Valuation Considerations in the Sale of Employer Corporation Stock to an ESOP and to Other Parties Chip Brown, CPA, Steve Whittington, and Robert F

ESOP Valuation Insights

Best Practices

Valuation Considerations in the Sale of Employer Corporation Stock to an ESOP and to Other Parties Chip Brown, CPA, Steve Whittington, and Robert F. Reilly, CPA

Sometimes close corporations sell common stock at the same time to an employee stock ownership plan (ESOP) and to a non-ESOP investor. In such an instance, for many reasons, the values (i.e., prices) of the two blocks of stock may not be the same. This discussion summarizes the different considerations between (1) valuing employer stock for an ESOP purchase transaction and (2) valuing employer stock for a non-ESOP purchase transaction.

ntroduction ed to the level of value, the employer stock rights I and privileges, and the level at which funds are An employee stock ownership plan (ESOP) sponsor transferred from the sponsor company to the ESOP. company may be involved in many types of stock sale transactions over the life of the plan. Valuation These factors may affect the value of all employer analysts who practice in the ESOP discipline are stock that sold or transferred to all parties (includ- most commonly asked to analyze stock sale trans- ing the ESOP). actions between (1) the sponsor company and the Second, this discussion summarizes specific ESOP or (2) the selling/founding shareholders and valuation analyst considerations with regard to the ESOP. sponsor company stock sales to the ESOP versus to However, the sponsor company (or the selling other (non-ESOP) parties. This discussion explores shareholders) may also be involved with the sale of the reasons why two employer stock sale transac- the employer stock outside of the ESOP. For exam- tions that occur on the same day may occur at two ple, the sponsor company could sell employer stock different prices. to key employees, independent directors, strategic Such transactions can be both fair to the ESOP partners, and capital providers. and in compliance with ERISA and other regulatory There may also be sales or other transfers of requirements. As will be considered, such price employer stock that do not involve either the spon- differences may be due to differences (1) in the sor company or the ESOP. For example, key employ- subject securities (e.g., voting stock versus non- ees (and other non-ESOP parties) who own the voting stock) or (2) in the size of the subject block employer stock may transfer that stock in a gift, in of employer stock. an estate, as a charitable contribution, in a marital In addition, two identical blocks of identical dissolution, and so on. employer stock can be sold on the same day at two First, this discussion summarizes the generally different prices, with one block sold to the ESOP accepted business valuation approaches with regard and one block sold to, say, a key employee. This to sponsor company securities. In particular, this discussion explains some of the reasons for such a discussion considers general valuation factors relat- price (and value) difference.

78 INSIGHTS • AUTUMN 2012 www .willamette .com Valuation Analyst 3. Asset-based approach Considerations in Sponsor Income Approach Company Stock Sales to the The income approach is based on the principle ESOP that the value of the employer corporation (or the employer stock) is the present value of the future This discussion first summarizes the generally income expected to be earned by the corporation accepted approaches and methods with regard to owners. the valuation of the sponsor company shares to be sold to the ESOP. There are many different ways to measure income for purposes of an income approach valua- In addition to the generally accepted consider- tion analysis, including the following: ations that apply to any business or stock valuation, 1. Net operating income the following valuation analyst considerations may make the ESOP transaction block of stock different 2. EBITDA from an otherwise identical block of stock: 3. EBIT 1. The level of value to apply in the employer 4. Pretax net income stock valuation 5. After-tax net income 2. The contractual rights and privileges relat- 6. Net cash flow ed to the ESOP-owned stock 3. How the ESOP purchase of the employer Each of these (and other) measures of sponsor stock will be financed company income may be applicable to the sponsor company valuation as long as the discount rate or capitalization rate corresponds to the selected Business and Stock Valuation income measure. A discount rate (also called a “present value discount rate”) is the required rate Approaches and Methods of return on an investment in the sponsor company. There are three generally accepted approaches to There are a number of generally accepted mod- the valuation of the sponsor company and the spon- els that the valuation analyst may use to estimate sor company shares. the discount rate. These models all incorporate the Many close corporation owners and industry following: consultants often believe that there are specific 1. Some measure of market-derived rate of rules of thumb or unique shortcut formulas that are return data only applicable to companies in the subject indus- 2. Some adjustment for the risk of the particu- try. These rules or formulas often relate to some lar sponsor company pricing multiple that is multiplied by a company- specific metric. A capitalization rate is typically calculated as (1) For example, these industry-specific formula the discount rate minus (2) the expected long-term may include the following: growth rate in the particular income measure. So, 1. A multiple × annual company revenue let’s assume that the analyst selects net cash flow as 2. A multiple × annual company EBITDA the income measure for the valuation of the Alpha 3. A multiple × number of company customers Sponsor Company (“Alpha”). 4. A multiple × number of homes passed by Let’s assume that the analyst concludes that 14 the company wire, pipe, cable, etc. percent is the appropriate market-derived discount rate to apply to net cash flow. And, the analyst proj- ects that the Alpha net cash flow will increase at Nonetheless, when the valuation analyst exam- the rate of 4 percent per year over the long term. In ines these so-called industry rules of thumb, they that case, the analyst would conclude a 10 percent may be categorized into the three generally accept- direct capitalization rate (i.e. 14% discount rate – 4% ed business valuation approaches. growth rate = 10% capitalization rate). These generally accepted valuation approaches There are two common income approach valua- are listed below: tion methods: 1. Income approach 1. The yield capitalization method 2. Market approach 2. The direct capitalization method

