Valuations are central to the employee stock ownership plan (ESOP) process. Leaders of both companies with ESOPs and companies considering ESOPs need a clear understanding of how the valuation process works. How many potential ESOPs have been derailed because sellers had unrealistic expectations about what their business was worth? How many existing ESOPs faced unnecessary problems because managers, employees, or even advisors didn't have a firm grasp on how the business would be or should be appraised? This booklet is designed to help make sure people do understand what an ESOP valuation is. For a book with a much lengthier and more advanced treatment of the subject, see our book ESOP Valuation.
Table of Contents
Why Do You Need a Valuation?
How Often Must an Appraisal Be Performed?
Who Performs an Appraisal?
How Do You Find a Good Appraiser?
Who Hires the Appraiser?
Is the Appraised Price the One the ESOP Pays?
What Does the Appraiser Need from You?
What Is in the Appraisal Report?
Steps in the Valuation Process: What Is Fair Market Value and How Is It Calculated?
What Discounts or Premiums Apply to Fair Market Value?
The Impact of Leverage on Valuation
Appendix: How ESOPs Work
From "Why Do You Need a Valuation?"
There is a T-shirt in the Exploratorium museum in San Francisco with a picture of Albert Einstein in a policeman's hat. The legend on the T-shirt says "186,000 miles per second. It's not just a good idea, it's the law." If you want to have an employee stock ownership plan (ESOP) in a closely held company, an independent, outside valuation is not just a good idea, it's the law. You must have an appraiser figure out what a willing buyer would pay a willing seller, assuming both have all the relevant information they need to make the transaction.
From "How Do You Find a Good Appraiser?"
Different ESOP appraisers have different approaches to key appraisal issues, such as discounts for lack of control or liquidity (these are discussed below), or in their general appraisal approach (such as whether they rely more on earnings multiples or on comparable companies). These will have a potentially dramatic affect on value. Initial assumptions tend to get locked into your ongoing ESOP appraisal. It will always arouse suspicion if, a few years after the first ESOP appraisal, you decide you are unhappy with the approach and choose someone else who comes in with a different set of assumptions. Your business won't have changed, but ESOP participants and the IRS may now see a very different appraisal number. At best, you have a serious communications problem; at worst, you have a lawsuit or problem with the government.
From "Who Hires the Appraiser?"
The appraiser's client, by law, is the ESOP trust, no matter who actually writes the checks to cover the fees. This has important implications. First, the letter of engagement should clearly specify that the appraiser is working for the ESOP. Second, it means the appraiser is not trying to find the highest price that can be justified or, as in some tax-oriented appraisals, the lowest. Third, it should remind everyone involved that the point of the appraisal is to protect the interests of the ESOP participants from paying more than fair market value.
From "What Discounts or Premiums Apply to ESOP Value?"
If you buy shares in IBM, you can sell them any time and get your money in three days. If you buy stock in Sally's Computers, there is no ready market for the shares. You might not be able to sell them for years, and you may have to settle for less than market price if you need the money and no one is eager to buy. This lack of marketability creates a discount over the price for the sale of otherwise comparable shares in a public company or shares in a closely held company about to be sold (because in this case there is immediate liquidity). So in any closely held company selling shares other than in a total sale, there is a discount over what the price would be for publicly traded shares, usually in the range of 20% to 40% depending on the circumstances, such as any restrictions on the sale of stock, buy-sell agreements, prospects of an initial public offering, dividends, or the availability of other buyers.