Fair Market Value and ESOP Valuations

Understanding equity value is not only important on Wall Street but also Main Street. According to the National Center for Employee Ownership (NCEO), employees control approximately eight percent of corporate equity.[1] A company offers stock ownership as a means of incentivizing employees to improve productivity and thereby the performance of the company. The NCEO estimates that productivity improves by four percent to five percent on average in the year an employee stock ownership plan (ESOP) is adopted. At present, the NCEO estimates that there are approximately 6,500 ESOPs that cover more than 14 million participants.

The prevalence of ESOPs signifies its importance as an employee benefit and as a way of providing for employees’ retirement. The ESOP is a trust for employees whereby a company contributes cash to buy company stock, contributes shares directly to the plan, or borrows money to buy shares. In an ESOP, the trust acquires company stock and holds it in the trust for employees where the shares vest over time. When an employee leaves a company with an ESOP trust, the trust pays the employee his/her ownership interest in the vested shares. An ESOP is a qualified retirement plan.

The Board of Directors of closely held companies set up ESOP trusts. Trustees are appointed as fiduciaries to govern the ESOP according to Employee Retirement Income Security Act of 1974 (ERISA) with the Department of Labor having oversight over these trusts. ERISA is a federal tax and labor law that establishes minimum standards for most voluntarily established retirement and health plans to protect individuals in these plans. Federal laws and regulations govern ESOP contributions, allocations, vesting, benefit distributions, diversification, and other provisions.

ERISA standards state that “a fiduciary must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”[2] The ESOP trustees protect the retirement benefits of the trust. Trustees ensure the following: the best interests of the participants are realized, the compliance of the ESOP under ERISA regulations, and the alignment of ESOP policies with the corporate strategic goals.

The value of the Company’s shares is determined by an independent appraiser. The appraiser uses fair market value as the standard of value. Fair market value was defined by the Department of Labor in a 1988 “Proposed” regulation as “the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset. This proposed definition essentially reflects the well-established meaning of this term.”[3] The fair market value of the asset is determined in good faith by the independent appraiser.

The ESOP Trustees review the independent appraiser’s derivation of value. The Trustees, therefore, cannot cause the ESOP to pay more than (or sell for less than) “adequate consideration”[4] for the stock. ERISA regulations tend to support that the ESOP pay the lowest price, or the fair market value.

ESOPs are concerned with fair market value, which considers the seller’s perspective. Further, fair market value reflects the amount the business would be valued in a sale between a buyer and a seller who both have full knowledge of the facts. A fair market valuation considers the market’s value; in other words, “all the potential buyers and sellers of like businesses or practices.”[5] Fair market value also assumes “prevalent economic and market conditions at the time of the valuation.”[6] Market value refers to the price of an asset in the marketplace. For a closely held company, the market equivalent sought usually involves discounting adjustments for lack of control and lack of marketability.

The independent appraiser applies a fair market value standard and reviews the general factors to be considered in the valuation of the equity of closely held companies as follows:

• The nature of the business and the history of the enterprise from its inception
• The economic outlook in general and the conditions and outlook of the specific industry in particular
• The book value of the interest and the financial condition of the business
• The earning capacity of the company
• The dividend-paying capacity of the company
• Whether or not the enterprise has goodwill or other intangible value
• Sales of the interest and the size of the block of interest to be valued
• The market prices of stocks of corporations engaged in the same or a similar line of business, having their stocks actively traded in a free and open market, either on an exchange or over the counter

These factors are defined in the Revenue Ruling 59-60 issued by the Internal Revenue Service in March 1959 and are the basis for the Department of Labor’s determination of “adequate consideration” for valuing ESOPs. The fact that Revenue Ruling 59-60 was initially intended for estate and gift tax purposes and that the Department of Labor has not set forth guidance as to what constitutes “adequate consideration,” ESOP fiduciaries are vulnerable to shareholder disputes filed with the Department of Labor.

As part of the “adequate consideration”, Trustees must consider the independence and qualifications of the appraiser to confirm that he/she is appropriate for performing due diligence and building the financial models and writing the valuation reports. The independent appraiser must not have conflicts of interests. Further, the independent appraiser must document a prudent process to consider the value of and the risks to a company. Specifically, the case involving Keach v. U.S. Trust Co.[7] was a dispute that the valuation expert did not anticipate the risks of a significant adverse impact on the financial situation to result in a lower price per share. The plaintiff asserted that the valuation expert did not foresee market risk in its appraisal, but the valuation expert documented its performance of a management interview, tour of facilities, a review of the business plans and examined the financial documents. The district court found the ESOP had paid fair market value for the stock.

Valuation experts are most criticized in court due to their financial projections. Another case, Perez v. First Bankers Trust Services, Inc.,[8] the valuation expert relied on management’s forecasts that were overly optimistic. The court sided with the Department of Labor expert and determined that the ESOP paid in excess of fair market value. The Trustees have the burden to establish that the ESOP paid no more than the fair market value for the assets and that the fair market value was determined in good faith as the fiduciary. In the Department of Labor’s Proposed Regulations, the proposed regulation defines “adequate consideration” by linking the fair market value and good faith requirements to assure that the resulting valuations reflects market considerations and is the product of a valuation process conducted in good faith.[9] The ESOP Trustees rely on the independent appraiser to value the ESOP shares according to “adequate consideration.”

