Common Flaws in ESOP Valuations
With the ever-increasing scrutiny of the Department of Labor (“DOL”), the Internal Revenue Service (“IRS”), and the Employee Benefits Security Administration (“EBSA”), valuations of employee stock ownership plans (“ESOP”) are best performed by a specialized valuation advisor. A valuation not tailored to ESOP-specific considerations poses a risk of DOL audit as well as a risk to the reputation of a trustee, who has a fiduciary responsibility to the ESOP. The following are several key considerations for trustees and others, based on Marcum’s experience in performing hundreds of annual updates for ESOP purposes and in advising selling shareholders considering an ESOP as an exit plan. Trustees and valuation advisors must be mindful of these common pitfalls in ESOP valuation reports.
1. Accepting management’s forecasts without proper questioning.
Valuation experts must understand the underlying assumptions as well as the associated risks of achieving those assumptions that are imbedded in the forecast. In many cases, management may not have developed annual forecasts before the formation of an ESOP. Thus, valuation experts must understand how the forecasts were produced, who produced them, and if applicable, how current forecasts compare to prior forecasts. The use and application of management’s forecasts will continue to receive increased attention by the DOL and other administrative and advisory committees. The DOL has established appraisal guidelines1 specifying that, at a minimum, the analysis shall “consider how the projections compare to, and whether they are reasonable in light of, the subject company’s five-year historical averages and/or medians as well as the five-year historical averages and/or medians of a group of comparable public companies (if any exist)” for a set of seven ratios. These are minimum requirements; additional analysis may be required for specific industries. Last, if the appraiser believes that the projections provided by management contain significant forecast risk, appraisers must contemplate this when considering “risk” in one of the key approaches, the income approach by (i) accounting for the increased risk inherent in the projections by providing ample support in risk factors, (ii) requesting new and reasonable projections from management, (iii) rejecting the use of a multi-period discounted cash flow analysis and instead contemplating reliance on historical cash flows as a proxy for the future, and, finally, (iv) properly documenting all of these considerations in the ESOP valuation report for the trustee.
2. Providing sufficient support when considering risk in management-prepared forecasts.
In addition to understanding the process by which the forecasts were produced (when management does prepare forecasts), and after considering a risk factor specific to the company as well as to the forecasts, an adequate level of support must be documented in the workpapers as well as in the final report and/or final exhibits of the valuation. When heavy consideration is applied to the income approach to valuing a company for ESOP purposes, the analysis and documentation surrounding management’s forecasts are considered to be the most important aspects of an ESOP valuation. An ESOP report that uses over-generalized risk factors or items which effect the industry at large but fail to clearly explain how a specific company has additional risks (as compared to the industry) is subject to significant criticism by a trustee, or worse, by the DOL. Additionally, a valuation advisor should also clearly present factors that would favor a decrease in the company-specific risk as well as those factors that would increase such risk. Lastly, risk factors must be quantified in the context of how risk was measured and how the factors in the current valuation differ from those in previous valuations, if any. Trustees and the governing bodies are looking for a trend in management forecasts over time, as opposed to focusing on missed forecasts in the current year.
3. Consideration of alternative methods of valuing a company.
As stated earlier, in some circumstances, approaches other than the income approach should be considered. In many cases, a single period method, such as the capitalization of earnings/cash flow, or other approaches (such as the market approach or the cost approach) may be more appropriate, which will be driven by many factors and by the quality of market data or the financial condition of the company. However, if these approaches are taken, adequate documentation is needed to support these methods.
4. Adequate documentation of the company’s operations.
A defensible and reliable ESOP valuation report to aid the trustee should have a heightened level of detail when discussing the company’s background and operations. Failing to include details of a company’s suppliers and customers, for instance, could result in additional risks the appraiser was not aware of. The stock price of a company for purposes of an ESOP is required to be set annually by the trustee. Trustees will hire qualified business appraisers to inform them on many aspects of the company. Thus, the ESOP valuation report becomes a key document. An insufficient narrative that omits key operational, legal and managerial matters may raise questions about the valuation professional’s understanding of the business and its associated risks.
