609-664-7955 gcaruso@artofbv.com

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 gcaruso@artofbv.com.

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.