Valuation Discounts in ESOPs
A commonly distressing experience for owners in a company with an employee stock ownership plan (ESOP) is that the price of the business as a whole is not the price the ESOP will actually pay. An ESOP appraiser will reduce the value of the company by a number of discounts, including one for a lack of control, another for a lack of marketability, and a third for repurchase liability (the last two being closely related). Sellers and employee owners need to understand why these discounts apply and how different appraisers evaluate them.
Probably the most controversial discount is for a lack of control. According to the Department of Labor's proposed regulations on ESOP valuation, an ESOP can only pay a control price if it has control "in form and in substance" and this control will not be "dissipated within a short period of time." The theory behind paying more for control is straightforward: buyers will pay more for a company if they can make decisions about the use of its assets. Control allows a buyer to take additional salary or perquisites, sell off pieces of a company or use the assets to buy other operations, and make decisions about business strategy, among other things. When a public company is the target of a takeover, the run-up in price that usually results is simply a buyer offering a control premium over the discounted minority price investors have previously paid.
On a stock market, the mechanism for determining the premium is the market itself. The premium is worth what people will pay for it. In private companies, the issue is much more complicated. Several issues arise:
- What level of control do we mean? More than 50% may seem the obvious answer, but in many states, a super-majority is needed to decided some issues. So an ESOP owning 34% may have the ability to block some decisions. There may be different tiers of discounts as a result.
- If the ESOP doesn't have control, will it get it soon? A seller may want to get the control price, but not sell more than 50% all at once. Or imagine there are three owners, each owning a third of the company. The first owner sells in 1994 at a minority price; the second in 1997 at a control price. Because the ESOP only acquired control in the second transaction, only the second sale technically requires a control premium. These problems can be resolved. The proposed regulations state, if there is a written, binding agreement with the ESOP to acquire control within a reasonable period of time, then the ESOP can pay a control premium throughout. "Reasonable" is a word that often pops up in law and regulation, but is rarely defined. It isn't in this case either. Most valuation experts say three to five years would be acceptable.
- What does control in "form and in substance" mean? This phrase has the same resonance as "reasonable." It sounds fair, but it only narrows the boundaries of what can be done. For instance, say an ESOP owns 51% of the common, but someone else owns preferred that is worth 60% of the actual value of all the shares. Imagine further that the preferred holder has governance rights that effectively block any ESOP control. This arrangement probably would not allow the ESOP to pay control price. But what
about an ESOP trusteed by management in which the trustee votes ESOP shares at the direction of management? Do the fiduciary rules for ESOPs provide enough "form and substance" to make the ESOP really an independent, controlling party? Most valuation appraisers would say yes, but this issue has not been well tested.
- Are individual ESOP shares always on a minority basis? That was the court's conclusion in the U.S. News case. There, the appraiser argued the company profit sharing plan (which functioned much like an ESOP) did not have to pay a controlling price when repurchasing shares from employees because none of them had control. Almost all valuation experts would argue that the ESOP should be treated as one shareholder, however.
Even after these issues have been decided, there is still the question of how large a discount to apply for a lack of control. Discounts of 25% or so are common, but they vary from company to company and appraiser to appraiser.
Lack of Marketability and Repurchase Liability Discounts
If you own stock in Microsoft, you can sell it whenever you like at a price you can look up, to lots of willing buyers. Not so, of course, in an ESOP in a private company. Marketability discounts also vary a great deal, from very little to 25% or more. At the same time, this lack of marketability requires companies to repurchase shares from employees. That liability reduces the future profitability of the company, meaning the company is worth less than it would be otherwise.
These two factors are interrelated, of course. To the extent that the company has assets available or a credible plan in place to fund repurchase obligations, the discount for a lack of marketability should shrink, perhaps to little or nothing. On the other hand, this commitment needs to be reflected in estimates of the company's future earnings. Otherwise, the company may pay employees who leave early in the plan's life too much and those who leave later too little.
Our book ESOP Valuation discusses these and other matters in detail.