Valuation of ESOP Shares

Valuation of ESOP Shares

This article was published in its entirity in CPA Expert; Fall 2005, and reprinted in summary in BV Update; BV Resources; formally Pratt's Stats; March 2006

Opportunities and Challenges in Valuing This Complex Finance Tool

Sam G. Torolopoulos, CPA/ABV

Employee Stock Ownership Plan (“ESOP”) valuations are unique in many ways, the valuation of shares held by the trust requires the review of specific value elements or features which are not a part of performing a  corporate valuation for any other purpose. As we all know, all valuations rely on Revenue Ruling 59-60 which states in part that “fair market value, in effect, as the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under compulsion to sell, both parties having reasonable knowledge of relevant facts.”1 Moreover, the introduction to Revenue Ruling 59-60 states “No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock.”2 What the revenue ruling is saying to the business valuation community is that we must use generally accepted methods of calculating value. The ruling also tells the reader what the Department of the Treasury requires when completing a valuation for gift and estate tax purposes.

The Employee Retirement Income Security Act of 1974 (ERISA) gave the Department of Labor (DOL) oversight as to certain statutory requirements which must be satisfied by the sponsor of an ESOP. To that end, the following represents the unique factors which must be taken into consideration when performing the valuation of stock held by an ESOP Trust (“ESOT”). Those factors are:

• Adequate consideration as it relates to the price paid by the Trust for the stock (extremely important at the time of the transaction);
• Independence and qualifications of appraisers;
• The proper applications of premiums and discounts based on the facts and circumstances of the stock held by the plan;
• Reporting requirements; and
• Proper treatment of multi-stage transactions to the participants, which relates to adequate consideration as well as control premiums.

Adequate Consideration

As it relates to ERISA, the DOL requires that the ESOT pay NO MORE than fair market value or give no more than adequate consideration when purchasing stock from a shareholder. The DOL position is reasonable when you consider that the owner of the Company is the seller of stock and wants the highest possible price; therefore, the plan must be properly represented to insure that the employees do not over pay for the Company stock.  This issue is further complicated when the trustee of the ESOP (party representing the purchaser) is also the party selling stock to the ESOP (owner in control) making it seemingly impossible for the employees to get a fair price. To that end, in 1988 the DOL issued “Proposed Regulations Relating to the Definition of Adequate Consideration” to be followed by independent professionals when conducting appraisals for ESOP transactions3. These regulations are to be followed when valuing stock to be purchased by the ESOP Trust, as well as for shares held in the trust. “Guidance is especially important in this area because many of the transactions covered by these statutory exemptions involve plan dealings with the plan sponsor. A fiduciary’s determination of the adequacy of consideration paid under such circumstances represents a major safeguard for plans against the potential for abuse inherent in such transactions.”4 Finally, the regulations state, “It should be specifically noted that comparable valuations reflecting transactions resulting from other than free and equal negotiations (e.g. a distress sale) will fail to establish fair market value. See Hooker Industries, Inc. v. Commissioner, 3 EBC 1849, 1854-55 (T.C. June 24, 1982).”5 As it relates to the ongoing valuations, the DOL regulations require the appraisal document contain an assessment of all the relevant factors. In the case of a valuation of the stock held in an Employee Stock Ownership Trust, all relevant factors include the factors listed in Revenue Ruling 59-60; as well as those factors listed as 8 and 9 below. The factors are:

1. Nature and history of the company;
2. Economic outlook in general and the outlook of the specific industry;
3. The book value and financial condition of the company;
4. The earning capacity of the company;
5. The dividend-paying capacity of the company;
6. If the company has goodwill or intangible value;
7. The market price of securities of companies engaged in the same or similar line of business, which are actively traded in a free market, either on an exchange or over-the-counter;
8. The marketability of the securities; and
9. The ability to include a control premium.

Independence and Qualifications of Appraisers

The regulations are very clear in stating that the valuator must be independent in fact and in perception. The regulations actually allow the fiduciary to perform the valuation, provided they meet two requirements. First, the fiduciary must be independent of all the parties, other than the plan trust. Second, the fiduciary must have the facilities and the expertise to undertake the valuation. If the fiduciary does not possess the training and expertise to meet these requirements, the fiduciary would fail to meet the prudent investigation and the sound business principals requirement of §2510.3-18(b)(3)(iii).When this occurs, the trustee must hire an independent qualified valuation professional.