www .willamette .com INSIGHTS • AUTUMN 2012 79 The valuation analyst will typically use the yield tax rate) = 12% pretax rate. If the analyst applies the capitalization method when the sponsor company 12 percent pretax income capitalization rate to the income (however defined) is expected to change $120 pretax income estimate, the Alpha business (increase or decrease) at a nonconstant rate in the value is still $1,000. future. These last two calculations also answer an This valuation method requires a discrete projec- income approach question commonly asked by an tion of annual income for many years into the future ESOP trustee: should the valuation be performed (typically until the expected long-term growth rate on a pretax basis or on an after-tax basis? As these stabilizes). The analyst calculates the business value calculations indicate, the answer to this question is: as (1) the present value of the projected future cash it doesn’t matter. flow plus (2) the present value of a terminal (or As long as (1) the income measure and (2) residual value) estimated at the end of the discrete the discount/capitalization rates are both adjusted period. Both value components are calculated using by exactly the same income tax rate, then either the above-described present value discount rate. income approach application should conclude the This valuation method is also called the dis- same business value. counted cash flow method. This name is often used even when cash flow is not selected as the measure of the sponsor company income. Market Approach The market approach is based on the principle that The valuation analyst will typically use the direct the sponsor company can be valued by reference capitalization method when the sponsor company to pricing guidance extracted from what investors income (however defined) is expected to change paid in arm’s-length transactions for comparative (increase or decrease) at a constant rate in the investments. future. This method requires a one-year estimate of normalized income for the sponsor company. The The most common market approach valuation analyst calculates the business value by dividing the methods are as follows: one-year income estimate by the direct capitaliza- 1. The guideline publicly traded company tion rate. method (GPTCM) Let’s assume the expected net cash flow for the 2. The guideline merger and acquisition trans- Alpha is $100. Then, based on the above-mentioned actions method (GMATM) 10 percent direct capitalization rate, the Alpha business value would be $1,000 ($100 net cash flow ÷ 3. The backsolve method 10% capitalization rate = $1,000 value). To see how different income measures can be In each of these methods, the valuation analyst used in the sponsor company valuation, let’s assume identifies and analyzes market data regarding arm’s- that the Alpha estimated next period pretax income length transactions. Using these empirical data, the is $1,200. And, based on a 33 percent income tax valuation analyst extracts pricing multiples to apply rate, the Alpha estimated next period after-tax to the subject sponsor company. income is $800 (i.e., $1,200 pretax income less 33% income tax rate). These pricing multiples often include the following: Let’s assume the analyst applies the appropriate cost of capital models to conclude an after-tax net 1. Price to revenue multiple income (and not net cash flow) capitalization rate of 2. Price to book value multiple 8 percent. Applying this net-income-based 8 percent 3. Price to EBITDA multiple capitalization rate to the $800 after-tax income estimate indicates that the Alpha business value is still 4. Price to EBIT multiple $1,000 (i.e., $800 after-tax income ÷ 8% after-tax 5. Price to pretax income multiple capitalization rate = $1,000 value). 6. Price to after-tax multiple Next, let’s assume the analyst adjusts the 8 per- 7. Price to cash flow multiple cent after-tax income capitalization rate for income taxes. The direct capitalization rate income tax adjustment formula is: the after-tax rate of 8% ÷ (1 The analyst typically will apply more than one – income tax rate) = the pretax rate. pricing multiple in the market approach analysis. So, the corresponding pretax income direct capi- And, the analyst will typically apply more than one talization rate is: 8% after tax rate ÷ (1 – 33% income time period in the market approach analysis.

80 INSIGHTS • AUTUMN 2012 www .willamette .com For example, the analyst may derive pricing sponsor company. Typically, it is not reasonable multiples to apply to the sponsor company financial to assume that mean or median pricing multiples fundamentals for these different time periods: would automatically apply to the sponsor company. 1. Latest twelve months actual results This is because the selected companies are not directly comparable to the sponsor company. 2. Next twelve months projected results However, the analyst can compare the sponsor 3. Three-year average actual results company to the guideline companies in terms of 4. Five-year average actual results factors such as (1) relative growth rates, (2) relative profit margins, and (3) relative returns on invest- On each of the GPTCM and the GMATM analy- ment. ses, the analyst first attempts to identify companies From these comparative analyses, the analyst that are directly comparable to the sponsor com- can extract pricing multiples to apply to the sponsor pany. Such comparable companies look very much company financial fundamentals. like the sponsor company. They are about the same The GPTCM is based on the analyst’s consid- size, they operate in the same industry or profes- erations of guideline companies that trade on the sion, they may compete with each other, they have national and regional stock exchanges. Those trad- the same sources of supply, they have the same ing prices and pricing multiples are typically based types of customers, and so forth. on relatively small trades (say, a few thousand When the analyst can identify such comparable shares per trade) of very liquid securities. companies, the market approach analysis is rela- The GMATM is based on the analyst’s assessment tively easy. Of course, the analyst will have to adjust of recent mergers and acquisitions of entire compa- both the comparable companies and the sponsor nies in the sponsor company industry. Therefore, company financial statements for nonoperating these transaction prices and pricing multiples are items, nonrecurring items, differences in account- typically based on what a strategic buyer is willing ing principles, and other so-called normalization to pay to get control of an overall business enter- adjustments. prise. However, then the analyst can often apply the The backsolve method looks at historical sales derived mean or median pricing multiples to the of stock in the subject sponsor company. In other sponsor company financial fundamentals. This use words, the analyst investigates actual, arm’s-length of mean or median multiples is appropriate because sales of sponsor company stock and then develops the selected comparable companies are so similar pricing multiples from those transactions. to the sponsor company. The analyst will typically Such transactions typically represent sales of synthesize (or weight) the various value indications small blocks of stock in very illiquid (sponsor com- into one sponsor company market approach busi- pany) securities. Based on the pricing multiples ness value estimate. indicated by the recent sale transactions, the ana- However, it is rare for the analyst to identify lyst “backsolves” the value of the sponsor company comparable companies for most sponsor compa- overall business. nies. Compared to most publicly traded or recently As indicated above, the different market approach acquired companies, the typical sponsor company is valuation methods could all conclude value indica- much smaller, operates regionally, and operates in a tions based on a different level of value. The adjust- specialized segment of an industry. ments related to level of value are summarized later in this discussion. Therefore, commonly, valuation analysts select and rely on guideline companies. Guideline companies are similar to the sponsor company from an Asset Approach investment risk and expected investment return The asset approach (also called the asset-based perspective. Guideline companies would fit into approach) is based on the principle that the sponsor the same investment portfolio of companies as the company equity value is equal to: sponsor companies. That is, investors would expect the same rates of return and variability of returns the value of the sponsor company assets for all of these companies. However, the guideline less companies would not necessarily “look like” the the value of the sponsor company liabilities sponsor company. Guideline company pricing multiples are more The asset approach is used less frequently (than difficult for the valuation analyst to apply to the the income approach or the market approach) in

