Valuation Concepts - Independent Valuation Critical for ESOPs

Employee stock ownership plans (ESOPs) offer many attractive tax, financial, and organizational benefits to corporations and their owners. At the same time, ESOPs are strictly regulated to protect employees. For example, the value of ESOP shares that aren’t publicly traded must be determined at least annually by a qualified, independent appraiser.

Plan fiduciaries — which may include trustees, administrators, sponsors, and certain directors or managers — must take special care to act in the best interest of participants. Failure to do so exposes fiduciaries to potential damage claims for breach of fiduciary duty and may result in hefty excise taxes on insiders deemed to have engaged in prohibited transactions (e.g., selling stock to the plan at inflated prices).

The most effective way for ESOP fiduciaries to fulfill their duties is to obtain the advice of qualified independent financial advisors. This advice may extend to a number of areas, from opining on the fairness of proposed ESOP transactions to assisting in the negotiation of loan terms for a leveraged ESOP. This article focuses on the need for a qualified, independent valuation.

Fiduciary Duties With Respect to Valuation
An ESOP is prohibited from paying more than "adequate consideration" for the employer’s stock. A plan’s fiduciaries, therefore, must determine the fair market value of the shares in good faith based on a prudent investigation. While a professional valuation is critical, the fiduciaries’ duties go beyond simply hiring an appraiser. As a federal appellate court explained in Donovan v. Cunningham, 716 F.2d 1455 (5th Cir. 1983):

An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly. To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock — they are entitled to rely on the expertise of others. However, as the source of the information upon which the experts’ opinions are based, the fiduciaries are responsible for ensuring that that information is complete and up-to-date.

Fiduciaries should be familiar with the unique issues involved in ESOP valuations, should engage only qualified valuation professionals, and should work closely with those professionals to ensure that all relevant factors are properly considered.

Special Valuation Concerns
In general, valuation methods for ESOP stock are consistent with established guidelines for determining fair market value in other settings. But there are some significant differences:

ESOPs are required to give participants put options — i.e., the right to sell the stock back to the employer. An appraiser needs to analyze the impact of such rights on the stock’s marketability. The effect on value will depend on the features of the put options in question — especially payment terms — as well as the corporation’s financial ability to meet its repurchase obligations.
Experts disagree on the applicability of premiums when ESOP transactions involve blocks of stock that contain elements of control. Some feel that a control premium should be applied to reflect what a hypothetical willing buyer would pay. Others believe that practical limitations on an ESOP’s ability to exercise control should be taken into account.
One challenge presented by ESOP valuations is determining how to treat cash contributions to the ESOP when applying a valuation method that involves capitalization of economic income.
Leveraged ESOPs raise additional valuation issues concerning the impact of the ESOP debt itself on the value of the corporation’s stock.

To protect themselves from liability, ESOP fiduciaries should engage a valuation professional with the appropriate skills and experience to accurately value the ESOP shares. But they shouldn’t stop there. To ensure that the valuation will hold up in court, they should establish written parameters for the work — including fees, timeframes, and valuation standards. It’s also critical to ensure full disclosure at all levels. Valuators analyze historical information to arrive at an informed conclusion about the future, based on management’s performance. For an accurate valuation, management must be candid about the company’s plans and expectations for the future.

Finally, the most comprehensive, accurate valuation is of little use if the appraiser’s assumptions, methods, and conclusions aren’t adequately documented in a written report.