September 29, 2021 •Alex Mumblat
Valuations are central to the employee ownership process. When a company initially explores an ESOP, its fair market valuation can inform plan feasibility, structuring, and financing considerations. And once a plan is in place, annual valuations dictate the pricing of an employee’s allocated shares.
The inner workings of ESOP valuations are often a source of confusion for plan sponsors and participants alike. What is fair market value? How does it compare to a company’s book or strategic value? Who makes the determination?
The answers to these questions and others have significant financial and tax implications.
The Key Players
Employee stock ownership plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA). With this regulatory context in mind, it’s important to understand the relevant parties to an employee stock ownership plan valuation.
The primary representative of an employee trust, a trustee acts as the shareholder of record and has a fiduciary obligation to all plan participants. As a result, they are liable when claims related to share pricing are brought against an ESOP. Trustees make sure that plan sponsors follow and execute the terms of an ESOP plan document, while receiving input from their legal and financial advisors.
Retained by the ESOP trustee, this professional helps establish a fair market valuation of the plan sponsor and pricing for ESOP-owned shares. The appraiser must not be influenced by the company or its shareholders. Ultimately, the trustee makes the final determination of valuation, based on the independent appraiser’s recommendation.
US Department of Labor
The DOL provides federal oversight of all ESOPs in accordance with ERISA. In addition to regulating plan procedures and reviewing the activities of plan professionals, the department verifies that ESOP sale and subsequent valuations reflect fair market value.
Valuations and the ESOP Process
Establishing an employee stock ownership plan necessitates an independent valuation. In a leveraged ESOP sale – where a company’s stock is sold to an employee trust – a trustee hires an independent appraiser to determine the company’s fair market value (FMV). The ESOP trustee will use that valuation to negotiate the final sale price with the plan sponsor.
In a contributory ESOP, a company issues new shares to an employee trust and receives a tax deduction for the fair market value of those shares on the contribution date. To determine this corporate income tax benefit, an independent valuation is performed each time new shares are issued.
Once an ESOP is formed, an independent appraiser will perform an annual valuation of the plan sponsor. This appraisal determines a market price for employee-owned shares. When employees retire or leave the company, their vested shares are repurchased by the sponsor at the most recent valuation price.
What is Fair Market Value?
FMV is the price a company would sell for on the open market. It’s what a financial buyer would pay for the business. The IRS further defines FMV as “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
Determining Fair Market Value
There are three common methods used to determine FMV. In some cases, a valuation expert may use more than one. A company’s industry, size, relevant peers, and other available market data informs how valuation methods are selected and weighted.
Discounted Cash Flow
Based on the expected future cash flows of a business, a DCF is the most common method. The calculation uses a discount rate (weighted average cost of capital or WACC) to determine a risk-adjusted, present value of those cash flows. In addition to external factors such as prevailing interest rates, a DCF valuation makes specific assumptions about a company’s projected performance, debt-to-equity ratio, tax rate and the market in which it competes.
Public Market Comparables
This method leverages public companies’ available financial data and analyst coverage to determine the value of a similar company.
While this data is often plentiful, public comp valuations aren’t always applicable to private companies due to significant discrepancies in size, diversification, and complexity.
Recent, industry-specific M&A transactions are used to derive a company’s valuation in this methodology. Although deal pricing offers a market-oriented approximation of value, company-to-company comparisons have limitations. Unlike public comps, available transaction data can be lacking.
In all methods, the appraiser will also look at non-operating assets and liabilities to determine how these may impact the company’s value, even if these elements do not directly contribute to cash flow.
Valuation Due Diligence
There are often nuances to an individual appraiser’s valuation process, but companies can expect certain, common due diligence requests, including:
- Historical financial statements (audited or reviewed)
- Current year-to-date internal financials
- Five-year projections and supporting operational data
- Outstanding M&A offers
- Recent valuations by another party
Upon completing an initial document review, a valuation firm will often request additional information. What typically ensues is an ongoing dialogue between the appraiser, trustee and the company being assessed. The full process – from initial data request to final valuation – may take a month or longer.
Determining the value of a company for employee ownership purposes is both art and science. The product is critical to initial ESOP transactions and to ongoing plan operations. Although full ESOP valuations are not made public, the information is subject to DOL review, and the value of a plan’s overall assets will appear in a sponsor’s IRS Form 5500 filing.
Therefore, it’s imperative that employee-owned companies, and those considering ESOPs, work with experienced fiduciaries and valuation experts. Fair market value determinations are critical and open to scrutiny. Reputable, independent partners can play a significant role in the success of an employee stock ownership plan.