As a trustee of an ESOP company, it is important to understand the primary drivers of value. We call them People, Processes, Profits. While simple, if you always keep these factors in mind, it will help you make informed decisions on correctly pricing annual shares. Some details about these simple factors that can help you determine how your ESOP company should be priced include:
People – basically the business and the people that run it. Does the sum of the parts create resiliency or is the ESOP-owned company brittle? Here are a few more items to consider when valuing your people.
Business Model: Look at the company’s business model to determine whether it is focused on producing a few products or services or has a more complex business model with multiple products, services, and business lines.
Market Position: Evaluate the company’s market position to determine whether it is a market leader or a follower. Is your company a market leader in a specific niche? Is your company focused on disrupting existing markets or creating new ones?
Management: Assess the company’s management team to see if it has a track record of successfully managing a simple or complex business model. Winners tend to solve problems and win. Other companies never quite reach their potential.
Staff: Many businesses rely on highly trained technical staff. Whether they are licensed mechanics, highly trained programmers, or professional personnel, having a well-trained cohesive team to implement processes is essential.
Processes
Does the Company have well defined processes and procedures for all necessary components of the business? This applies from initial lead generation right though final invoice collection and after-the-sale (or perhaps making the next sale) customer care.
Does the Company have the Processes in place to prepare projections and goals? (This is like playing chess and thinking 3 or 5 moves ahead.)
Do they have regular management meetings and regular staff meetings where goals are reviewed, bottlenecks are resolved, and people are listened to?
“A company has excellent processes when Average People get extraordinary results Every Time.”
Profits
Does the Company consistently make money, or are there frequently reasons why goals were not met?
Are gross profits (including reasonable allocations of soft costs) estimated on jobs, product lines, services? Can more of those goods or services be sold?
In summary, as a trustee of an ESOP company, it is important to understand the company’s People which encompasses the business model, market position, and management; it’s Processes including goal setting and review; and Profits to determine its share value. A highly resilient, consistently profitable business has high value. This can help you make informed decisions that are in the best interest of the plan participants and beneficiaries.
The Art of Business Valuation is pleased to be sponsoring the NCEO 2023 Annual Conference. NCEO is a leading ESOP Association that promotes, educates, and protects ESOP Companies and their employee-owners. Join me and 2,000 employee-owners who are passionate about doing business in a way that offers social wealth and equality for the many! See you at the NCEO 2023 Annual Conference at the Kansas City Convention Center April 25-27. https://www.nceo.org/
Greg Caruso is an expert ESOP business valuator. Let him know if you plan on being at the NCEO Employee Ownership Conference. .
One of the most important roles the Employee Stock Ownership Plan (ESOP) Trustee has is to determine the stock price for the ESOP plan at the time of the initial transaction and then again each year. This is a fiduciary decision that must be made with care and diligence.
This can be a difficult decision as the Employee Retirement Income Security Act (ERISA) does not provide all the specific requirements for setting the price. It does state that part of determining adequate consideration for private companies is the price needs to be no more than Fair Market Value. But blind acceptance of a valuation consultant’s report has been determined to not be sufficient to meet fiduciary obligations.
Below I will provide some suggested steps of how I would review an ESOP business valuation as a valuation expert. Trustees can follow these steps in reviewing an ESOP business valuation. Note that this advice is general in nature and not legal advice. If you have concerns, always get advice from your retained advisors and counsel.
Perhaps the most important part of the process is to document each step as you perform them and document your reasons for all decisions made. Remember, it will likely be a few years later if a problem arises, so clear written documentation is essential.
1. Who is doing your ESOP business valuation?
The Department of Labor has made it clear that you must select a qualified independent valuation advisor. This means at a minimum that the valuation advisor should not have worked for the Company or pre-ESOP company ownership directly. It also means that they should be properly certified in business valuation (Usually an ASA, ABV, CVA designation) and have relevant business valuation experience. There is an art to business valuation and both real world business experience and extensive business valuation experience tend to improve the valuator and their ESOP business valuations. In all cases, review the CV of the valuator and discuss any concerns you have with them. And, as mentioned above, document that you did this.
2. Provide Requested Accounting and Business Data
Assuming you have selected a qualified appraiser, you or management (if you are an internal trustee you have both roles) will receive a rather long document request list. Go through the list with the valuator and make sure all necessary documents are generated and sent to the ESOP business valuator. In addition, depending on the company size, as trustee you should see that the valuator receives correct financials. In most cases that includes at least outside compiled financials for very small companies and reviewed or audited financials for larger companies. Remember, you are the fiduciary and have a say in the level of statements provided. The valuator is allowed to rely on the provided statements.
Valuators are required by standards to receive sufficient documentation in their professional opinion before they can issue a conclusion or opinion of value. Too often a valuator will believe they can issue an opinion, but they will note restrictions or limitations on data received. As a trustee you want to eliminate restrictions and limitations or have the valuator explain them in as much detail as possible.
3. Are Company Projections or Forecasts Reasonable
Valuation is forward looking. That means the business valuator looks to future cash flow. Company provided or approved projections or forecasts (a forecast is the most likely projection to occur) are reviewed and when appropriate relied upon by the valuator to determine future cash flows. Therefore they must be reasonable based on what is known at the time of the business valuation. (They will only rarely be “right” with hindsight.) This means you as trustee should review the assumptions with management and/or the valuator. You must see that past results (and the various line items such as revenues, expenses, etc.) tie into the past. Some companies have reasonable prospects for fast growth. This must be thoroughly explained, documented, and be reasonable when looking at all available facts including industry and economic data. Again, document your process and reasons.