www .willamette .com INSIGHTS • AUTUMN 2012 81 the valuation of employer corporation securities for 4. Identified intangible assets (e.g., patents, these reasons: copyrights, trademarks, licenses and per- 1. It is more time consuming and, therefore, mits, computer software, customer relation- more expensive to perform. ships) 2. Many ESOP valuation analysts do not have 5. Intangible value in the nature of goodwill the experience or expertise required to 6. Contingent liabilities value individual assets and liabilities. 7. Recorded liabilities 3. Many ESOP valuation analysts are unin- formed or misinformed regarding the appli- And, to correct the misinformation that many cation of this valuation approach. ESOP valuation analysts believe, the asset approach does not do the following: However, the asset approach is particularly 1. Conclude a liquidation value in the spon- applicable in the following circumstances: sor company; rather, all of the tangible and 1. The sponsor company is either capital asset intangible assets are valued on a value in intensive or intangible asset intensive; that continued use/going concern basis, so the is, the value of the sponsor company relates concluded business value is a going concern directly to the value of its tangible assets or value its intangible assets 2. Consider tangible assets only; rather, in 2. The sponsor company is either a relatively most successful sponsor companies, most new company or has experienced a recent of the business value relates to identified period of negative operating results; there- intangible asset value and to goodwill fore, the market approach and the income 3. Rely on speculative values for intangible approach may understate the value of the assets; rather, these values are exactly the sponsor company. same fair values that would be recorded on 3. The ESOP trustee or the stock acquisition audited GAAP financial statements as the financing source wants to know the debt result of a purchase price allocation collateral value of the sponsor company 4. Result in the net book value conclusion as assets. reported in the sponsor company balance 4. The ESOP trustee or the financing source sheet; rather, a pre–fair value balance sheet wants to know the post-financing solvency and a post–fair value balance sheet bear of the sponsor company. little relationship to each other (except for 5. Any party wants to know what the post- the name of the sponsor company) transaction sponsor company fair value balance sheet will look like if the ESOP stock The common asset approach valuation methods purchase results in a change of control; include the following: such a change in control may trigger the fair 1. The asset accumulation method value purchase accounting requirements. 2. The adjusted net asset value method 6. The ESOP participants want to know exactly why they are being asked to pay a multiple of earnings or a multiple of book value The typical asset approach valuation formula is for the sponsor company; in other words, summarized as follows: what operating assets are the ESOP buying Working capital value in the employer stock purchase transac- + Tangible assets value tion? + Intangible assets value = Total assets value In order to perform an asset approach valuation, the analyst has to identify and value the following – Recorded liabilities value categories of assets and liabilities: – Contingent liabilities value 1. Net working capital (e.g., accounts receiv- = Sponsor company equity value able and inventory) 2. Tangible personal property (e.g., machinery Therefore, in addition to valuing the sponsor and equipment) company intangible assets, the analyst has to also 3. Real estate (e.g., land and buildings) identify and quantify any sponsor company off-

82 INSIGHTS • AUTUMN 2012 www .willamette .com balance-sheet contingent liabilities. Such liabilities 1. Marketable versus nonmarketable—this include lawsuits, environmental concerns, and so criterion indicates how easy it is for the forth. stockholder to sell the employer shares and Typically, the asset approach will indicate the convert that stock investment into cash. sponsor company total equity value on a market- 2. Control versus lack of control—this cri- able, controlling interest level of value. terion relates to how much control the employer stock shareholder has over the sponsor company business operations and Valuation Synthesis and Conclusion strategic direction. At this stage of the employer stock valuation, the analyst will typically adjust all of the value indica- Many ESOP valuation analysts believe that there tions to be on the same level of value. Then, the are only three separate and independent levels of analyst will synthesize (i.e., weight) the income, value: market, and (if performed) asset approach value indications in order to reach one final value conclu- 1. A marketable, controlling ownership inter- sion for the sponsor company business. est (e.g., one stockholder owns 100% of the employer corporation) This weighting is typically based on the analyst’s assessment of the following: 2. A marketable, noncontrolling ownership interest (e.g., as if the employer corpora- 1. The quantity and quality of available data tion stock was publicly traded on a stock 2. The applicability of each approach to the exchange) sponsor company 3. A nonmarketable, noncontrolling owner- 3. The range and reasonableness of the vari- ship interest (e.g., the stockholder owns a ous value indication small block of stock in the private employer corporation) To simplify this discussion, let’s assume that the analyst has now concluded the sponsor company In fact, the above-listed levels of value represent total common equity value. In practice, there is an over-simplification. For all sponsor companies, typically an intermediate procedure. That is, the these two investment criteria each exist on a con- analyst first concludes the sponsor company invest- tinuum, not as discrete points on a graph. ed capital value. Figure 1 more accurately reflects the level of From this invested capital value, the analyst value considerations that the investment analyst subtracts the sponsor company long-term interest- should assess with regard to the sponsor company bearing debt. This calculation results in the total stock: equity value. Where the subject (i.e., ESOP transaction) From this total equity value amount, the ana- employer stock falls in this X axis and Y axis con- lyst subtracts the value of any sponsor company tinuum is a function of the following factors: preferred stock to conclude a preliminary common 1. The absolute size of the subject stock block equity value. The analyst finally adjusts the total common equity value for the proceeds from any in- 2. The relative size of the subject stock block the-money stock options. (compared to other stockholders) The analyst then concludes the final total equity 3. The relative voting rights and policies of the value (and the number of sponsor company out- sponsor company standing shares that include exercised in-the-money 4. The state in which the sponsor company is options). incorporated This above-described procedure is typically 5. The absolute number of board of directors called the waterfall analysis. And, let’s assume the and the rotation of board elections valuation analyst completed the waterfall analysis 6. The potential for a corporate liquidity event for the sponsor company and estimated the total (e.g., IPO, stock tender offer, etc.) common equity value. 7. The ability of the plan participant to put his/her shares back to the sponsor company Levels of Value 8. The contractual rights of the ESOP-owned stock block (such as come-along rights, tag- The term level of value relates to two investment along rights, rights of first refusal, registra- criteria regarding to the employer stock: tion rights, etc.)