5. Proper consideration of valuation levels of control.
In the Proposed Regulation Relating to the Definition of Adequate Consideration2, the Department of Labor has stated that that an ESOP may only pay a controlling price level if it has control “in form and substance,” and the control cannot be “dissipated within a short time.” As part of the valuation process for an ESOP company, the level of control is not automatically a result of ownership or the amount of stock controlled by the ESOP. It is essential that valuation professionals read and thoroughly consider the ESOP plan document, the composition of the board (and members’ relative control), and other important governing legal documents that outline how an ESOP plan is to be administered and the true control of the ESOP trustee. A careful consideration of these documents will indicate how to appropriately apply a correct level of control. Under the standard of fair market value (FMV), a hypothetical investor will consider the level of legal and operating control held by an ESOP trust. Once the appropriate level of control is established, it is incumbent on the appraiser to determine how such control is reflected in the analysis (e.g., typically seen in control- based adjustments, or using empirical data from the marketplace if appropriate, when determining value of the ESOP block of stock).
6. Adjusting financial statements to a non-ESOP standard.
When adjusting historical and projected financial statements, a careful study of expenses as well as balance sheet items occurred as a result of the ESOP formation must ensue. As part of the Fair Market Value standard and in any valuation, valuation experts must normalize discretionary expenses that do not exist in a typical well-run, publicly traded company. As part of these discretionary expenses, an analyst must carefully consider what ESOP-related expenses would not occur in a well-run, typically traded public company. Some of these expenses might include excess contribution expenses and ESOP-related professional fees, which are commonly adjusted in an ESOP valuation. However, valuation professional must also consider what expenses should be included, if any, to the ESOP Company that is normally an expense in a well-run, public Company. These could include insurance costs, 401(k) contributions, and other benefits.
7. Contemplating ESOP repurchase obligations.
A repurchase obligation is on off-balance sheet, contingent liability that occurs as a result of the benefit of a “put option” on the ESOP shares in the accounts of ESOP participants, by which ESOP participants can “put” (or sell) their respective shares at fair market value. Although there are differing opinions in the valuation community as to how to treat the contingent liability in an ESOP valuation analysis and report, failing to recognize the timing of possible future repurchase obligations can be problematic for the trustee. Does management have an idea of the timeline of employees’ retirement dates and their ages? Does management, the board, the trustee or the ESOP plan document have a policy in place as to when a repurchase obligation study is required? Does the company have sufficient cash flow or sufficient liquid assets and/or bank capacity to cover unexpected retirements? These are all questions that a valuation advisor must consider and disclose in a report.
8. Assisting Trustees in their responsibility as fiduciaries.
The Employee Retirement Income Security Act of 1794 (“ERISA”) requires that a[n] [ESOP] plan act in the sole interest of the participants in the plan. This includes providing a proper valuation of the ESOP interest, protecting the interests of the plan participants, and approving purchases and sales of ESOP stock. As part of that duty, valuation professionals are hired by the trustee to aid in the analysis and the determination of fair market value of the ESOP stock as of the ESOP anniversary date. What potential risk might be mitigated by a thorough analysis and report by a financial advisor? This scope of services offered by a valuation specialist goes far beyond providing the price per share of a given company. Through their analyses and reports, valuation specialists should be able to call out risks and concerns for consideration by the board and trustee. As ESOP trustees are coming under increasing regulatory scrutiny, is your valuation practice adequately prepared to face the challenges that lay ahead?
1. Department of Labor, Agreement Concerning Fiduciary Engagements and Process Requirements for Employer Stock Transactions, Case 5:12-cv-01648-R-DTB
2. 53 Fed. Reg. 17,632; 17,633 (May 17, 1988), at 29 C.F.R. 2501.3-18(b)(3)(ii).