As part of the valuation of the ESOP shares, the independent appraiser considers three approaches: the asset approach, the income approach, and the market approach.

The asset approach results in the net asset value that is the liquidation value and is generally not representative of a going concern entity with significant operating earnings relative to the value of the underlying assets.

The income approach relies on the capitalized earnings method based on converting a single period of economic benefits into a present value or the discounted cash flow (DCF) method which captures the future earnings potential of the subject company based upon differing cash flow streams. The DCF method sums the present value of the future expected free cash flows, using a risk-adjusted discount rate.

The market approach relies on market data from the guideline public companies and compares the subject company to public company peers or the guideline transactions method that evaluates public/private transactions and compares those valuation metrics to the subject company.

Generally speaking, the valuation process involves multiple methods that are weighted according to the merits of reasonableness. A control adjustment is considered as a controlling interest is considered to have greater value than a minority interest because of the purchaser’s ability to affect changes in the overall business structure. A control premium occurs with ownership control and is also referred to as an “acquisition premium” when the standard of value is investment value because the particular buyer included synergies to be realized from the purchase. The fair market value standard refers to a hypothetical and willing buyer and does not include an “acquisition premium” for the subject company because no synergies are included.

A discount for lack of marketability is considered for shares in closely held entities because the shares are not publicly traded and therefore lack marketability. Empirical studies have been performed for restricted stocks and pre-IPO shares that quantify a marketability discount in the valuation of privately held securities. Because ESOPs are required to include a “put option” as part of the trust document, a discount for lack of marketability tends to be lower than reflected in the empirical studies. In a “put option,” the employee has the right to put the shares to the company and the company has an obligation to buy back those shares. The “put option” is a repurchase obligation to buy back shares from ESOP employees according to the distribution policies of the trust document. The result of the valuation is the value of the ESOP shares based on a non-marketable majority or minority interest using the fair market value standard of value.

Management decision-making benefits from ESOP share price valuations. ESOPs can be used to acquire and retain talent, but the key to effective implementation involves communicating its current and future benefits. A well-conceived ESOP can provide long-term benefits to a company, enhancing operating performance and the sustainability of a company.[10] Shareholders that are employees are considered good owners.

Building equity value, sharing that value through an ESOP, and measuring that value using fair market value standards in good faith are successful hallmarks of many closely held companies that want to continue beyond their founder’s tenure. The ESOP equity share price is important to many constituents of a closely held company and knowledge of it directly benefits the employees. Understanding that equity value in the context of the fair market value standard of value is important to the growth of ESOPs.

[1] National Center for Employee Ownership (NCEO) found at: https://www.nceo.org.

[2] U.S. Code, Title 29. Labor. Chapter 18. Employee Retirement Income Security Program. Subchapter I. Protection of Employee Benefit Rights. Subtitle B. Regulatory Provisions. Part 4. Fiduciary Responsibility, Section 1104. Fiduciary Duties (ERISA §404(a)).

[3] Department of Labor Proposed Regulation §2510.3-18(b)(2)(i) of the Act and section 8477 (a)(2)(B) of The Federal Employees’ Retirement System Act of 1986 (FERSA).

[4] Department of Labor Proposed Regulation §2510.3-18(b)(2)(i). of the Act and section 8477 (a)(2)(B) of The Federal Employees’ Retirement System Act of 1986 (FERSA).

[5] Pratt, Shannon P., Alina V. Niculita, Valuing a Business, The Analysis and Appraisal of Closely Held Companies; Fifth Edition, The McGraw-Hill Companies, Inc. (2008).

[6] Id.

[7] Debra K. Keach and Patricia A. Sage v. U.S. Trust Company, formerly known as U.S. Trust Company of California, N.A., 2005 U.S. Court of Appeals for the Seventh Circuit. LEXIS 17355, Argued December 10, 2004, and Decided August 17, 2005.

[8] Thomas E. Perez, Secretary of Labor v. First Bankers Trust Services, Inc., Civil Action No. 12-4450 (MAS)(DEA) U.S. District of New Jersey, March 31, 2017.

[9] Department of Labor Proposed Regulation §2510.3-18(b)(2)(i). of the Act and section 8477 (a)(2)(B) of The Federal Employees’ Retirement System Act of 1986 (FERSA).

[10] Cook, Greg and Nick Dolan, a Prairie Capital Advisors, Inc.’s webinar, “Sustainability Series: ESOP Sustainability 101,” May 14, 2020.

The HoganTaylor Forensic, Valuation and Litigation Support  Practice

If you would like more information about Fair Market Value, ESOP Valuations and how they could affect the value of  your  business, please contact FVLS Practice Lead, Clay Glasgow, at cglasgow@hogantaylor.com, or any other member of the HoganTaylor FVLS practice.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.