Proper Application of premiums and discounts

Discount for Lack of Marketability: With regard to the determination of the marketability of the securities, the DOL states, “the department is aware that, especially in the situations involving employee stock ownership plans (ESOP), the employer securities held by the ESOP will provide a “put” option whereby individuals upon retirement sell their securities back to the employer.”6 The DOL believes the put option should be taken into consideration when valuing the shares held in an ESOP and that the valuator should specifically take the put option into consideration only to the extent it is enforceable and the employer has, and may reasonably be expected to continue to have, adequate resources to meet its obligations. Thus, the department proposes to require that the plan fiduciary assess whether these “put” rights are actually enforceable and whether the employer will be able to pay for the securities when and if the put is exercised7[emphasis added ours]. What is clearly stated by the DOL is that the reduction of the otherwise calculated discount for a lack of marketability shall be based on the facts and circumstances of the subject company, therefore, the valuator must determine if the funding mechanism meets the above requirements. Failure to provide for an adequate funding mechanism by the company will not only cause the discount for a lack of marketability to increase over time as shares allocate and participants vest, it will also jeopardize the tax advantages afforded to the company8. Furthermore, if the funding mechanism is deemed to be “inadequate”, the plan could lose its tax-exempt status.9

Control Premium or Discount for a Lack of Control: With regard to the determination of a control premium the Department of Labor acknowledges that the fiduciary may allow the trust to pay a control premium for a less than 50% block of stock, provided certain requirements are met at the time of purchase. “The Department proposes that a plan purchasing control may pay a control premium, and a plan selling control should receive a control premium.”10 This is generally allowable so long as there is a plan, it is in writing, the plan will obtain both actual and voting control, also known as control in fact, and lastly the plan is not dissipated or diluted shortly after receiving control. The DOL does not make clear how much time can pass before the ESOP has control; some professionals believe that the ESOP needs to have 50.1% by the time the inside loan (the loan between the ESOT and Corporation) for the initial block of stock is paid in full. Still others believe that a reasonable amount of time is finite and much shorter, three to five years. The valuator must also look at factors such as executive compensation and stock based incentive plans to determine if control is going to pass to the trust, and for how long. Giving the ESOP temporary control several years from now with no written plan to sell additional shares will not allow the plan to purchase a minority block of stock for a control price. Lastly, we must keep in mind that if the employees pay a control price they are to receive a control price when they separate from service after having vested. This is commonly known as “control in, control out”.

Reporting Requirements

Proposed regulation §2510.3-18(b)(4)(i) sets forth the general requirements for reporting on the determination of fair market value of stock held inside an ESOP. The regulations indicate a desire to generally follow Rev. Proc. 666-49, 1966-2 C.B. 1257, which describes the reporting format when reporting the fair market value of donated property. Additionally, the Department requires a statement as to the purpose of the valuation.11 Next, the regulations indicate that a statement as to the relative weight accorded to relevant valuation methodology be disclosed. Finally, the department points out in §2510.3-18(b)(4)(i)(G) that the valuator must give a statement as to the effective date of the valuation, which for an initial valuation should be the date of sale.  These are the same requirements which must be adhered to when a valuator is determining the fair market value of stock for any other purpose; these items are stated again for emphasis. These requirements, along with the others given above, as well as those which document the permitted departures from Revenue Ruling 59-60 and progeny rulings (such as when determining the control premium or discount and discount for lack of marketability) encompass the reporting requirement of an ESOP valuation.

Going beyond the DOL regulations

Having a deep understanding of ESOP transactions and keeping up with trends in the industry requires us to go beyond that which is required by any governing body. To that end, current topics of discussion relating to the valuation of ESOP shares include calculating the “Tax Shield”, and determining the proper treatment of second stage transactions.

Calculating the Tax Shield

It has long been understood that there is a significant advantage to the Company of an ESOP in that it gives significant employee benefit deductions generally equal to the principal and interest on the loan used to acquire the shares in the ESOP. To that end, there is recent consensus as to how to properly treat this tremendous benefit when performing the valuation of stock held in the plan during the period of time the debt is being paid. Calculating the Tax Shield consists of scheduling out the net benefit based on statutory tax rates for the Company, and then calculating the present value of the benefit based on the Company’s current equity discount rate. That net present value is then added to the enterprise value in order to come up with value of the shares held in the trust.

