How to Choose Employee Ownership Consultants
4. Choosing an AppraiserIf your company is closely held, and for some purposes even if it is public, you should have an appraisal to determine the share value. Outside appraisals are required for ESOPs and sensible for equity compensation plans. This may be the most complex and important part of your task in putting a team together.
Note that in the ESOP context, the appraiser is hired by and reports to the trustee of the plan, not the seller or the board, although the seller or company may hire an appraiser for a preliminary valuation when evaluating the feasibility of an ESOP. Thus, if an ESOP transaction is in question, the recommendations directed to "you" below about hiring an appraiser are addressed to the ESOP trustee, and in particular an internal trustee (i.e., a company employee or committee) as opposed to an external trustee whose business it is to know these matters.
First, you want to make sure the appraiser is independent, a requirement of the law for ESOPs and desirable for broad stock option plans. There is no "bright line" definition of this term. At a minimum, the appraiser should have no other business relationship with your company. Clearly, your company's CPA is not independent, nor is your CFO. But what if your CPA is a member of a major accounting firm that has a separate appraisal division? Or your appraiser is a member of a brokerage firm that also has a lending division making you an ESOP loan or is handling the sale of exercised stock options in a broad stock option plan? Most people think that large firms like these can create sufficient separation between the units to provide independence, but you should have a compelling reason for taking this approach when there are lots of truly independent appraisers available. Some legal consultants also have affiliated appraisers who are technically not part of their firm but who get referrals from them. This is not clearly improper, but our advice at the NCEO is that it is a risk that is not worth taking and that it creates a clear conflict of interest. The point of having an independent appraisal is to avoid putting the appraiser in a situation where he or she knows that coming up with an acceptable price will win business for a related firm.
Second, you want to check qualifications, as outlined above. Appraisers have particular professional designations granted by either the American Society of Appraisers or Institute of Business Appraisers. Various designations offered by these groups indicate professionals have reviewed materials and taken tests to demonstrate their competence. You should ask if an appraiser has any such designations and what they entail. Industry-specific expertise is generally not an issue. Appraisers all have access to various databases indicating the relevant ratios and other information that are used to make appraisals for particular business areas. ESOP-specific or options-specific expertise is another matter, since both plans raise special valuation issues. In order to become familiar with these issues, appraisers should have participated extensively in professional organizations.
Third, you want to evaluate the cost of an appraisal. Fees will vary widely. In part, the variation is a function of the size and reputation of the firm. In a larger firm, your appraisal will be reviewed by one or more other people. Some firms also have proprietary databases tracking such things as how much closely held business have sold for in various industries. Naturally, you will pay more for this additional infrastructure and time. Will this result in a better or different number than using a smaller firm? There are costs and benefits either way.
Finally, you should find an appraiser whose approach is one that fits your definition of what is in the best interests of the plan. This is a complex issue. The general methods used to assess the value of a company overall do not vary dramatically from one qualified appraiser to another, but some appraisers are more aggressive in their assumptions than others. More important, the philosophy about ESOP-specific or options-specific issues varies widely.
- As noted above, the appraiser is hired by and reports to the trustee of the plan, not the seller or the board, although the company normally pays the appraisal fees.
- Often, the selling shareholder or company hires an appraiser to do a preliminary valuation when deciding whether to adopt an ESOP. In the past, the same appraiser has often been hired to perform the full-blown valuation for the transaction, but in recent years this has come under fire. The Department of Labor has severely criticized this practice, arguing that the seller or company is "road testing" an appraiser to see whether they will arrive at a high price and then turning that same appraiser over to their counterparty in the transaction (the ESOP), for which the appraiser will tend to arrive at the same valuation conclusion, compromising their independence. The most prudent approach is to use a different firm for the preliminary appraisal than for the transaction.
- There are two other ESOP issues of particular concern: the impact of the repurchase obligation on marketability and whether it makes sense to apply a control premium. Closely held company stock is not as marketable as the stock of a publicly traded company, and hence is worth less, often 25% or more. The ESOP, however, provides a market for the shares of a closely held company. Some appraisers argue this should reduce the marketability discount to zero; some say it should only reduce it if and when the company shows its has the specific capacity to buy the shares; some say the discount should only be reduced to the extent that the cost of repurchase does not exceed what the company would otherwise put into employee benefit plans; others argue that it should have no effect. An aggressive approach will result in a higher price for sellers, but problems for the ESOP down the road when it tries to buy the shares back. Too aggressive an approach can also land you in court. There is not a right or wrong answer on this issue, but its importance indicates that you and the ESOP trustee should at least know which philosophy is being used and be comfortable with it.
- Similarly, if the ESOP is not buying a controlling interest, it cannot pay a control premium. This too can be 25% or more. In some cases, the ESOP is not buying control now, but will in the future. Should this allow a current control premium and, if so, under what conditions? Some valuation consultants even argue that an ESOP can never pay control prices because each employee interest is a minority interest. Again, there is not a right or wrong approach, but you and the plan trustee need to understand what is going on and find an appraiser whose approach makes sense given the fiduciary interests of the plan and the plans of the company.
Equity Compensation Issues
- In valuing equity compensation awards, the guidelines are less rigid than for ESOPs. In fact, an independent appraiser is not a legal requirement. Determining the value of the options correctly, however, is important in a number of ways. First, under accounting rules effective in 1997, companies must include the present value of their options either as a compensation cost on their income statement (an alternative few companies select) or as an entry into their footnote disclosures. So companies, at the least, must figure out what this number should be. Figuring it out is a complex task that involves not just understanding the current value of the business, but the value of options that will be exercised at current or historic prices some time in the future. A formula such as the Black-Scholes model must be used to determine this. Even if the company is publicly traded, an appraiser may be desirable to help with this calculation. Second, unless the company is publicly traded, the share price must be determined for any stock buyback arrangement. An improper valuation can cost the company or the recipient a great deal of money, so it pays to get it right. Some closely held companies may choose just to use a formula to determine value (an almost certain guarantee that the price will be inaccurate). The company may be willing to trade off accuracy for simplicity, but, at the very least, it makes sense to hire an appraiser to help establish the formula and to review it periodically.