Rebuttal: Another Point of View Regarding the Role of the Valuation Analyst
In the Formation of an ESOP
Mr. Robert Reilly, in a two-part January 2020 QuickRead article, as published by NACVA, provides a detailed and learned discussion regarding the role a valuation analyst might play in the early stages of the formation of an Employee Stock Ownership Plan (ESOP). This paper is not intended to be, in any way, a critique of Mr. Reilly’s presentation, but rather an appendix highlighting some of the many risks a valuation analyst will face when accepting an ESOP related engagement.
Mr. Robert Reilly, in a two-part January 2020 QuickRead article, as published by NACVA, provides a detailed and learned discussion regarding the role a valuation analyst might play in the early stages of the formation of an Employee Stock Ownership Plan (ESOP). This paper is not intended to be, in any way, a critique of Mr. Reilly’s presentation, but rather an appendix highlighting some of the many risks a valuation analyst will face when accepting an ESOP related engagement. Mr. Reilly rightfully points out, and it is true that in some circumstances, an ESOP may be useful and a preferred vehicle for a partial or complete liquidation of a closely held company’s stock. The feasibility analysis referred to in the article is the first step in the development of an ESOP. In its simplest terms, an ESOP involves the sale of stock by an existing shareholder(s) to a trust; the beneficiaries of which are the company’s employees. While involvement with the formation of an ESOP may present new business opportunities to the analyst, ESOPs are costly to the company, fraught with risks, and, for many reasons, should be avoided by valuation analysts inexperienced in ESOPs. Here is why.
It is pointed out by Mr. Reilly that an ESOP is a qualified ERISA plan, meaning because it is a retirement plan for the employees, it is governed by the Employee Retirement Investment Security Act. This act imposes many requirements on employers and is enforced by the Department of Labor (DOL). All employers, including ESOPs, should beware of the DOL—a powerful enforcement agency.
To paraphrase the National Center for Employee Ownership (NCEO): Valuation is the area of the most intense efforts by the DOL. In legal challenges brought against ESOPs, almost all significant monetary recoveries which can vary from small amounts to tens of millions of dollars, arise from issues surrounding the initial and subsequent valuations. The U.S. DOL has made it clear that it views sales to the ESOP as the most potentially fraught issue and has focused its resources on this area. According to Timothy Hauser, when acting as the Deputy Assistant Secretary for National Office Operations, valuation is the “first, second, third, and fourth problem” with ESOPs. In a 2014 interview published in a NCEO issued brief, Hauser stated that, “We believe there is a chronic problem with ESOP appraisals. To address this problem, we have increased the level of scrutiny of ESOP appraisals. When we go in and open an ESOP case, I ask my field people to take a close look at the appraisal. And we often review the appraisal at the national office as well. The bottom line is that we want ESOP transactions to occur at the right price and be in the best interest of the plan.” (This fact alone, which brings the valuation analysts front and center in most litigation matters involving ESOPs, is cause for great concern. What is the right price for an ESOP transaction? Usually it is the fair market value as defined by revenue ruling 59-60. This brings into play issues of control and marketability that can often lead to disagreement and controversy.) As pointed out by Mr. Reilly, if the company, whose shares are to be sold to the ESOP, has a strategic value greater than fair market value, then perhaps an ESOP trust may not be the best buyer.
The DOL also looks for excessive or improper fees paid to plan service providers. The list of providers is usually long but always includes the valuation analyst. This can be problematic because an ESOP feasibility study and accompanying valuation is extremely complicated, time consuming, and therefore, costly. Also, the analyst’s usual fee structure may need to be increased to pay for additional liability insurance coverage necessitated by the greater likelihood of future litigation. Analysts may want to consult with their insurance agent regarding this issue. ESOPs are qualified retirement plans and coverage related to them is often carved out of many liability policies. If the ESOP is formed and goes forward, the analyst must insist that the plan trustee have a specific fiduciary liability policy, which, should there be a problem, might provide the analysis some cover.
Another sticking point according to the NCEO, is excessively optimistic forecasts, including ones that ignore apparent risks or that project prior-year growth trends into the future without considering how they might change. (This brings into question the use of growth rates included in discount/capitalization calculations that are often projected into perpetuity by valuation analysts.)
Finally, the NCEO points out that companies often take on debt (the seller’s personal guarantee is usually required) as part of an ESOP transaction, and that debt begins to be reflected in the first valuation after the transaction. With this controversial issue in hand, the DOL often argues that the post-debt drop in ESOP share value is evidence of overpaying for the shares. Once again, the light of litigation is shining brightly on the valuation analyst.
