Simple Checklist to Understanding the ESOP Valuation Process for Internal ESOP Trustees

Value Management Inc.
Value Management Inc.


Every Employee Stock Ownership Plan (“ESOP”) is governed by at least one trustee.

That trustee can be an individual or individuals employed by, or closely related to, the sponsor company (an internal trustee) or an unrelated party (external trustee).  All ESOP trustees are held to the same fiduciary standards by the Employee Retirement Income Security Act (“ERISA”) and the Department of Labor (“DOL”).

The internal ESOP trustee is entrusted with serious responsibilities, the most important of which might be the oversight of the valuation of the sponsor company’s stock.  In addition to the valuation required for the ESOP transaction, an annual ESOP stock appraisal is required for plan administrative purposes including: making distributions to terminated participants; funding diversification elections; allocating forfeitures; preparing participants’ annual statements, and to complete the annual Form 5500 and the plan audit.

The internal ESOP trustee’s valuation-related duties include:

  • Selecting the ESOP’s financial advisor/business appraiser
  • Reading the appraisal report
  • Understanding the valuation and the conclusion of value
  • Asking questions

Sounds easy, doesn’t it?

It may sound easy but there are some subtle nuances of which you’ll want to be aware.  Read on to learn what steps every internal trustee should take to carry out his/her fiduciary responsibilities.

Step 1: Selecting the Financial Advisor/Business Appraiser

Before hiring the financial advisor/business appraiser, the internal ESOP trustee should check the appraiser’s:

  • Credentials
  • ESOP valuation experience
  • Team depth
  • Independence

The trustee should periodically reassess the business appraiser to make sure they continue to meet these criteria.

Step 2: Reading the Appraisal Report

Not only does the ESOP appraisal have to satisfy the ESOP trustee, it must satisfy the Internal Revenue Service (“IRS”) and the DOL.  These regulations require that the internal ESOP trustee understands the appraisal, not simply adopt the ESOP appraiser’s conclusion.

The appraiser’s report should be concise, readable, replicable and comprehensive.  It should clearly present the internal (e.g. history, markets, customers, etc.) and external (regulatory issues, economic conditions, industry, etc.) factors that impact value.

Specifically, the valuation report should support the conclusion and:

  • Be based on a complete and thorough understanding of the company and its risks and opportunities
  • Consider all relevant factors
  • Be mathematically correct
  • Be based on reasonable assumptions
  • Be in compliance with IRS and DOL regulations

Step 3: Understanding the Valuation Process and the Conclusion of Value

The financial advisor/business appraiser typically arrives at a single conclusion of value which the internal ESOP trustee must then independently affirm.  The starting point is knowing what adjustments (remove atypical, non-recurring or non-operating items), if any, were made to the historical financial statements and why.

To determine the value of the sponsor company’s stock, the appraiser will consider the following approaches and methods:

  • Market Approach
  • Guideline public company method
  • Guideline transaction method
  • Income Approach
  • Capitalization of cash flow method
  • Discounted cash flow method (“DCF”)
  • Asset Approach

One, two, or all of these approaches may be applied.

The internal ESOP trustee needs to understand what approaches and methods were selected and why.  Furthermore, the internal ESOP trustee should understand the variables used under each method and how they were determined.

Factors to consider:

  • Guideline Public Company Method
  • What were the selection criteria?
  • Was there any change from the prior year?
  • Were the guideline public company’s financial statement adjustments consistent with the subject company’s?
  • What quantitative and qualitative analyses were performed?
  • How did the subject company compare to the selected guideline public companies?
  • Guideline Transaction Method
  • How were the transactions selected?
  • Stock or asset sale?
  • Is it a cash deal or was it financed?
  • Is there an earnout?
  • Does the transaction reflect synergistic value?
  • How does the subject company compare to the target companies?
  • What valuation multiples were applied to the subject company?
  • What adjustments were made to the multiples and why?

No matter which of the above methods is used, the internal trustee should be sure to understand what valuation multiple(s) were deemed relevant and why.

  • Capitalization of Cash Flow & Discounted Cash Flow Methods
  • How were the company’s earnings/cash flow capacity determined (capitalization of cash flow method)?
  • Who prepared the projections?
  • What is the projection process?
  • What analysis and due diligence were conducted to arrive at the forecast?
  • What are the projections used for?
  • What are the key assumptions? Are they reasonable?
  • How do the projections compare to the past performance?
  • How does the forecast compare to industry analysis?
  • How successful has the company been in meeting past forecasts?
  • The terminal year may account for a large portion of the value. How is it derived?
  • Understand impact of working capital requirements
  • Understand impact of capital expenditures
  • If using weighted average cost of capital, how was the percentage of debt and cost of debt determined?
  • How was the required return on equity determined?
  • How was the long-term growth rate selected?
  • Asset Approach
  • Why applied or not applied?
  • What, if any, are the adjustments to the stated book value?
  • How does it compare to the past?
  • What are the industry practices with regard to this approach?
  • When might it be relevant?

Finally, the internal ESOP trustee must examine the appropriateness and selection of any valuation adjustments applied, such as control premiums or discounts for lack of control and/or marketability.  Key to understanding these adjustments is the level of value (minority-interest or majority interest), and how the various methods consider the level of value.

For instance, does the income / cash flow projections reflect the amounts available to a minority or a majority shareholder?

Step 4: Asking Questions

It is imperative that the trustee feels comfortable in asking the financial advisor/business appraiser any questions to clarify the valuation process.

Remember the old adage, there’s no such thing as a stupid question!!


Being named as an internal ESOP trustee brings serious fiduciary responsibilities.

There are a number of things to consider, and if the above responsibilities seem daunting please give us a call and let the VMI team show you how to meet your ESOP trustee responsibilities.

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