Valuations are central to the ESOP process. This innovative book has been written primarily for inside ESOP trustees, company leaders, and board members. We hope it will also be useful to ESOP professionals, although its approach is not as highly technical as in material directed specifically at them. The core of this book is chapter 1, "How Your Appraisal Report Works," an actual redacted valuation report that has been annotated with explanatory comments. Subsequent chapters discuss how control premiums or discounts are calculated, reviewing the valuation (taught in a Q&A format), how to communicate valuation to employees, and how to select an appraiser. An appendix has a useful checklist for reviewing the appraisal report.
The goal of this book is to help people who need to read and use valuation reports understand what is in them and how to use them. Board members, executives, and especially fiduciaries need to understand the valuation process well, know how to spot red flags and problems, and know how the report can tell them about how the company’s value might be improved. Readers that want to begin with a general overview of valuation before diving into the complexities of this book should read the chapter "Understanding ESOP Valuation" included in our books Understanding ESOPs and Selling to an ESOP.
Table of Contents
1. How Your Appraisal Report Works
2. Control in ESOP Valuations
3. Reviewing the Valuation: A Step-by-Step Guide for Inside Fiduciaries
4. Communicating Valuation: The Power of the Multiple
5. Choosing a Valuation Consultant
6. Appendix: Evaluating an Appraisal Report
From Chapter 1, "How Your Appraisal Report Works"
This section describes the process for applying the normalization adjustments to result in a final value for earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA is the standard measure of earnings appraisers use. EBITDA is a way of not counting the factors that a buyer may approach differently. For instance, your company may have debt (and hence interest expense) that the buyer would liquidate or not take on. The buyers’ tax rate may also be different, and their amortization and depreciation schedule could vary as well after the purchase.
Note the normalization for the contribution to the ESOP. The theory here is that a willing buyer will not maintain the ESOP and that when the dust settles, the total contribution to retirement plans will be 5% (this will vary by industry). This calculation will often include what the ESOP company contributes both to the ESOP and any other retirement plan. Some appraisers take a different view. For instance, they may conclude that a high benefit level, while not the industry norm, is part of the ESOP company’s culture and that it would not be able to attract and retain people of the same quality without doing this. So a willing buyer would have to do the same to have the same success.
The appraiser will look at projected revenues and cost then apply the normalization adjustments to produce a final number. Note that the more “addbacks” are included in normalized earnings, the lower the “quality” of earnings, which may affect the appropriate multiple.
From Chapter 2, "Control in ESOP Valuations"
The degree of transferred control in ESOP transactions and/or the prospective exercise of control by an ESOP have been featured issues (among others) in a series of publicly disclosed fiduciary process agreements since 2014. Before the proliferation of these fiduciary process agreements, stock pricing for ESOP transactions frequently relied on a fair market value appraisal. Common practice generally involved a single financial advisor serving the overall needs of the transaction. In some instances, fairness opinions were used to examine other important aspects of a transaction, including entity governance, financing, repurchase obligation, post-transaction compensation arrangements, and other concerns that affect the financial welfare and sustainability of the ESOP. These process agreements have altered the procedural norms for modern?day ESOP transactions, shifting from the unilateral advisory valuation process to a process of bilateral negotiation, with both sides of the transaction having their own financial advisors.
Many ESOP transactions now include significant side agreements and processes that serve to cement post-transaction economics of the ESOP and the governance of the sponsoring company. Despite this evolution to a state where the nuances of transaction terms and pricing are subject to enhanced scrutiny by all parties, the question of control as a value enhancement persists. The continuing scrutiny reminds ESOP stakeholders to achieve a clear understanding of certain questions: How are the attributes of control best considered in a transaction and thereafter in annual plan year valuations? Is the use of an explicit financial control premium an issue in a properly vetted and documented transaction? (Spoiler alert—more than likely yes.) Is the application of an explicit control premium adjustment an antiquated and potentially erroneous procedure in light of a better understanding of what control premiums actually measure? (Spoiler alert redux—more than likely yes.)
From Chapter 4, "Communicating Valuation: The Power of the Multiple"
In many ESOPs, the trust buys some, but not all, of the stock and then buys more some years later. This can create some confusion for employees, but it is actually a very straightforward situation. Say the ESOP bought 30% of EOB for $32 per share and five years later the shares are $50, a 56% increase. Now the ESOP borrows money to buy the remaining 70%. EOB borrows a bunch of money to do that. The company had a great year and is worth $7.8 million. But the share value drops, by a lot! Depending on the company’s prospective earnings, it could fall by 50% or more.
So how to explain this? Remember, the value of the company is a function of its projected earnings. Now those earnings are lower because the debt has to be repaid. The situation is very much like owning a house as a rental. Say you own 30% of a $500,000 house. You have no debt but you have ongoing costs (taxes, maintenance, etc.). The house seems like a good investment, so you borrow money to buy the remaining 70% from your partner. The next day, the house is still worth $500,000, but now you have a lot of debt to repay, reducing your income after rent is paid. So the equity value of your investment is worth less than $500,000. The good news is that you own it all and as the debt is paid, your equity value will go up, and will go up even more if you can get a higher rental rate. The value of the house is the same as it was before the debt, but the value of your equity in the house is much less than that value.
The same thing happens at EOB. EOB’s earnings are now reduced to pay the debt, so the price of the shares, which are mostly a multiple of future earnings, goes down. But as the debt is repaid, it goes back up, and it goes back up even more if earnings increase. While the share value has gone down, the employees now also own a lot more of the company, which will eventually make their accounts worth a lot more, because more shares will be allocated over time than if the ESOP stayed at 30%, other things being equal.