The Fundamentals of ESOP Valuation: Understanding the Process and Methodologies

April 18, 2023

Understanding the process and methodologies of an ESOP Valuation can help your company grasp an essential component to every employee stock ownership plan (ESOP). This ESOP Valuation guide will review the importance of valuation accuracy, the basic ESOP valuation process, and different methodologies used by appraisers or valuation experts.

What is an ESOP Valuation: An Overview

An ESOP Valuation is the process by which the Fair Market Value (FMV) of a company’s ESOP shares is determined by an independent appraiser and confirmed by the company’s ESOP trustee. Ultimately, under the recommendation of the appraiser, the fiduciary (trustee) makes the final ESOP valuation.

ESOP valuations must be completed annually and with extreme particularity as the ESOP faces great scrutiny from ERISA, the IRS, and the DOL. If you are still asking, “What is an ESOP Valuation?” For ESOP valuation basics, see our Introduction to ESOP Valuations.

The Importance of Accurate ESOP Valuation

An accurate employee stock ownership plan valuation is essential to the legal compatibility and success of an ESOP.  The valuation determines the Fair Market Value of the shares. Fair Market Value is “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts” as defined by the IRS.

Employee stock ownership plans are regulated by the both Employee Retirement Income Security Act of 1974 (ERISA) under the U.S. Department of Labor (DOL), and the IRS. After the DOL reviews ESOP valuations, the value of the plan assets will appear in the plan sponsor’s IRS Form 5500 filing.

Failure to accurately comply with ERISA regulations and IRS requirements can threaten the fiduciary’s individual liability, jeopardize company employee’s retirement savings, and endanger ESOP viability.

A Step-by-Step Guide To ESOP Valuation Process

The ESOP Valuation process takes at least a month as it is multifaceted and requires the cooperation of several individuals. An ESOP Valuation will follow these basic steps:

  1. Your ESOP trustee hires a qualified independent valuation expert or appraiser.
  2. The valuation expert or appraiser examines your company’s data. The appraiser will inspect data such as past financial statements, internal financials, five-year projections, operational data, outstanding M&A offers, and valuations from other parties.
  3. The valuation expert or appraiser determines the FMV of the company’s ESOP shares through various methods (see “methods” below).
  4. Your ESOP trustee reviews the work of the appraiser, and establishes that the value and the method used by the appraiser accurately valuates the FMV of the company’s ESOP shares.
  5. The DOL reviews the ESOP valuations, and then the plan asset values will appear on the IRS FORM 5500 for filing.

This is the basic ESOP valuation process. If information or data is complex, a frequent occurrence, the valuation expert and fiduciary will both enter into dialogue after the initial review until an accurate ESOP valuation is finalized.

Understanding ESOP Valuation Methods

There are several different methods appraisers use to obtain an ESOP valuation. Methods, or combinations of methods, are selected and weighed by the appraiser for the most accurate outcome. Methods are chosen based on your company’s size, competitors, available industry data, and internal information.

Three common methods used in the ESOP valuation process are Income-Based methods, Markets-Based methods, and Asset-Based methods.

Income-Based ESOP Valuation Methods

Income-Based ESOP Valuations methods generate value by working off the expected future income of your business.

The Discounted Cash Flow method is the most common ESOP valuation method. The appraiser uses a rate referred to as the Weighted Average Cost of Capital in order to calculate a present value of those incomes, risk-adjusted. Current interest rates, business’ projected performance, debt-to-equity ratio, tax rate, and the competitive market should all be taken into account by the appraiser.

Market-Based ESOP Valuation Methods

Market-Based ESOP valuation methods directly compare your company’s ESOP share to other shares made publicly available. Two common market-based methods are Public Market Comparable and Precedent Transactions.

The Public Market Comparable method uses publicly available financial information and analyses to determine the value of your company. This method bases your company’s ESOP value off other companies.

The Precedent Transactions method can be utilized when there is not comparable public company data available. Industry-specific M&A transaction data can help the appraiser develop an ESOP valuation. Yet sometimes, depending on the market specific demand, the data reflects inflated values or is missing chunks of transactional data.

Although insightful at times, these methods use public companies and public comp valuations which can be a drawback. Publicly available information is not always comparable to your private company.

Asset-Based ESOP Valuation Methods

Best for asset-heavy businesses, the Asset-Based ESOP valuation methods determine your company’s value using the value of tangible and intangible assets. In this method, the appraiser has to be cautious because the book value of an asset is not always equivalent to the time-adjusted, market value of assets.

Whichever method is chosen, Income-Based, Market-Based or Asset-Based, the appraiser will also need to take into account your company's liabilities and any non-operating assets. Although these may not have a direct effect on cash flow of your company, they do weigh in on your company’s ESOP Valuation.

What is Next for My ESOP Valuation?

Now that I have an understanding of the necessity of an ESOP Valuation, and the processes and methodologies of the valuation, what is my next step?

  • As an ESOP company, we need to hire a trustee, who understands the nuances of the valuation process, and can appoint a qualified appraiser or valuation expert.

Contact Aegis’ ESOP consultants to hire us as your experienced ESOP trustee.

  • My business is considering an Employee Stock Ownership Plan and needs to find out our company value.

Even before an ESOP is established, an ESOP valuation of a business, known as a “Feasibility Study,” is needed. Contact Aegis to conduct a feasibility study.

Contact Aegis today. Our team is happy to discuss the ins and outs of an ESOP valuation and what it would look like for your company.

Ready to find out more?

Get in touch with us to see how we can help your company transition to an ESOP or provide ongoing trustee services.

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