www .willamette .com INSIGHTS • AUTUMN 2012 83 tual attribute). However, the analyst Figure 1 should also ensure that the full Sponsor Company Common Stock value increment related to these Levels of Value contractual attributes is considered in the employer stock valuation. It is noteworthy that this contractual rights value increment Absolute should be considered even if the ESOP-purchased stock is not the control of only stock that enjoys that attri- the employer bute. For example, there is still a business value increment associated with dividend preferences and liquidation preferences, even if both the ESOP-owned stock and the key executive-owned stock both enjoy No control at those preferences. The following list presents some

Ownership Control Ownership all of the employer of the common contractual rights and privileges that the valuation business analyst should consider in the valuation of the ESOP-owned employer stock: No employer Employer stock 1. Dividend and liquidation pref- stock liquidity perfect liquidity erences Investment Marketability 2. Mandatory redemption rights 3. Preemptive rights 9. The history of private transactions in the 4. Conversion and participation rights sponsor company stock 5. Antidilution rights 10. The age, investment, retirement, estate, and other plans of the sponsor company’s 6. Registration rights other major shareholders 7. Voting rights 8. Protective provisions and veto rights As mentioned above, the valuation analyst will adjust all of the business value indications to be on 9. Board participation rights the same level of value. Then, the valuation analyst 10. Drag-along rights will adjust that level of value to be consistent with 11. Right to participate in future equity offer- the level that describes the actual marketability and ings control attributes of the ESOP transaction employer stock. 12. Right of first refusal in future equity offer- ings 13. Management rights Contractual Rights and 14. Access to information rights Privileges 15. Tag-along rights In addition to their effect on the employer stock marketability and control attributes, some con- Each of the above contractual rights may relate tractual rights and privileges can separately (and to a particular class of sponsor company equity. materially) affect the value of the ESOP transaction More commonly, these particular rights and privi- employer stock. leges may only relate, by contract, to a particular The analyst should ensure that the value incre- block of employer stock. ment associated with contractual rights is not dou- For example, that block of employer stock may ble-counted (i.e., both considered as a marketability/ be the stock sold to the ESOP, the stock granted to control attribute and then added again as a contrac- identified senior executives, or the stock retained

84 INSIGHTS • AUTUMN 2012 www .willamette .com by certain members of the sponsor company found- stock acquisition loan? The source may be one of ing family. the following: Each of these contractual rights and privileges 1. Employer contributions (“contributions”) has an economic value. And, that economic value from the sponsor company should be considered in the allocation of the overall 2. Profit distributions (“distributions”) from sponsor company business value to that particular the sponsor company block of stock.

In both instances, the cash transfers from the How the ESOP Purchase sponsor company to the ESOP (and, then from the ESOP to the bank, to repay the acquisition loan). of the Employer Stock Is However, the answer to the above question may Financed affect the employer stock valuation. Typically, the ESOP purchase of the employer This is because ESOP contributions are corporation stock is financed by debt capital. This accounted for as an operating expense of the spon- statement is true whether (1) the ESOP purchases sor company, just like any other retirement plan a noncontrolling block of employer stock or (2) the contributions would be. The sponsor company ESOP purchases 100 percent of the employer cor- records that expense, and that expense (like any poration stock. other expense) reduces the profitability of the sponsor company. And, all other things (such as There are various structures through which the discount rates and capitalization rates) assumed ESOP trust can finance the employer stock pur- equal, a sponsor company with lower profits will chase. Some of the common financing structures have a lower stock value. include the following: In contrast, ESOP distributions are not account- 1. The ESOP borrows funds directly from a ed for as an operating expense of the sponsor financial institution, in a so-called outside company, just like any other profit distributions or loan dividends to shareholders. Distributions are the pay- 2. The sponsor company borrows the funds ment of the sponsor net profits to its stockholders. from the financial institution and the ESOP Unlike contributions, distributions are not the borrows the funds from the sponsor compa- payment of an employer expense that reduces ny, through a so-called minor loan structure sponsor company profits. That is, the payment of 3. The ESOP borrows some or all of the distributions does not affect the sponsor profitabil- financing from the employer stock sellers ity. So, all other things (such as discount rates and (in a seller-financed transaction) capitalization rates) assumed equal, a sponsor company profit distribution does not affect the employer stock value. The structure of the employer stock acquisition financing (including debt term, interest rate, Let’s assume the ESOP receives the sponsor prepayment options, etc.) is important to the ESOP, distributions, and then the ESOP pays the bank in of course. However, the structure of the employer order to repay the stock acquisitions loan. However, stock purchase financing is not that important to the this payment is just like any third-party investor employer common stock valuation (i.e., pricing). who buys General Electric Company (GE) common stock on margin. When the investor pays back the However, how the stock purchase financing will stockbroker margin loan from the GE quarterly divi- be paid off may be important to the employer stock dend payments, that margin loan repayment does valuation. This issue relates to who will repay the not reduce the value of the GE stock. employer stock acquisition loan, which may be one of the following parties: To illustrate the effect of how the employer transfers funds to the ESOP, let’s consider two iden- 1. The sponsor company (directly or indi- tical sponsor companies. rectly) Beta Sponsor Company (“Beta”) transfers cash 2. The ESOP (as a sponsor company share- to the ESOP through contributions. Gamma Sponsor holder) Company (“Gamma”) transfers cash to the ESOP through distributions. Both ESOPs borrowed the A more technical way to consider this issue same employer stock acquisition loan, and both is: what is the source of cash to pay the employer ESOPs make the same annual principal and inter-

