Valuing an ESOP: Valuation Assurance

“It is courage based on confidence, not daring, and it is confidence based on experience” -Dr. Jonas Salk

Congress created ESOPs (Employee Stock Ownership Plans) to foster employee ownership so that employees might share in their employers’ successes. To induce owners to implement ESOPs, the proceeds of the sale of the company’s shares to an ESOP are tax deferred, so long as certain requirements are met.

ERISA (the federal Employment Retirement Income Security Act) requires that ESOPs can pay no more than adequate consideration when buying the stock of the company. This means that the owner must make a good faith effort to determine the “fair market value” of securities being sold to the ESOP trust.

The valuation must contain written documentation, and must include provisions that meet the requirements of a special ERISA rule for securities with no generally recognized market. Furthermore, a valuation of the shares held by an ESOP must be performed annually for purposes of allocating and distributing those shares to employees. For these reasons, independent appraisers should be engaged in the valuation of ESOP shares.

Valuing the shares of an ESOP requires the implementation of the valuation techniques outlined in IRS Revenue Ruling 59-60, with certain additions. Thus, the valuation standard applied to ESOPs is the “willing buyer, willing seller” standard applied frequently by the IRS for other types of valuations. The valuation guidance outlined in the Department of Labor’s (DOL) guidelines directs appraisers to consider the following:

  • The nature and history of the business from its inception;
  • The economic outlook in general, and the condition and outlook of the specific industry, in particular;
  • The book value of the securities and the financial condition of the business;
  • The earnings capacity of the company;
  • The dividend-paying capacity of the company;
  • Whether or not the enterprise has goodwill or other intangible value;
  • The market price of securities of corporations engaged in the same or similar lines of business, which are actively traded in a free and open market;
  • The marketability, or lack thereof, of the securities. Where the plan is a purchaser of the securities that are subject to “put” rights, and such rights are enforceable, as well as the company’s ability to meet its obligations with respect to the “put” rights (taking into account the company’s financial strength and liquidity);
  • Whether or not the seller would be able to obtain a control premium from an unrelated third party with regard to the block of securities being valued, provided that in cases where a control premium is taken into account:
    • Actual control (both in form and in substance) is passed to the purchaser with the sale, or will
    • pass to the purchaser within a reasonable time pursuant to a binding agreement in effect at the
    • time of the sale, and
    • It is reasonable to assume that the purchaser’s control will not be dissipated within a short period
    • of time subsequent to acquisition

This list is not exclusive, nor does it relieve the fiduciary from considering all relevant facts and circumstances, or the requirement of good faith. According to the DOL’s guidelines, the requirement of good faith can be met only when the fiduciary can establish that:

  • The fiduciary has arrived at a determination of fair market value by the way of prudent investigation of circumstances prevailing at the time of the valuation, and the application of sound business principles of evaluation; and
  • The fiduciary making the valuation either
    • – Is independent of all parties to the transaction (other than the plan), or
    • – Relies on the report of an appraiser who is independent of all parties to the transaction (other than the plan).

Therefore, when you are involved with the creation of an ESOP, it is important to retain an independent appraiser to issue the valuation report. This will ensure that the valuation satisfies both the “good faith” requirement and the “adequate consideration” requirement.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Tracy Lamb

Orlando Office

407-621-2100 (main)
407-621-2118 (direct)
407-621-2199 (fax)