The Use of Projected Financial Information in ESOP Valuations

Over the past decade, ESOP sponsors’ and advisors’ attention to, and concern regarding, the scrutiny of both the Department of Labor (“DOL”) and Internal Revenue Service (“IRS”) has increased noticeably. These government entities have the responsibility of ensuring that ESOPs are in compliance with the applicable provisions of the Employee Retirement Income Security Act (“ERISA”), the federal income tax code and regulations thereunder (proposed or otherwise). Although there have been numerous areas of concern, recent developments have put the focus on financial projections in ESOP valuations. While it is natural for a company’s management to be optimistic about its outlook, this optimism can result in projections that overstate value, if not properly vetted for consistency and reliability by the valuation expert.

The DOL’s opinion is that it has become too commonplace for valuation experts to accept and utilize management-prepared projections without thoroughly vetting and scrutinizing the projections and the underlying assumptions made by management in their development. Management-prepared projections generally serve as one of the more critical components of the Discounted Cash Flow Method. Therefore, it is imperative that a valuation expert thoroughly understand all assumptions included in the projection process and the associated risks in achieving the forecasted results, in order to be able to determine an appropriate discount rate for the company and its projected results from operations.

When assessing and evaluating the reasonableness of projections, tasks generally performed include but are not limited to:

1. Comparing the current projection with previous forecasts;
2. Understanding the frequency with which management prepares projections and the purposes of those projections;
3. Comparing prior forecasts with actual results and discussing with management the reasons why previous forecasts were exceeded or missed;
4. Reviewing the projections for inconsistencies in mathematical formulas and logic;
5. Comparing projected growth and earnings margins to the company’s historical results, guideline public company estimates, and industry and economic expectations; and
6. Assessing potential management bias in developing the projections and discussing the forecasting process with those responsible at the company.

Additionally, when determining the reasonableness of management’s projections, the trustee or company should consider engaging a qualified CPA firm to perform a quality of earnings (“QofE”) analysis, in order to better understand the value drivers of the company and its prospective earnings power. A QofE analysis focuses on the financial statements, with the goal of determining a company’s assets, liabilities, earnings, and cash flow potential, and assists the valuation professional in understanding how the company records and reports its transactions and results from operations. This analysis includes adjusting historical reported results for items that are nonrecurring and nonoperating, to calculate normalized earnings. These normalized expenses and earnings margins can then be compared to the management-provided projections.

Management projections generally tend to be most reliable and representative of future results when they contain the following:

1. Revenue growth rates that are comparable to historical results or revenue changes that are consistent with industry expectations, the economic outlook, or company-specific factors such as capacity issues or known changes in customers or competition; and
2. Projected expenses and earnings margins that are similar to normalized historical results.

Warning signs of projections that may be overly optimistic or unreliable can include:

1. Projections that are materially different than past results and previous projections;
2. Projections which result in a market value that significantly differs from values derived from alternative approaches or which yield exceptionally high or low valuation multiples; and
3. Projections that are not comparable to analyst estimates for publicly traded companies or industry outlooks.

The valuation expert is tasked with evaluating whether the projections are representative of expected performance and properly supported. When it is determined that this is not the case, the analyst must determine the most appropriate way to bring together the projections and the fair market value of the company. These options include some, all, or a combination of the following:

1. Requesting that management adjust its projections;
2. Revising the assumptions that management relied on and developing modified projections;
3. Adjusting the discount rate to better reflect the risk in the provided projections;
4. Not relying on the projections in the valuation and utilizing alternative valuation methodologies;
5. Making adjustments to future cash flow reserves for capital expenditures and working capital that better match the forecast.

Marcum’s ESOP Advisory Practice provides numerous expert services, including:

• Valuations in connection with transactions involving stock to be acquired by an ESOP (buy-side for the Trustee).
• Fairness opinions in connection with transactions involving stock to be acquired by an ESOP (buy-side).
• Annual ESOP valuation updates for compliance with ERISA (for the Trustee).
• Valuations for ESOP stock redemption (buy-side).
• Valuations for warrant redemptions.
• Valuations for the sale of an ESOP company (buy-side or sell-side).
• Valuations for plan terminations (buy-side or sell-side).
• ESOP valuation feasibility analysis (buy-side or sell-side).
• ESOP transaction feasibility analysis (sell-side).
• Financial statement analysis and input to valuation team and Trustee.
• Quality of earnings analysis (buy-side or sell-side).
• Litigation support involving ESOP companies.

In addition, Marcum can perform a formal Quality of Earnings Analysis within the context of our ESOP transaction advisory services, which can provide a greater degree of confidence to ESOP trustees in matters involving a determination of “adequate consideration.”