ESOP Valuation Nuances


What makes ESOP valuations unique from other business valuations? The discussion below highlights some of these nuances.

ESOP Advantages

Employee Stock Ownership Plan is a qualified retirement plan which invests primarily in the sponsoring company stock. The shareholders sell at fair market value and defer capital gains, so long as they sell at least 30% of the company shares to an ESOP and reinvest the proceeds in qualified investment securities (usually public securities). This tax free rollover sale is covered by IRS Section 1042.

Subchapter S corporations owned exclusively by ESOPs pay no Federal income tax. C corps sponsoring leveraged ESOPs can deduct contributions for debt principal (limited by 25% of aggregate payroll) and loan interest.

Preliminary Analysis

Often, the seller of private company stock is uncertain of the value. Thus, we recommend a preliminary analysis be undertaken first, to estimate a range of possible per share value. This early analysis provides the shareholders with the economics of instituting an ESOP.

Discounting Share Value

The sale of at least 30% of the shares (and less than 50%) creates a consideration of discounting for lack of liquidity (not a fluid, public market) and lack of control (minority interest). Offsetting the illiquid investment is the fact that the ESOP will likely purchase more shares over time. Thus, the marketability discount is greatly reduced from the norm. The combined lack of marketability and control discounts often fall in the 20-25% range.

There is one caveat to these discounts. Many advisors have opined that a signed purchase agreement between the sellers and the ESOP that binds the sellers to ultimately sell control to the ESOP should result in no discounts to value, even before the ESOP ownership reaches over 50%.

Repurchase Liability

The ESOP provides for a contracted obligation to repurchase ESOP vested shares at least one year after retirement, death or disability. These distributions are most often in the form of cash. For terminated employees, the payout can be delayed for an additional five years. Mature plans account for repurchases amounts at 2-5% of the plan value, or more. To account for this repurchase liability, cash reserves are usually created. In any event, many plans require that an actuarial analysis of the future purchase liabilities is an essential factor to consider in projected cash flows for the valuation.

Value of Intellectual Property

For ESOP purposes, it is not necessary to identify and value specific intangibles or intellectual property (IP). The value of these assets is included when you value the business enterprise. However, when developing cash flow projections for the business, we account for unique characteristics of IP, such as:

  1. Impact on profit margins
  2. Protection of a product/service is a particular market
  3. Other competitive advantage, such as lower production costs

Impending Contracts

Any near term contracts expected are factored into the cash flow projections. The larger and more certain are these customer agreements, the risk of achieving the cash flow projections is reduced; and, business value increases.

Real Estate Owned by Company

The most reasonable way to treat the owned real estate is the following:

  1. Remove the depreciation from the cash flow (reduction of income)
  2. Charge as an expense a fair rent for use of the facilities
  3. Appraise the real estate and add the value to business enterprise value