4. Make Sure the ESOP Plan Structure is Taken Into Account
Make sure the structure of the ESOP ties into the assumptions used in the business valuation. Namely does the ESOP have control or is it in a minority position. This will impact discounts and the found ESOP share value.
For annual ESOP valuations considerations include – are appreciation rights or other options accounted for correctly? Has someone estimated repurchase obligations and is that factored into value if material? Finally, has ESOP and other debt been properly calculated and accounted for?
5. Read and Understand the Whole ESOP Business Valuation Report
A properly written full valuation report has many assumptions and detailed explanations of how the work was performed. Make sure you read everything and ask questions where you do not agree or understand. A few critical areas to make sure you understand in addition to those mentioned elsewhere are Adjusting Entries to the Cash Flow, Selected Cash Flow, Calculation of the Discount and/or Capitalization Rate, Excess Assets Calculations, Appreciation Rights or Options, Discounts and the Final Value Found.
6. Market Method Comparisons
There are three valuation approaches: Asset, Market, and Income Approaches. The Market Method of business valuation relies on comparisons to either private company transaction data or public company stock price data. Make sure the comparisons are reasonable. Typically, if using public company stock prices, the valuator will discount the findings due to your company being smaller and having more risk than a large public company. Make sure the reasoning and discount make sense and clearly document why it does.
7. Document Decisions and Send Formal Notes to All Participants
You, as the ESOP trustee, when reviewing an ESOP business valuation have the fiduciary responsibility to determine the correct fair market value for the ESOP trust. Make sure you document all people who assisted and participated in the decision. Document both the process and the reasoning for the decision. If there are material disagreements between people document that, and how and why the final decision was made. Send notes to all participants to ensure clarity as to each person’s participation and opinion.
Clearly having a business valuator that meets or exceeds the qualified independent valuation advisor is a first step starting point. In addition, many trustees have a business valuation background, or they hire a valuation advisor to review the independent valuation advisor’s work. Obtain help from an experienced ERISA attorney for legal representation to ensure all steps are followed and properly documented. Finally, ask yourself, does this all make sense and is it reasonable. Then document how and why.
If you have any questions, reach out to me, Gregory R. Caruso, JD, CPA, ABV, CVA at .
NOTE: We are not providing legal, tax, or accounting assurance advice. This is intended to be general information. All comments are made from the perspective of a business valuation expert practicing in that area. Please consult your advisors and attorneys for specific requirements and compliance advice.
In 2018 the Main Street Employee Ownership Act (MSEOA) was passed. It was thought the MSEOA would allow companies to get an SBA 7(a) loan for an ESOP transition. Unfortunately, the SBA requirements to secure the 7(a) loan for an ESOP transition made it unlikely that anyone to use it. They are still using a case-by-case approval process for ESOP loans. The NCEO outlines those requirements in a recent blog post.
This June, Congress introduced H.R. 8254. The Appropriations Committee report states:
Employee Ownership.–The Committee recognizes that employee-owned businesses are uniquely structured and provide wide-ranging benefits for businesses, workers, and the local economy. The Committee notes that the Main Street Employee Ownership Act, which Congress enacted in section 862 of Public Law 115-232, requires SBA to make structural changes in SBA lending programs to ease the challenges faced by employee-owned businesses in accessing financing. This legislation also requires SBA to use Small Business Development Centers (SBDCs) to establish an employee-owned business promotion program to provide assistance on structure, business succession, and planning. SBA is directed to fully implement these requirements. The Committee further directs SBA to work with the Departments of Agriculture, Labor, and Commerce to provide education and outreach to businesses, employees and financial institutions about employee-ownership, including cooperatives and employee stock ownership plans; provide technical assistance to assist employees’ efforts to become businesses; and assist in accessing capital sources. https://www.congress.gov/congressional-report/117th-congress/house-report/393
If this bill gets passed, it may create a great opportunity for businesses to sell to their employees.
Employee Stock Ownership Plans, better known as ESOPs, are required to have a compliant opinion of business value each year to assist the ESOP trustee in determining the share value for distributions and purchases of beneficiary stock. The trustee has the fiduciary responsibility of representing the employee shareholders, and has final say in determining the company’s share value. Selecting an experienced and professional ESOP business valuator is an important step in properly carrying out the ESOP trustee’s fiduciary duties and selecting the proper annual share value for the following year.
ESOP Experience
A trustee should look for a business valuation company that has already done many ESOP valuations. ESOP valuations are governed by ERISA, the Department of Justice, and the IRS making them subject to serious review. Because of the ESOP structures and ESOP accounting along with qualified options Employee Stock Ownership Plan business valuations are more complex than a general business valuation. The trustee should examine the independent business valuation company’s internal processes and methodologies to be sure they are a good match for the company being valued. Ask for references when selecting an ESOP business valuator. Close attention should be paid if any of the ESOP business valuations completed by the independent valuator have been challenged and the valuator had to make material adjustments as part of a settlement.
Assess “soft” elements of ESOP company
The independent ESOP business valuator will at a minimum review the past five years of financial records from the employee-owned company and their accountants. These are then compared to common sized financial statements and various financial ratios from similar companies within the same industry and the ESOP company’s past and expected future performance. This is followed by reviewing the most recent budget and forecasts for the company. The business valuator also looks at the company management team, customer and/or supplier concentrations, the economic outlook, industry data, and other “soft” elements as part of assessing the risk of the ESOP company making the projected future cash flows.
The ESOP business valuator will prepare all this information into a detailed business valuation report that contains an opinion or conclusion of value. The trustee then uses the valuation to assist in determining the price of the shares that will be distributed or purchased for the following year.
