An Introduction to ESOP Valuations

September 23, 2022

ESOP valuations are a critical component of every employee stock ownership plan (ESOP). Accurate valuations are most obviously necessary in order to ascertain the value of employee shares, but they are also needed well before an ESOP is established. For instance, companies need to conduct an ESOP valuation in order to determine the feasibility of an ESOP, how to best structure the plan, and gauge the impact of the financial implications of forming an ESOP. This is often called a “Feasibility Study.”This begs the question, “How are ESOP valuations determined?”

Why Do Companies Need an Annual Valuation?

An ESOP valuation must be undertaken each year in order to determine the fair market value (FMV) of a share of company stock. This numerical value forms the foundation of how much each employee has invested in their ESOP account and provides a share price which will be paid by the company when a vested employee seeks their distribution and the shares are repurchased by the company. An accurate valuation also provides protection for the company if it ever needs to provide evidence against lawsuits and Department of Labor investigations that claim the ESOP overpaid when purchasing the stock from the plan sponsor.

The Three Key Players Involved in ESOP Valuations

Given the scrutiny ESOPs face from ERISA, the IRS, and the DOL, valuations must be undertaken with extreme care and consideration. Three key players work together to ensure impartiality, accuracy, transparency, and fairness in ESOP valuations.

  1. ESOP Trustee An ESOP trustee is an independent, non-participant representative of the employee trust. ESOP trustees have a fiduciary responsibility to plan participants and act as the shareholder of record. They ensure that the sponsoring company adheres to the terms set forth in the ESOP plan document. ESOP trustees are liable if claims are brought against the ESOP and, as a result, work closely with legal and financial advisors to ensure absolute compliance with both regulatory agency requirements and the plan document. Prior to the formation of the ESOP, the trustee negotiates the final sale price with the plan sponsor, using the ESOP valuation.
  2. Independent Appraiser The independent appraiser is retained by the ESOP trustee to provide a professional, unbiased analysis of the fair market value of the plan sponsor and, subsequently, the ESOP shares. The appraiser must be fully independent of the sponsoring company and its shareholders. The ESOP trustee will use the information and recommendations provided by the appraiser to make the final ESOP valuation.
  3. U.S. Department of Labor (DOL) The DOL exercises federal oversight of all ESOPs, in compliance with ERISA. The DOL is responsible for regulating plan procedures. This includes a review of the plan professionals’ activities. The DOL also verifies that the ESOP sale and annual valuations accurately reflect fair market value.

ESOP Valuation Process

The ESOP valuation process is necessary to determine the fair market value of the ESOP shares. The first step in the process is for the ESOP trustee to hire an independent appraiser. It is the appraiser’s job to determine the FMV of the company’s shares held by the ESOP and it is the ESOP trustee’s job to review the valuation along with the method used to ascertain the value and decide whether or not the presented value is, in fact, fair market value. The Department of Labor reviews ESOP valuations and the value of the plan assets will appear in the plan sponsor’s IRS Form 5500 filing. From start to finish the ESOP valuation process can take a month or longer.

Determining Fair Market Value

Employee stock ownership plans are regulated by the Employee Retirement Income Security Act of 1974 (ERISA). ERISA dictates that an ESOP can neither pay more for company shares nor sell them for less than their “fair market value.” The IRS defines fair market value as “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.”Appraisers use a variety of methods to determine FMV. The method selected depends on the company’s industry and size, their peers and competitors, and available market data. The three methods typically used to attain an ESOP valuation are:

  1. Discounted Cash Flow (DCF) This is based on the anticipated future cash flow of the business and is the most common ESOP valuation method. This calculation uses a discount rate referred to as the weighted average cost of capital to determine a risk-adjusted, present value of those cash flows. DCF valuations take into account current interest rates while also making assumptions about the business’ projected performance, debt-to-equity ratio, tax rate, and the company’s competitive market.
  1. Public Market Comparables This method uses publicly available financial information and analyses to determine the value of a similar company. The drawback to this method is that it pulls data from public companies and uses public comp valuations, which are not always transferrable to private companies.
  2. Precedent Transactions In some situations, recent, industry-specific M&A transaction data can be used to develop an ESOP valuation. This type of information is often used when there aren’t comparable public company data sets available. However, the precedent transaction data may reflect inflated values, depending on the market demand, and may lack transaction data.

Regardless of the method chosen, the appraiser will also examine non-operating assets and liabilities to determine if and how they could impact the company’s value, despite their having no direct effect on cash flow.

ESOP Valuation Due Diligence

The appraiser or valuation expert will examine several pieces of data during the course of their work, including:

  • Past financial statements
  • Year-to-date internal financials
  • Five-year projections and supporting operational data
  • Outstanding M&A offers
  • Recent valuations by another party

The items listed above are the most commonly requested. After finishing their initial review, the appraiser may ask for more information. This usually prompts an ongoing dialogue between the appraiser, the ESOP trustee and the plan sponsor which continues until the valuation is complete.

The Role of the Fiduciary in ESOP Valuations

ESOP valuations are subject to DOL and IRS scrutiny, are critical to the success and legality of an ESOP and represent the retirement savings of employees. Any misstep could impact plan viability and participant benefits. This is why it is so important for plan sponsors to work with experienced fiduciaries. The fiduciary has several responsibilities which help facilitate valuation and protect participants:

  1. Ensure the capabilities and independence of the appraiser or valuation expert.
  2. Provide the appraiser with access to the data required to develop the valuation.
  3. Review company performance projections for accuracy.
  4. Ensure any comparables used are appropriate.
  5. Confirm that the report adheres to the terms of the ESOP.
  6. Review and accept the recommended valuation. Including the valuation methods used, the weightings, calculations, and analysis.
  7. Retain records and draft valuations.
  8. Document the final decision.

Each one of the points above may require the fiduciary to provide additional insight or documentation to explain their use in the valuation.

Do You Need an ESOP Trustee?

Aegis Trust Company is an ESOP trustee. We provide fiduciary services to ESOPs as a transaction trustee or as an ongoing trustee. Our team follows a rigorous internal process that surpasses our competitors and far exceeds the standards imposed by the Department of Labor, ensuring that we fulfill our fiduciary duties to plan participants. Contact us to learn more about our services and find out if we are the right fit for your needs.

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