www .willamette .com INSIGHTS • AUTUMN 2012 85 Since the Gamma Exhibit 1 ESOP owns 80 per- Current Year Summary Income Statement cent of the sponsor company stock, it Beta Gamma will receive 80 per- Sponsor Sponsor cent of all share- Company Company holder distributions. Earnings before interest and taxes and ESOP contributions $10,000,000 $10,000,000 Assuming all income – ESOP contributions 5,000,000 — is distributed in the Earnings before interest and taxes 5,000,000 10,000,000 above example, the – Interest on (non-ESOP) long-term debt 3,000,000 3,000,000 ESOP would receive Pretax income $2,000,000 $7,000,000 80 percent of the shareholder distri- Distribution to the ESOP (based on 80% equity ownership) $5,600,000 butions (i.e., more than enough cash to service the stock est payments to the bank to repay those acquisition acquisition debt). loans. And, the non-ESOP shareholders (i.e., the senior The current year summary financial state- management) would receive the remaining 20 per- ments for both sponsor companies are presented cent of the profit distributions. in Exhibit 1. Unlike the Beta ESOP contributions, the Gamma In both cases, let’s assume that the sponsor com- profit distributions do not reduce the sponsor company stock is owned 80 percent by an ESOP and pany income. And, unlike the Beta ESOP contribu- 20 percent by senior management. In addition, to tions, the Gamma ESOP distributions are not an simplify the example, let’s assume that each spon- economic burden on the non-ESOP shareholders. sor company is an S corporation for federal income Each Gamma shareholder receives a proportion- tax purposes. ate profit distribution. That Gamma shareholder Of course, both Beta and Gamma would have can use that profit distribution to pay stock pur- reported identical income statements prior to the chase debt (as the ESOP will) or not. In contrast, ESOP purchase of the employer stock. For that rea- the Beta $5,000,000 ESOP contribution will cost the son, in both cases, the ESOP would pay the same non-ESOP shareholders $1,000,000. price (i.e., recognize the same fair market value) That is because of the $5,000,000 reduction for the employer stock in the initial purchase of the in the sponsor company income and the fact that sponsor company securities. non-ESOP executives own 20 percent of the Beta However, after the ESOP formation and the income. employer stock purchase, the structure for the stock How the ESOP pays the stock acquisition loan acquisition loan may affect the employer stock valu- (either with contributions or with distributions) also ation. Let’s assume both the Beta and the Gamma impacts the effect of that stock acquisition debt on ESOP need to service $5,000,000 of annual debt the sponsor company valuation. service on the stock acquisition loan. Valuation analysts sometimes value employer Beta transfers the cash to the Beta ESOP as an corporation stock using the direct equity method. ESOP contribution (i.e., an expense). If Beta was a That is, they value the common stock directly with- C corporation, such a cash transfer would make a out reference to the sponsor company total enter- great deal of sense. This is because the $5,000,000 prise value. contribution would be a tax-deductible expense to Beta for federal income tax purposes. (This deduc- More frequently, valuation analysts value tion assumes that Beta meets the payroll-related employer corporation stock using the invested capi- deduction limitations.) tal method. That is, they value the employer corporation total enterprise (also called total invested Since Beta and Gamma are both S corporations, capital). They then subtract the sponsor company there is little value to the ESOP contribution tax long-term debt. And, finally, they subtract any spon- deduction. In contrast, Gamma elects to not rec- sor company preferred stock in order to conclude ognize the cash transfer as an ESOP contribution a residual value for the sponsor company common expense. This recognition increases the Gamma stock. As mentioned above, this residual valuation pretax income. procedure is often called the “waterfall procedure.”