Proper Treatment of Multi-Stage Transactions

Since most companies are sold to their ESOT in stages, the valuator must take into consideration the affect each subsequent transaction has on the value of the securities allocated in prior transactions. When a second stage transaction takes place, the new debt on the books of the Company dilutes the value of all the shares in the plan unless the valuator properly accounts for these facts in the valuation. The improper treatment of the current transaction debt can have the affect of underpaying the shareholders of all prior transactions for their shares, should the participant die, retire, become permanently and totally disabled, or quit after vesting, but before the second stage transaction is paid in full. There are a couple of ways in which the fiduciary can protect the shareholders of prior transactions during the time in which the Company is paying for subsequent transactions.

One option for the trustee is to negotiate a floor value for the shares allocated under the initial transaction based on the value at the time of the subsequent transaction. This option attempts to take into consideration the effort put forth by the employees as it relates to the payment of the first loan. What it does not take into consideration is the fact that the value of the stock in the trust will change over time, and any decrease in value attributed to any factor other than the debt associated with the second transaction will unjustly enrich the employees of the first transaction. Because of that, most plan sponsors will not agree to a floor or a “freeze” of the value at the time of the subsequent transaction.

The second, and a more appropriate option, is to have the valuator prepare a valuation which takes into consideration and properly calculates the value the shares paid for, as well as those not yet paid for, as if they were two classes of stock. Under this example, the valuator would value the enterprise without regard to the second ESOP loan. The per-share value would be applicable to the shares purchased and allocated by the plan under the initial transaction, or any shares not currently leveraged. Then the valuator would continue with the valuation taking into consideration the debt and “tax shield” associated with the current stock transaction. Per the discussion above regarding the tax shield, it is important to note that the shareholders of the first transaction have already received the benefit of the tax shield and are not entitled to the benefit of the tax shield of any subsequent transaction. This approach, in the valuators judgment, properly calculates the value the leveraged and non-leveraged shares, properly takes into consideration the “tax shield”, and is the only approach which takes into consideration all other factors required in the regulations. This approach would no longer be required once the leveraged shares on any subsequent transaction are paid in full. Should there be a third sale of stock to the trust, the shares purchased in the first and second block would be treated in the same manner as the first block of stock during the period of the payoff of the second ESOP loan.

Conclusion

            It is clear that the valuation of ESOP shares have some unique features. The relationship between the seller and purchaser can further complicate matters. It is the responsibility of the fiduciary to ensure that the stock held in the trust is valued annually by an independent, professionally credentialed valuator who is capable of understanding and taking into consideration the IRS and DOL requirements. Although DOL regulations do not preclude the seller of stock from acting as the fiduciary, it is clearly not a wise business decision. At the very least, if the seller is the trustee, he\she should surround him\herself with competent, independent professionals who can give sound advice as to how to operate this type of qualified plan with integrity and independence.   It is important for the valuator to maintain that independence, even though it is the fiduciary who hires the valuation professional. Issues such as the determination of premiums and discounts, the proper calculation and application of the tax shield, and the proper valuation procedures to be applied when valuing second stage transactions are important factors to observe when valuing ESOP shares.  To that end the value conclusion should include a notation informing the reader that that the valuator has been engaged to value the shares held by the trust. The valuation of shares held by the trust are unique and therefore, had the valuator been retained to value shares held outside the trust, the approaches, premiums and\or discounts applied would have resulted in value conclusion that, in all likelihood, would be materially different than the value conclusion reached in this report, therefore, no inference of value is to be applied to the shares outside the trust.

Footnotes:

1.  Revenue Ruling 59-60 Sec. 2.02
2.  Revenue Ruling 59-60  Introduction
3.  29 CFR Part 2510.3-18
4.  Par. A of Preamble to Dept of Labor Prop. Reg. §2510.3-18
5.  Par. B.2 of Preamble to Dept of Labor Prop. Reg. §2510.3-18
6.  Par. B.5 of Preamble to Dept of Labor Prop. Reg. §2510.3-18
7.  Id.
8.  IRC §503(a)(1); Tres. Reg. §1.503-1(b)(1); IRC §409(h)(5)(b) ERISA §408(b)(1); 26 CFR §    2550.408b-1
9.  IRC§401(a)(23) and §409(h)
10.  Par B.5 of Preamble to Dept of Labor Prop Reg. §2510.3-18
11.  26 CFR §2510.3-18(b)(4)(i)(E).

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