A Note on ESOP Valuation

A Note on ESOP Valuation[1]

One of the most critical issues regarding valuation is the concept of adequate consideration.  The ESOP trustee cannot pay more than “adequate consideration” for the stock it purchases.^[2]   In the context of an ESOP, ERISA defines adequate consideration as the stock’s “fair market value…as determined in good faith by the trustee…”^[3]  The proposed Department of Labor regulations define “fair market value” as the “price at which [the stock] would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell…”^[4]  The regulations go on to say that the fair market value must be determined “as of the date of the transaction” and must be reflected “in written documentation of valuation.”^[5]

In order to establish fair market value for the stock of a company whose securities are not readily tradable on an established securities market, the trustee must—by law—hire an “independent appraiser.”^[6]  In the context of an ESOP, an independent appraiser is someone who does not perform any other services for a party whose interest may be adverse to the ESOP, including the selling shareholder(s), and who meets an objective standard of impartiality.^[7]  More simply, the trustee should select an appraiser who has no other business relationship with the company or its shareholder(s).^[8]

In order to determine fair market value for the stock that the trustee is purchasing from the company’s shareholder(s) on behalf of the ESOP, the independent appraiser engages in a thorough due diligence process in which he or she collects and reviews company documents and information, such as historical financial statements and projections; material contracts and lease agreements; corporate legal documents, such as articles of incorporation, bylaws, and buy-sell agreements; descriptions of past transactions involving company stock; and any relevant environmental or industry information.  He or she also meets with company management and conducts on-site inspections and interviews.  After the appraiser completes his or her due diligence, he or she reports a range of fair market value of the company’s stock only to the trustee and its legal counsel. The trustee negotiates the purchase price and the other terms of the transaction with the selling shareholder(s), and the final purchase price cannot exceed the top end of the range of value. ^[9]  It is important to note that the standard of value is the amount a “financial buyer” would pay, which in certain situations, may be less than the amount a strategic buyer is willing to pay.  The trustee is legally prohibited from paying more than fair market value for the stock on behalf of the ESOP. The adequate consideration requirement places a great deal of scrutiny on the advantages that the non-ESOP parties (such as the selling shareholder(s) and the company’s key employees) could gain as a result of the ESOP transaction.^[10]  In addition to the requirement that the ESOP cannot pay more than fair market value for its investment, the adequate consideration standard also requires that the ESOP transaction be “fair” to the ESOP relative to the other parties to the transaction.^[11]

The trustee can establish that he acted in “good faith” in determining fair market value if he relies on the report of a qualified independent appraiser.^[12]  A qualified independent appraiser is one who (1) holds himself or herself out to the public as an appraiser or performs appraisals on a regular basis and is qualified to make appraisals of the type of property being appraised; and (2) is independent with respect to the company and the other parties to the ESOP transaction other than the ESOP itself.^[13]  The proposed regulations provide that the appraiser must apply “sound business principles of evaluation” and “conduct a prudent investigation of the circumstances prevailing at the time of the valuation.”^[14]  The “sound business principles of evaluation” requirement includes the application of the generally accepted approaches to valuation, which are the Income Approach, the Market Approach, and the Asset-Based Approach, along with the companying methodologies to the various approaches.^[15]

Under the proposed regulations, the “written documentation of valuation” must be signed and dated by the appraiser and include the following information:

• A summary of the appraiser’s qualifications
• A statement of the value of the stock that the ESOP trustee is purchasing and the methods the appraiser used in determining value
• A full description of the stock that is the subject of the valuation
• All of the factors the appraiser considered in making his determination of fair market value
• The purpose of the valuation
• The relevance or weight the appraiser gave to the valuation methodologies he or she used
• The effective date of the valuation, which is the closing date of the ESOP sale.^[16]

Although not legally required, it is prudent that the trustee have the appraiser issue a fairness opinion as of the date of the ESOP transaction, which states that the price and other financial terms of the transaction are fair to the ESOP participants.  The ESOP is also required to have its stock appraised as of the last day of each plan year and upon the occurrence of certain activities.^[17]

[1] An excerpt from “Consider ESOPs as an Estate Plan Component for Business Owners,” Finnell, Kelly O., and Andrew T. Holmes, Estate Planning, Volume 41, Number 2, 2014, Thomson Reuters/RIA.

