For business owners who are evaluating exit strategies, the first question is often, “How much money can I get when I sell my company?” After all, getting liquidity out of the business is often a primary reason for selling to an ESOP.
The answer to this question is not always as simple as a sale price. Selling to an ESOP can involve tax benefits and sale structure advantages that can net a seller more over the long term than even a strategic premium third party offer can deliver.
An essential step is establishing fair market value for the business, which in turn determines the ESOP company stock price. The company stock price is determined on an annual basis by an independent appraiser, as required under Internal Revenue Code Section 401(a)(28)(c).
What do these requirements mean to a business owner who is ready to sell, and what conditions and variables can impact an ESOP company’s stock price, both at the time of sale and on an annual basis?
In this article, we’ll examine a few key factors surrounding ESOP valuation and ESOP stock price, including:
- How a valuation professional determines fair market value
- Factors that influence stock price
- Steps and business information required for an annual stock valuation
While a lot of focus goes toward the determination of ESOP value at the sale, these same considerations are relevant annually at stock valuation time.
What is Fair Market Value?
In short, the Internal Revenue Service (IRS) defines “fair market value” as a company valuation standard that arrives as a price at which the sale transaction would take place between a buyer and seller in which neither party is under compulsion to buy or sell. In addition, arriving at fair market value assumes that both parties to the sale have reasonable knowledge of the relevant details affecting company sale price.
Why is Fair Market Value Important for ESOP Sales and Annual Valuations?
First, it is vital to remember that an ESOP is more than a company structure and means of ownership transition. An ESOP is a qualified retirement plan, and that means it must meet certain regulatory requirements prescribed in the IRC and the U.S. Department of Labor regulations under the Employee Retirement Income Security Act (ERISA).
An ESOP sale creates a buyer and relies on fair market value, rather than finding a buyer on the market and arriving at company value through potentially aggressive negotiations. The ESOP trustee acts on behalf of the company employees, who become the company owners at sale. Employees’ interest in the company are long-term and personal, and they contribute to company value through their productivity, engagement, and work. In turn, ESOP stock value delivers a retirement benefit to employees when they retire or leave the company.
A third party purchaser, on the other hand, may have various interests in a company, some of which could involve taking over customer relationships and winding the company down after purchase.
|So while a third party, such as a competitor, may offer a strategic premium, the impact of that transaction could be devastating to employees who depend on the company for their jobs.|
So it makes sense that fair market value is determined both at sale and annually, and the fair market value approach has the potential to deliver value on all sides of the sale, especially over the long term.
For the seller, ESOP tax and sale structure advantages can deliver added value over time. For employees, rising stock prices deliver value at retirement. And for the company, employees’ commitment to stock value drives productivity and supports an ownership culture that can reduce turnover and improve engagement.
What Are Some Typical ESOP Valuation Approaches?
Business consultants often address valuation methods as separate and unrelated. An independent ESOP valuation professional typically uses several valuation techniques to arrive at a company valuation, weighting certain methods over others as appropriate for the industry and other company variables. The most commonly used methods include:
- Capitalization using discounted cash flow: This income approach method is often used with smaller privately held companies whose future cash flows can be difficult to forecast. Discounted cash flow is the sum of future cash flows expressed in current dollars, and capitalization rate is determined by accounting for risk to those cash flows.
|Business Fair Market Value Estimate||=||Single Period Estimate of Next Year’s Earnings|
- Multiples of EBITDA: This method is a multiple of enterprise value to EBITDA. Enterprise value is the total value of the company, regardless of debt or equity employed in the company’s capital structure. EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a measure of a business’s pre-tax operating cash flow.
This is a market approach to valuation that’s similar to real estate comparables. It uses comparisons to publicly traded companies that are similar and/or recent sales of similar closely held businesses. These values are available to valuators on a number of transaction databases.
- Asset approach: This method uses market value of tangible assets like equipment and real estate, and intangible assets such as patents and trademarks to determine company value. It’s most relevant for asset-intensive businesses.
These and other methods are selected and weighted by the valuation professional, who uses the combined, weighted outcomes to arrive at company value. It’s important to understand that independent, professional valuators rely on a combination of research, experience, and professional judgment in their work.
How Do Stock Value Discounts Apply?
An ESOP sale is a stock sale — but because the business is privately held and the transaction creates a market and a buyer, there is no ready market for company stock. To account for this, a “marketability discount” is often applied to the valuation of a privately held company’s stock. It’s important to note that a discount for lack of marketability is part of valuation in all privately held company sale valuations, not only ESOPs.
In the cases when less than 50.1% of a company is sold to an ESOP, an additional minority interest discount may be applied to the stock value. This discount recognizes the lack of control the ESOP trust would have, compared with the seller’s majority interest.
Factors That May Influence ESOP Sale and Annual Stock Price
The most influential factors include:
- Historical financials and forecasts — forward-looking cash-flow generating capacity versus risks
- Competitive landscape and industry or market changes or disruptions
- Company changes year over year — real estate, facilities, headcount
- Customer information — new customers, lost customers, customer concentration
- Company debt
- Key supplier changes or changes to agreements
- Outstanding stock options, warrants, or other liabilities — including stock repurchase obligations
What to Expect: Steps in the ESOP Valuation Process
No two companies are exactly alike and additional follow-up information may be required at any step, but generally, the valuation process is straightforward and predictable:
- Company leadership gathers and provides relevant information to the valuation professional. This can include:
- Income statements, balance sheets, notes and supplementary schedules
- Corporate income tax returns
- Most recent year-to-date interim financial statement, and the statement for the same period in the previous year
- Long-term and short-term budgets
- Business plan and financial forecasts
- Fixed asset depreciation schedule
- Loan agreements and amortization schedules
- Key supplier and customer agreements
- Other documentation, as necessary
- Company management, ESOP trustee, and valuator meet to discuss and address any additional information needs.
- The valuator selects and weights methods and calculates value.
- In a sale appraisal, the valuator provides the trustee a fair market value range to use in negotiating the sale.
- In an annual valuation, the valuator writes a detailed report explaining how (s)he arrived at each factor and the valuation, and sends the report to the ESOP trustee.
- The ESOP trustee and valuator meet to discuss the valuator’s conclusions.
- In an annual valuation, the ESOP trustee sets the share price based on the valuation report.
ESOP Stock Price Valuation Doesn’t Have to Be Stressful
Overall, many ESOP companies find the sale transaction and annual valuation to be less stressful than third party sale negotiations or M&A transactions. In fact, many ESOP companies use the annual stock price reveal as a way to support and promote employee ownership culture within the organization.
Over time, employees embrace and internalize the ESOP culture perspective, and come to see the link between employee performance and ESOP share value. That results in a true three-way win: the seller, the company, and the employees all stand to gain over the long term.
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