📢THE UPDATE (10 YEARS LATER) TO: Simple Checklist to Understanding the ESOP Valuation Process for Internal ESOP Trustees📢
An Employee Stock Ownership Trust is established pursuant to every Employee Stock Ownership Plan (“ESOP”) created and 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 UPDATE: Unlike when this blog was first composed ten years ago, there is a new threat to the ESOP community: plaintiff’s attorneys! More and more ESOPs are facing litigation from lawsuit happy attorneys looking for a quick insurance settlement or big payday. Read on for some additional tips on how to best protect yourself and your ESOP.📢
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 completing the annual Form 5500 and the plan audit.
The internal ESOP trustee’s valuation-related duties include:
- Selecting the trustee’s financial advisor/business appraiser
- Reading the appraisal report
- Understanding the valuation and the conclusion of value
- Asking questions
- 📢DOCUMENTATION📢
📢THE UPDATE: As a trustee you are held to the same fiduciary standards as an external trustee who probably review a significant number of annual ESOP company valuations. So, it is critical that you have a thorough process in place to adequately review the valuation, including documentation of the discussion with the valuation advisor. 📢
It may sound easy but there are some subtle nuances to which you’ll want to be aware. Read on to learn what steps every internal trustee should take to conduct 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 UPDATE: In addition to being a qualified business appraiser, the valuation advisor should be experienced/knowledgeable on performing ESOP valuations. Ask how many annual ESOP valuations they perform. Also, find out how involved they are in the ESOP community: do they attend and present at the major ESOP conferences? Also, team depth can be important: does the company have multiple analysts with ESOP experience? Finally, confirm the appraiser’s independence as the trustee’s financial advisor may only perform work for the ESOP trustee and cannot have performed services on behalf of the sponsor company and/or any non-ESOP shareholders.
If the cost of the valuation seems too good to be true- it is.  Saving a few dollars now may not be worth it if it results in a lengthy and costly lawsuit.📢
Step 2: Reading the Appraisal Report
Not only does the ESOP appraisal have to satisfy the ESOP trustee, but it must also 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.
📢THE UPDATE: For ESOP appraisals, longer is not always better. The key to a strong valuation report is accuracy and providing sufficient supporting detail.📢
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.
- Comply with IRS and DOL regulations.
📢THE UPDATE: A comparison to the prior valuation showing the key drivers of change from year to year is a helpful tool for the trustee to easily see and understand mathematically what drove the change. 📢
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.
📢THE UPDATE: A key factor that should be clearly addressed and supported in the valuation report is control or lack thereof: does the ESOP have control, and is the valuation prepared on a consistent basis with the ESOP’s level of control? This is a critical item that both the DOL and plaintiff’s attorneys have attacked.📢
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
- Net asset value method
One, two or all 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?
- Net Asset Value Method
- 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’s 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. Â Key to understanding these adjustments is the level of value (controlling or non-controlling interest), and how the various methods consider the level of value.
📢THE UPDATE: For instance, do the income/cash flow projections reflect the amounts available to a non-controlling or controlling shareholder (again, control issues rearing their head!!)?
The internal ESOP trustee should also understand how the ESOP’s repurchase obligation is being considered in the valuation analysis. Red flags: (1) the ESOP RO is not being considered at all; (2) the entire RO liability is subtracted! 📢
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 adage, there’s no such thing as a stupid question!!
📢THE UPDATE: Step 5: DOCUMENTATION!!
This is a critical step that should not be skipped. To best protect oneself from future criticism, be sure to document each step of the valuation process, including any questions you pose and the responses received. Create a memo and date it each year, especially when interviewing and selecting valuation advisors. Feel free to ask the valuation advisor to answer questions in writing and be sure to document if your question results in any changes in analysis.📢
Summary
Being named as an internal ESOP trustee brings serious fiduciary responsibilities.
📢THE UPDATE: Being named as an internal ESOP trustee may also include taking on risks and maybe even liability. More and more frequently, ESOP companies rely on an external trustee to mitigate these risks and liabilities. However, if you accept the internal ESOP trustee role, following this checklist should help you manage your risk and best serve the ESOP participants.  Lastly, the internal trustees should insist that the company provide him/her with fiduciary liability insurance!📢
There are several factors to consider before accepting the internal ESOP trustee role. If the above responsibilities seem overwhelming/daunting, feel free to give VMI a call and let the VMI team show you how to meet your ESOP trustee responsibilities.