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How to Avoid Mistakes in ESOP Valuations

Feb 9, 2023

Employee stock ownership plans (ESOPs) can be an effective hiring and retention strategy. ESOPs come with the promise of gaining ownership interest in a company, saving for retirement, and joining a rewarding, employee-focused culture. Unfortunately, ESOPs can also draw the attention of the Department of Labor (DOL).

Several court cases have highlighted problems related to inflated stock valuations in ESOP transactions; these problems resulted in participants paying over fair market value. Stock valuation is a key component to the operation of an ESOP, as it determines the value of an employee’s retirement benefits. When participants pay more than fair market value for their shares, they can experience a loss when it comes time to cash in their earnings.

To avoid mistakes that can lead to costly litigation, work with an independent third-party appraiser that specializes in ESOPs and follow a clear and transparent valuation process.

Select a Qualified Independent Valuation Analyst

Due to recent high-profile ESOP valuation discrepancies, the DOL has emphasized the importance of proper due diligence when vetting a valuation analyst. As the individual with authority and discretion over the plan assets, the ESOP trustee has a fiduciary responsibility to hire a qualified certified appraiser to facilitate the valuation process and provide a detailed appraisal report. However, it’s not uncommon for the seller of the ESOP stock to initiate the transaction and be part of the process. Because the seller has a vested interest in the value of the stock price, this may influence and skew the valuation in favor of the seller, which would present a conflict of interest in the valuation report.

As a fiduciary, it is ultimately the trustee’s responsibility to act in the best interest of the ESOP, its participants, and its beneficiaries; therefore, it is their duty to hire a qualified independent appraiser and to facilitate the valuation process.

The DOL requires that an ESOP value its shares annually To determine the fair market value of the ESOP shares, a certified appraiser will generally use one or more of the three generally accepted valuation approaches: income approach, market approach, and asset approach. Often, more than one method may be used to formulate the final value. Depending on the method used, the appraiser will evaluate factors such as the financial performance over the life of the company, future cash flows, previous valuations, and market conditions.

To make ESOP valuations more transparent, the DOL recommends that the trustee provide written documentation outlining the selection process for the appraiser, including those who were considered for the job, their qualifications and references, and a reasonable explanation of why the appraiser was selected to perform the valuation services. Documenting this process will help substantiate any claims against the valuation process and reduce the company’s exposure to litigation.

Ensure Access to Necessary Data

Another responsibility of the trustee is to make sure the appraiser has access to any documentation that supports the company’s value, such as prior valuation reports, projections, audited financial statements, tax returns, corporate documents, legal agreements, loan agreements, and any pending litigation.

Neglecting to consider all relevant documentation has been at the root of many DOL cases recently. In particular, management’s forecasts have received the most attention. Since value is based on the predicted future cash flows of a company, forecasts are a key indicator of a company’s value and have a direct impact on ESOP valuation considerations.

Because forecasts are created by management, the appraiser must apply professional skepticism to critically assess whether documents are reasonable. The ESOP trustee also has a fiduciary responsibility to thoroughly review and question the underlying assumptions used in formulating the valuation report, as she or he will ultimately approve or contest the final valuation.

Consider Company-Specific Risks When Applying Discount Rates

When determining the value of ESOP stock, discount factors are used to convert future anticipated cash flows into present-day value. Circumstances such as a lack of control, marketability, and repurchase liability may reduce the value of the company. However, mistakes can occur when applying valuation discounts if company-specific risks are not considered.

To avoid these mistakes, keep in mind that no single discount rate can be applied across the board. An appraiser must perform a meaningful analysis based on each company’s own risk structure. For example, it’s important to match the discount rate to the risk structure associated with each cash flow stream, adjust discount rates according to real and nominal cash flows, and consider different discount rates for various time periods.

If your organization is considering forming an ESOP, reach out to your CRI advisor to discuss how to avoid common challenges.



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