ESOP valuations contain subjective elements and can cause a variety of problems during an appraisal. Mitigate your risk by understanding the valuation process.

Reducing Risk

Credible Valuations Are Critical to ESOPs

  • Ben Miller
  • 8/12/2016

For many privately-held companies, employee stock ownership plans (ESOPs) can offer advantages to the selling shareholder(s), as well as to the employees who become owners in the business where they work. But estimating the fair market value of a privately-held company’s stock is not a simple process. It is important to understand how appraisers estimate the fair market value of an ESOP-owned company while navigating compliance regulations and the subtleties of each industry.

The benefits of selling your company to an ESOP

Most ESOP-sponsored plans are with privately-held companies. Selling your company to an ESOP can help give you:

  • Liquidity of your stock
  • The ability to gradually sell your business over time
  • Income tax advantages
  • The opportunity to reward employees for helping to build your business

The fair market value of your stock

The fair market value of your privately-held stock is not as readily determined as the value of publically traded stock investments. Instead of “the market” setting the stock price through the daily buying and selling by active investors, an ESOP-owned company’s stock price must be estimated by professional business appraisers using complex valuation methods and models.

Before purchasing or selling within an ESOP, trustees should review the Agreement Concerning Fiduciary Engagements and Process Requirements for Employer Stock Transactions signed by the U.S. Department of Labor and GreatBanc Trust Company.

Because many of the inputs for valuation models are subjective or are based on the appraiser’s professional judgement and experience, it is common that two or more appraisers analyzing the same facts can derive two or more opinions of the stock’s fair market value. Therefore, it is critical to expend significant effort to engage an appraiser or appraisal firm that has demonstrated its competence and experience in the valuation of privately held businesses.

Currently, the Department of Labor (DOL) is focusing its attention on transactions involving ESOPs and non-ESOP shareholders. Its recent lawsuit against the former owner and founder of AIT Laboratories demonstrates the serious nature of these transactions. The case recovered $7.1 million, which was distributed back into the company’s ESOP, and the plan’s trustee was stripped of privileges to serve on any ERISA-covered plans as a fiduciary or service provider in the future.

Factors to consider in selecting an appraiser

Because of increasing ERISA audits of ESOP appraisals, as well as the difficulty and elements of subjectivity in the appraisal of ESOP-owned stock in a privately-held business, your appraiser should have:

  • Independence from the trustee, company, and any shareholders or owners of the business (especially for transactions involving a selling non-ESOP shareholder and the company or ESOP trust)
  • Experience in the valuation of ESOP-owned companies
  • Experience in the valuation of businesses in your company’s specific industry
  • Professional appraiser credentials, such as an Accredited Senior Appraiser (ASA), Accredited in Business Valuation (ABV), Certified Business Appraiser (CBA), Certified Valuation Analyst (CVA), or a Chartered Financial Analyst (CFA)

Valuation for compliance purposes

We sometimes see appraisals of ESOP-owned companies performed by firms or individuals who “know the market.” These firms are typically business brokerage or investment banking firms. While these firms and professionals may be the right choice when it comes to buying and selling a business, they may not be the best choice for appraising the stock of a privately-held company for reporting purposes under ERISA.

ESOP-owned companies often face unique issues such as the stock repurchase obligation, the value of the tax shield of principal payments on ESOP debt, and the impact of the mandatory put option for employee owned stock. Appraisers not experienced in appraising a privately-held company under ERISA may not properly understand or consider these valuation attributes.

Valuation for your industry

Most industries have value drives or accounting conventions that may need to be considered in order to properly value closely held businesses. For example, the values of Software-as-a-Service (SaaS) companies are often driven by their level of subscription-based revenue (with less of an emphasis on profitability), and are viewed differently by investors than enterprise software companies, whose values are typically driven by their expected earnings and cash flow. An appraiser who understands both the common subtleties for accounting in your industry and the value drivers for companies similar to your own can competently determine the fair market value of your stock.

How we can help

CLA focuses on private businesses and their owners. Our professionals frequently specialize in the industries that they have worked in. Some of our construction professionals have poured concrete; some of our health care advisors have been hospital administrators. CLA understands ESOPs and how they work differently by industry. We can help you determine if an ESOP is a good fit for your business, and help you identify your risks as well as the possible rewards.