86 INSIGHTS • AUTUMN 2012 www .willamette .com A sponsor company has two categories of long- experience numerous scenarios in which employer term debt recorded on its balance sheets. First, the stock is sold to both an ESOP and a non-ESOP. sponsor company notes payable and bonds payable Such a transaction would occur when the ESOP are recorded as long-term debt. These liabilities rep- (through its trustee) participates in an employer resent funds borrowed by the sponsor company that stock purchase/sale transaction at about the same (1) are used by the sponsor company and (2) the time that a non-ESOP party also participates in an sponsor company is committed to pay back. employer stock purchase/sale transaction. Second, under generally accepted accounting In such scenarios, it is not uncommon that the principles (GAAP), the sponsor company also has two employer stock transactions take place at two to record the ESOP employer stock acquisition debt different prices. as long-term debt on its balance sheet. The GAAP The following discussion summarizes the valua- requirement applies even when the ESOP borrowed tion analyst considerations related to the following the funds directly from a third-party bank. types of employer stock transactional scenarios: This GAAP requirement is appropriate because the sponsor company invariably guarantees the 1. An initial ESOP formation, when the ESOP ESOP debt. That is, if the ESOP does not pay off the purchases sponsor company shares and stock purchase loan, then the bank will look to the special employees also purchase sponsor sponsor company to make good on the loan. company shares With regard to the employer stock value, the 2. A secondary ESOP employer stock pur- valuation analyst will always subtract the sponsor’s chase, when both the ESOP and special long-term debt from the invested capital value in employees purchase additional blocks of order to conclude the employer stock value. sponsor company shares And, the valuation analyst will typically subtract 3. The ESOP does not buy employer shares the ESOP debt recorded in the sponsor company in the current transaction; rather, only the balance sheet from the invested capital value in special employees buy shares order to conclude the employer stock value. This 4. The sale of employer shares only to a capi- is because most sponsor companies make contribu- tal provider (e.g., a venture capital investor, tions to the ESOP, and the ESOP pays off the debt a private equity investor, a merchant bank from these contributions. investor, etc.) As explained above, ESOP contributions (1) 5. The sale of employer stock only to a spon- reduce the employer stock value and (2) are shared sor company strategic partner (a key cus- proportionately by all of the sponsor company tomer, a key supplier, an intellectual prop- shareholders through their percentage of employer erty licensor or licensee, etc.) stock ownership. All C corporation and many S corporation sponsor companies use contributions to 6. A sponsor company repurchase of its own fund the ESOP debt service payments. stock from a non-ESOP party Therefore, the employer stock value is affected 7. The sale or other transfer of employer stock by the following: that does not involve either the ESOP or the 1. How the sponsor company distributes funds sponsor company (e.g., non-ESOP share- to the ESOP for debt service purposes holder gift, estate, charitable contribution, marital estate transfers) 2. How the ESOP receives the debt service funds from the sponsor company (relative 8. Other contractual agreements between the to all of the other employer corporation sponsor company and special employees shareholders) that do not include employer stock transfers (e.g., employment, noncompete, con- sultancy, board membership, intellectual The following discussion relates to the valuation property license, and other agreements) factors that may be different in (1) employer stock sold to the ESOP versus (2) employer stock sold to non-ESOP parties. In these above-listed scenarios, the valuation analyst (and the ESOP trustee) will likely have (1) one set of valuation considerations for transactions Transactional Scenarios involving the ESOP and (2) a slightly different set of The valuation analyst, the sponsor company, the valuation considerations for transactions involving selling stockholders, and the ESOP trustee can the non-ESOP party.

www .willamette .com INSIGHTS • AUTUMN 2012 87 For purposes of this allows special employees to purchase employer “Often, the selling discussion, the term “spe- stock at a favorable price, that decision does not cial employees” is synony- make the sale transaction unfair to the ESOP. stockholders may mous with the term “key unilaterally offer a employee.” For purposes of this discussion, these Factors that Affect the below-market stock are employees who (1) the price to the ESOP as sponsor company wants to Different Valuation retain and (2) are difficult onsiderations a form of gratitude to to replace. C There are a variety of reasons why the valuation In addition to senior the company employ- analyst will apply different valuation considerations management, the special to an ESOP stock transaction as compared to a non- ees or a reward for employees category could ESOP stock transaction. Several of these reasons are include skilled engineers, years of loyal service.” summarized below. scientists, salesmen, pro- duction specialists, quality First, the sponsor company may perceive the specialists, and so forth. ESOP stockholder and the non-ESOP stockholder And, for purposes of this differently. To the sponsor company, the ESOP is a discussion, what makes this class of employees spe- relatively permanent company owner. Certainly, the cial is that management may grant these employees ESOP is a long-term investor that will provide part options, warrants, or rights with regard to the spon- of the permanent capital structure for the sponsor sor company stock. company. As all ESOP practitioners are aware, ERISA In contrast, special employees, strategic part- provides that an ESOP may acquire employer stock ners, and certain capital providers are not long-term “if such acquisition, sale or lease is for adequate investors. The sponsor company wants to retain consideration.” With regard to pricing the employer these parties, of course. And the sponsor company stock, ERISA defines adequate consideration as the wants to compensate these parties for their services. “fair market value of the asset determined in good However, from the sponsor company perspec- faith by the trustee or named fiduciary.” tive, the ESOP stockholder and the non-ESOP These ERISA definitions mean that an ESOP stockholder have (1) different investment time hori- may pay no more than a fair market value price for zons and (2) different investment objectives. the employer stock. However, the ESOP can pay less Second, from the stockholder perspective, the than fair market value for the employer stock. The ESOP and the non-ESOP party may perceive the ESOP may be able to buy the employer stock for sponsor company differently. The ESOP partici- less than fair market value if the trustee negotiates pants own the sponsor company. The ESOP pro- a favorable deal with the sponsor company or selling vides retirement benefits to the plan participants, of stockholders. course. But, the plan participants often seek long- Often, the selling stockholders may unilaterally term capital appreciation over short-term income. offer a below-market stock price to the ESOP as Non-ESOP stockholders typically have a much (1) a form of gratitude to the company employees more finite investment perspective. They typically or (2) a reward for years of loyal service. This plan for a specific exit event after five years (or observation is sometimes presented as one expla- some similar time period). nation for why an ESOP may pay a different (in this The non-ESOP party wants to be compensated case, lower) price for the employer stock than the for the services they provide (e.g., executive talent, non-ESOP shareholder pays. capital, intellectual property.) during the period There are also situations where the sponsor com- they provide that service. Then, they want liquidity. pany or selling shareholders may sell the employer Again, from the stockholder perspective, the stock to non-ESOP shareholders for a below-market ESOP stockholder and the non-ESOP stockholder price. Such a situation often occurs when the spon- have (1) different investment time horizons and (2) sor company wants to attract, retain, or reward different investment objectives. special employees. Third, the ESOP and the non-ESOP parties may In a leveraged employer stock purchase transac- be buying different classes of employer securi- tion, the financing items should be at least as favor- ties. Of course, the type of security will affect the able to the ESOP as they are to the other deal partic- employer stock valuation. For example, the ESOP ipants. However, just because the sponsor company may purchase the employer common stock and the

