinion for the ESOP purchase. Of course, none of the potential selling shareholders should serve on the exploratory ESOP committee because this could create a potential conflict that would infringe on the appraiser's independence.
From "Valuation Approaches"
An important component of the DCF method is determining the discount rate to be applied to company future cash flows. The discount rate commonly used is the "cost" of capital rate, also called the weighted average cost of capital (WACC), which represents the weighted cost of debt and equity for the company (i.e., invested capital).
The WACC variable assigns an economic opportunity "cost" for investing or lending funds to this company rather than elsewhere. Thus, the WACC rate reflects the risk premium (and hence the need for a higher return and cost of capital) associated with either buying shares of or lending to a private company compared with safer investments like U.S. Treasuries.
As noted above, the WACC reflects a specific mix of debt and equity investment for the company. Where the ESOP has control, typically an industry capital structure of debt/equity is used because this represents the capital structure of potential buyers. Conversely, where the ESOP only has a minority noncontrolling interest, it is more common to use the company's actual debt/equity ratio. The ratio used is important because it will affect the resulting WACC number. Raising capital via debt is generally less expensive for a variety of reasons, including the lesser return needed to attract lenders rather than equity investors, and the deductibility of interest on debt.