[2] Employment Retirement Income Security Act (ERISA) of 1974, 29 U.S.C. §1002(18) (2012).

[3] Employment Retirement Income Security Act (ERISA) of 1974, 29 U.S.C. §1002(18) (B) (2012).

[4] DOL Prop. Regs. §2510.3-18(b) (2) (I).

[5] DOL Prop. Regs. §2510.3-18(b) (2) (ii), (iii).

[6] IRC §401(a) (28) (C).

[7] Jared Kaplan, Gregory K. Brown, and Luis Granados, “Basic Requirements of an ESOP,” 354 Tax Mgmt. Port. (BNA) ESOPs A-14 (2010).

[8] Corey Rosen, “Understanding ESOP Valuation,” in Leveraged ESOPs and Employee Buyouts, Sixth Edition, 31, 33 (Vaughn Gordy, Neal Hawkins, Mary Josephs, William Merten, Rebecca Miller, Scott Rodrick, Corey Rosen & John Solimine, Eds., 2013).

[9] Employment Retirement Income Security Act (ERISA) of 1974, 29 U.S.C. §1002(18) (2012); DOL Prop. Regs. §2510.3-18(b) (2).

[10] Susan L. Mueller and Judith C. Gehr, “Valuation Issues in Multi-Investor ESOP LBOs,” in ESOP Valuation, Third Edition, 25, 27 (Scott S. Rodrick ed., 2005).

[11] Id.

[12] DOL Prop. Regs. §2510.3-18(b) (3) (ii).

[13] John W. Murphy and John P. Murphy, “An Introduction to ESOP Valuation,” in ESOP Valuation, Third Edition, 1, 20 (Scott S. Rodrick ed., 2005).

[14] DOL Prop. Regs. §2510.3-18(b) (3) (ii) (A).

[15] A discussion of valuation is beyond the scope of this article.  For more in-depth discussions regarding valuation and the various methods of valuation, see John W. Murphy and John P. Murphy, “An Introduction to ESOP Valuation,” in ESOP Valuation, Third Edition, 1 (Scott S. Rodrick ed., 2005) and Corey Rosen, “Understanding ESOP Valuation,” in Leveraged ESOPs and Employee Buyouts, Sixth Edition, 31 (Vaughn Gordy, Neal Hawkins, Mary Josephs, William Merten, Rebecca Miller, Scott Rodrick, Corey Rosen & John Solimine, Eds., 2013).

[16] DOL Prop. Regs. §2510.3-18(b) (4) (I) (A)-(H).

[17] Rev. Rul. 80-155, 1980-1 C.B. 84.

Kelly Finnell, JD, CLU, AIF, is president and CEO of Executive Financial Services, Inc. He has published 13 articles on the use of ESOPs in ownership succession planning and is the author of one of the most highly acclaimed books on the subject, The ESOP Coach: Using ESOPs in Ownership Succession Planning. Mr. Finnell graduated from the University of Memphis, magna cum laude, and from the University of Memphis Cecil C. Humphreys School of Law, where he was published in the University of Memphis Law Review, served as chief justice of the Moot Court Board, received the American Jurisprudence Award for Equitable Remedies, was the recipient of the Judge John D. Martin Scholarship, and was named to Who’s Who Among Students in American Universities and Colleges. Mr. Finnell can be reached at (901) 259-7979 or kfin@execfin.com.

Andrew T. Holmes, JD, LLM, is vice president and shareholder of Executive Financial Services, Inc. After receiving a JD from Mississippi College School of Law, he received an LLM in taxation from Washington University in St. Louis School of Law. Mr. Holmes is a member of the Tennessee and Mississippi Bar and recently received a Retirement Plan Fundamentals Certificate from the ASPPA. He co-wrote an article published in the September 2014 issue of Estate Planning, and he is a featured panelist at the National Center for Employee Ownership (NCEO) Annual Employee Ownership Conference in April. Mr. Holmes can be reached at (901) 259-7900 or at aholmes@execfin.com.

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