88 INSIGHTS • AUTUMN 2012 www .willamette .com non-ESOP parties may purchase the employer pre- 5. Registration, transferability, or other liquid- ferred stock. In such a case, the special employee, ity even opportunities remaining family stockholders, or capital sources 6. Right of first refusal and preemptive right may want to be (relatively) assured of periodic dividend distributions. Sixth, the expected term of the employer stock In some instances, the ESOP may purchase the could affect the value of stock purchased by the employer preferred stock. This procedure some- ESOP compared to a non-ESOP party. The common times happens when the sponsor company may run stock typically purchased by the ESOP trust is usu- into contribution tax deduction limitations based on ally perpetual term stock. That is, there is no plan employee payroll levels. for the ESOP trust to redeem the stock (other than In that case, the preferred stock is intended to the ERISA-required plan participant retirement put provide more cash into the ESOP than the sponsor option). company could pay through annual plan contribu- Employer stock sold to a non-ESOP party may be tions. Accordingly, the valuation will be affected by issued with an expected finite term, such as 5 years the type of employer security subject to analysis. or 10 years. After that term, the sponsor company Fourth, the form of ownership may affect the may be able to call the stock. Or, after that term, the value of the employer stock. The ESOP trust will investor may be able to put the entire block of stock typically purchase the employer stock in fee simple back to the employer corporation. interest. That is, the title to the employer stock is Seventh, the liquidity of any security typically transferred from the sponsor company (or from the affects the valuation of that security. As mentioned selling stockholder) to the trust, subject any lien above, the ESOP participants enjoy an ERISA- that the bank may have related to the stock acquisi- required put option. That is, a plan participant of tion loan. a certain age can put the employer shares in his or In contrast, a non-ESOP party may receive only her account back to either the ESOP or the sponsor a fractional ownership interest in the employer company (depending on the plan terms). stock. For example, the special employee may not Over a specified pay-out period, the sponsor actually receive the stock ownership. Rather, the company must buy back the employer shares at employee may receive an option, warrant, grant, or a price based on the valuation analyst’s employer right related to the employer stock. The employee stock fair market value conclusion. Therefore, the or other non-ESOP party rights may vest over time. employer shares in the plan participant accounts This vesting may be a function of the term of have a certain degree of liquidity. employment, stock ownership, debt financing pro- At least when the employee reaches a certain vided, or some other relationship with the sponsor retirement-related age, the employee can put the company. And, therefore, unlike for the ESOP, such employer stock to the sponsor company. Unless employer stock ownership rights may be forfeited there are contractual or other agreements in place, if the sponsor company contractual relationship the non-ESOP shareholder may not have this liquid- lapses. ity expectation. Fifth, the employer security rights and privileges Eighth, the share vesting and allocation period directly affect the value of the employer stock. This may be different for the ESOP stockholder com- occurs when the ESOP and the non-ESOP party pared to the non-ESOP stockholder. The ESOP par- both acquire employer stock (perhaps of the same ticipant will expect the purchased employer shares class) with different sets of rights and privileges. The to be allocated to his or her account as the following valuation analyst will take these different rights into events occur: consideration in the relative valuations of the different employer stock ownerships. 1. The stock acquisition loan is paid by the ESOP For example, the ESOP and the non-ESOP party 2. Contributions and distributions are made could each own employer stock with differing rights by the sponsor company to the ESOP related to the following: 1. Voting versus nonvoting As mentioned above, the non-ESOP party may 2. Dividend and profit participation experience a much different vesting (and, effectively, 3. Liquidation preferences and participation allocation) period. For the non-ESOP party, the 4. Control of the sponsor company board or employer shares may be transferred from the spon- certain management decisions sor company as the employee provides management,