An ESOP is also inherently risky due to the many conflicting interests found within its formation. First, the selling shareholder(s) wants the highest possible price and will negotiate to get it, while the employees (who are often left out of the valuation process) want the lowest possible valuation; and keep in mind, the DOL wants the price that is best for the plan, whatever that may mean. This puts the valuation analyst, even in the feasibility phase, directly in the center of a conflict. The analyst, typically brought into the project and paid by the existing shareholder(s) or company, also carries an implied fiduciary responsibility to the ESOP trust. (If implemented, the ESOP fiduciary of record is the plan’s trustee). In addition, should problems arise, the analyst might be held accountable to the DOL. When considering conflicts of interest, a valuation analyst should be wary of plans promoted by investment bankers and consultants who are seeking fat commissions. Even if the valuation analyst has clean hands, they can be dragged into litigation by the acts of overly aggressive and highly commissioned plan promoters.
After formation, potential conflicts can arise between the company management, the ESOP trustee (often a member of the management team), and the employees. For example, the company management may want to adopt a new management compensation plan or explore a new venture while the employees would prefer to stay the course rather than risk capital and future profits. This brings on the menace of potential litigation where the trustee, who is now conflicted and searching for an out, will undoubtedly point a finger of guilt in the direction of the analyst.
Operational control is another area of potential conflict. This is particularly true in a partial buy-out. Sellers may like the idea of the more robust appraisal that gives control or the option for control to the ESOP trust. However, if the seller plans to stay around as part of the management team, egos may be aroused and the actuality of giving up control might become problematic
Another issue to consider when forming an ESOP is capital formation. If the company has an ever-increasing need for investment capital, either debt or equity that cannot be sustained by earnings, the ESOP structure may present obstacles that can prevent the company’s access to these markets. Also to be considered is the possible existence of an agreement with a third related party, such as a franchisor, who requires its approval of any change in management or ownership or perhaps has a right of first refusal to purchase the company’s assets or its stock. Because the ESOP is a retirement plan involving a change of ownership, these considerations can come into play.
Finally, when conducting the due diligence necessary prior to accepting an ESOP engagement, the valuation analyst, among other things, should make a determination of who is really sponsoring the project. ESOPs do not just start on their own. Is it the seller(s), the ESOP consultant, the investment banker, or the employees? If it is the seller(s), is the motivation really for the future well-being of the company and its employees or something less noble? If it is the investment banker or consultant, what is their motivation and track record in implementing ESOP plans? The initiative rarely comes from the employees. ESOPs are extremely complicated and difficult to understand, as a result, most employees do not see ESOPs as a benefit and would prefer a more traditional and proven retirement plan such as a pension or 401K.
In preparing to form an ESOP, there is much to be considered that may be beyond the experience level of the analyst. For example, there are very sophisticated tax advantages associated with an ESOP for both the seller and the trust.
All this being said is not to throw a wet blanket on either Mr. Reilly’s paper or ESOPs, but rather to shed light on just how treacherous ESOP engagements can be for a valuation analyst. Risk is an interesting phenomenon. Those who have operated in a risky environment for a prolonged period often have acquired the experience and knowledge that can immunize them from the fear of risk. I have never met Mr. Reilly but obviously, he is extremely familiar with all aspects of ESOPs and their formation, so while I am certain he is aware of the risks stated herein, perhaps, given his familiarity with the subject, he regards them as nothing more than problems to be solved.
My own experience with ESOPs, however, has taught me that it is an area to be left to the experts. Once taken on, an ESOP engagement, starting with the feasibility analysis, will stay with a valuation analyst forever. So unless and until a valuation analyst decides to dedicate their entire career to the study and complete understanding of ESOPs, when presented with an opportunity to become involved with a feasibility study or valuation for an ESOP, the best course of action might be to refer it to Mr. Reilly.
Mr. McKean, MBA, CVA, was born into an automotive family. His grandfather was the first automobile distributor in the State of South Dakota. His father was a Buick dealer in Sioux Falls for over thirty years. Mr. McKean started his professional automotive career with the Ford Motor Company. While at Ford, he held a wide variety of positions within manufacturing, sales and marketing, and its venture capital division, Dealer Development. His last position prior to leaving Ford was as New England Regional Manager for Dealer Development, directing the activities of as many as twenty-five Ford and Lincoln Mercury dealerships.
Mr. McKean can be contacted at (781) 926-5280 or by e-mail to mmckean@roadmasteradvisors.com.