www .willamette .com INSIGHTS • AUTUMN 2012 89 noncompetition, joint venture, financing, or other ments, but they may not have access to the employ- services. er stock valuation reports. Ninth, the expectation of a liquidity event is Eleventh, the ESOP shareholders and the non- different for the ESOP compared to the non-ESOP ESOP shareholders enjoy different levels of share- investor. The ESOP investors may give very little holder protection. The ESOP and the plan partici- consideration to a liquidity event in their employer pants are protected by ERISA. The annual employer stock purchase decision. Their investment objective stock valuation must also comply with ERISA. is to buy and hold the employer stock. ESOP partici- In addition, the annual employer stock valuation pants generally view themselves as the permanent is subject to contrarian review by the Internal owners of the sponsor company. Revenue Service and the U.S. Department of Labor. Typically, their only consideration of a liquidity In contrast, the non-ESOP party is not subject event is a company-wide liquidity event. Such a to ERISA protection. Rather, the non-ESOP party liquidity event would include an IPO or the overall is only protected by any applicable state securities acquisition of the sponsor company. statutes. The non-ESOP party has no assurance that it can (1) purchase the employer stock for no more In contrast, the non-ESOP investor typically than fair market value and (2) sell the employer plans for a specific, short-term liquidity event. And, stock for no less than fair market value. for the non-ESOP investor, the liquidity event is typ- Rather, the non-ESOP party may only be able to ically a contractual event and not a control event. negotiate the best price it can to buy or sell employ- That is, the non-ESOP party may expect to sell er stock. And, that negotiated price may be higher the employer stock back to the sponsor company or lower than fair market value. after the terms of an employment, noncompete, Twelfth, the most significant difference between intellectual property license, debt indenture, or the ESOP and the non-ESOP stockholders may be other contract expires. In contrast, the ESOP the level of value issue. As described above, the expects to be able to (at least) influence when level of value relates to the following two investment a sponsor company IPO or an M&A transaction criteria: occurs. 1. Marketable versus nonmarketable interests Tenth, there may be a difference in the informa- 2. Controlling versus noncontrolling interests tion disclosure rights available to the ESOP compared to the non-ESOP investor. The ESOP trustee receives the employer stock independent valuation The employer stock owned by the ESOP may report each year. That employer stock valuation represent a different level of value than the employ- includes the following: er stock owned by the non-ESOP party. In fact, this 1. Historical and current sponsor company situation will occur quite frequently. That is because financial statements two different shareholders cannot both own a controlling interest in the sponsor company. 2. A current company, industry, and strategic analysis If the ESOP owns a controlling interest, then the non-ESOP party does not own a controlling inter- 3. Projections of future results of operations est. And, if the non-ESOP party owns a controlling (typically) interest, then the ESOP does not own a controlling interest. Therefore, the ESOP trustee receives a fair In addition, many ESOPs have contractual rights amount of sponsor company financial and opera- that allow the plan to acquire ownership control tional information. Most closely held companies are over a period of time. For example, the contract not very forthcoming with such company-specific may allow the ESOP to continue to buy blocks of information. employer stock each year until it (1) owns control In contrast, unless they have specific contractual of the sponsor company or (2) owns 100 percent of rights, the non-ESOP parties do not have access to the sponsor company. the same sponsor company financial or valuation In such a case, the ESOP is often treated as a information. Even special employees (other than control owner (and the employer stock purchase a CEO and CFO) may not have as much access to transaction is often treated as a control level trans- company-specific information as the ESOP trustee action) for employer stock valuation purposes. does. Also, as described above, there are numerous Sponsor company financing sources may have factors (contractual, regulatory, and otherwise) contractual access to the company financial state- that affect the marketability of the ESOP-owned

90 INSIGHTS • AUTUMN 2012 www .willamette .com employer stock compared to the non-ESOP owned purchase. In this situation, employer stock. The valuation analyst should con- the non-ESOP stockholders “. . . different fair sider all of these factors in assessing where each do not subsidize the cost of block of sponsor company stock falls on the market- the ESOP stock purchase market value esti- ability continuum. through (1) reduced (after mates may be plan contribution expense) sponsor company profits appropriate for the Summary and Conclusion and (2) reduced (due to different blocks of lower profits) sponsor com- The experienced valuation analyst should under- pany stock values. sponsor company stand that different fair market value estimates may be appropriate for the different blocks of sponsor There are also a num- stock.” company stock. And, the experienced valuation ber of specific differences analyst should understand that there is even a valu- between ESOP-owned ation difference associated with whether the same employer stock and non- size block of employer stock is owned by the ESOP ESOP owned employer or a non-ESOP party. stock. This discussion summarized many of those differences. The valuation analyst should consider There are generally accepted valuation approach- each of these differences in the relative valuations es and methods related to the valuation of the spon- of the employer stock (1) to the ESOP versus (2) to sor company. And, there are generally accepted con- another party. siderations related to the valuation of ESOP-owned and non-ESOP owned employer stock. There are many different scenarios where a sponsor company may sell or otherwise transfer These valuation considerations are different for stock to the ESOP at a different price than to a the following reasons: non-ESOP party. This discussion summarized many 1. The ESOP and the non-ESOP party have of these scenarios. In these scenarios, the sponsor different investment objectives and differ- company (or the selling shareholders) sell stock to ent investment time horizons. the ESOP, where the ESOP will serve as a long-term 2. The ESOP and the non-ESOP party securi- owner of the company’s permanent capital base. ties may enjoy different rights and privi- In contrast, the sponsor company (or the sell- leges (including ERISA-related rights). ing shareholders) may sell stock to other parties to 3. The ESOP and the non-ESOP party may attract, retain, or compensate key employees, own employer stock at two different levels suppliers, joint venturers, financing sources, of value. and so forth. 4. The ESOP-owned employer stock and the The relationship between these parties non-ESOP owned employer stock may be and the sponsor company is fundamentally paid for from two fundamentally differ- different than the relationship between the ent levels of sponsor company cash flow ESOP and the sponsor company. And, the (i.e., employer contributions that reduce investment criteria of these parties may be the overall sponsor company value versus fundamentally different than the investment employer profit distributions that do not criteria of the ESOP. reduce the overall sponsor company value). The valuation analyst should consider all of these differences when estimating the fair This last difference is particularly important for market value of the employer stock to the an S corporation sponsor company. For an S corpo- ESOP compared to the investment value of ration, there is usually no income tax advantage to the employer stock to any particular non- paying plan contribution versus shareholder profit ESOP party. distributions. However, the employer stock valuation impact Chip Brown, CPA, is a principal in our Atlanta office. of this decision can be material. If the ESOP stock Chip can be reached at (404) 475-2306 or at cbrown@ acquisition loan is repaid from employer contribu- willamette.com. tions, then all sponsor company shareholders share Steve Whittington is a manager in our Atlanta office. Steve can be reached at (404) 475-2317 or at in the cost of the ESOP stock purchase. [email protected]. In contrast, if the ESOP stock acquisition loan Robert F. Reilly, CPA, is a firm managing director and is repaid from the sponsor profit distributions, then is resident in our Chicago office. Robert can be reached only the ESOP pays for the cost of the ESOP stock at (773) 399-4318 or at [email protected]

www .willamette .com INSIGHTS • AUTUMN 2012 91