Determining the fair market value of a sponsoring company’s shares is critical in establishing and administering an Employee Stock Ownership Plan (“ESOP”):
- If the fair market value is too low, the selling shareholders may have little interest in establishing an ESOP; or
- If the fair market value is too high, the shares may not be affordable.
For publicly traded companies, the fair market value of their shares are determined everyday through the aggregate decision-making of millions of investors (i.e., “the stock market”). However, according to the National Center for Employee Ownership, less than 10% of Employee Stock Ownership Plans (“ESOPs”) are in public companies. This creates a valuation problem for ESOP trustees, administrators and participants of the other 90% of ESOPs whose sponsoring company’s shares are infrequently, or perhaps never, transacted.
What is Fair Market Value?
ESOP valuation requirements for non-publicly traded are governed by two agencies: the Department of Labor (“DOL”) and the Internal Revenue Service (“IRS”). Although their definitions of fair market value are not identical, the DOL’s definition of fair market value essentially reflects the well-established definition of fair market value pursuant to the IRS’s Rev. Rul. 59-60:
- IRS Rev. Rul. 59-60: The price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts;
- DOL Prop. Reg. §2510.3-18(b)(2)(i): The price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset.
Additionally, ESOP valuations must also satisfy other DOL requirements regarding adequate consideration. Section 3(18)(B) of the Employee Retirement Income Security Act of 1974 and section 8477(a)(2)(B) of the Federal Employees’ Retirement System Act of 1986 provide that the term “adequate consideration” for assets, other than securities for which there is a generally recognized market, means
The fair market value of the asset as determined in good faith by the trustee or named fiduciary (or, in the case of Federal Employees’ Retirement System Act of 1986, a fiduciary) pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary of Labor.
Determining Fair Market Value for Non-Publicly Traded Companies
There are three generally accepted broad valuation approaches: (1) the asset approach; (2) the income approach; and (3) the market approach. There are many valuation methods under each approach, the application of which should be reconciled be the appraiser to form a valuation conclusion.
Rev. Rul. 59-60 states that the following eight factors, although not all-inclusive, are fundamental and require careful analysis:
- The nature of the business and the history of the enterprise from its inception;
- The economic outlook in general and the condition and outlook of the specific industry in particular;
- The book value of the stock and the financial condition of the business;
- The earning capacity of the company;
- The dividend-paying capacity;
- Whether or not the enterprise has goodwill or other intangible value;
- Sales of the stock and the size of the block of stock to be valued; and
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on exchange or over-the-counter.
ESOP Specific Valuation Considerations
Valuing a non-publicly traded company with an ESOP, the same valuation considerations generally apply; however, the following non-inclusive list illustrates common ESOP-specific valuation considerations:
- Excess Compensation: Similar to other valuation normalization adjustments, consideration should be given whether the ESOP plan expenses are in excess of similar expenses for non-ESOP companies;
- Put Rights: Generally, departing ESOP participants have the right to “put” their shares to the ESOP at their fair market value. In determining the fair market value of the sponsoring company’s shares, this put right generally decreases the magnitude of any applicable Discount for Lack of Marketability;
- The Repurchase Obligation: When a participant leaves or retires from the sponsoring company, the sponsoring company has an obligation to repurchase the ESOP participant’s shares. The sponsoring company can elect one of the following, or a combination thereof, regarding the shares put by the ESOP participant: (1) “redeem” the shares directly; (2) “recycle” the shares using current sponsor funding; or (3) “recycle” the shares using ESOP cash.
- The differences between these alternatives can have distinct implications on the fair market value of the sponsoring company’s shares; and
- ESOP Financing Structure: In a leveraged ESOP financing structure, after the initial ESOP transaction, there may be a decrease in the fair market value of the sponsoring company’s shares due to the additional debt service. However, if all else remains constant, this decrease reverses itself as the debt is repaid.
The IRS requires that a non-publicly traded company obtain a valuation of the ESOP shares each time the plan acquires shares and, at a minimum, at the end of each plan year thereafter by and independent appraiser.
Business owners that may be considering an ESOP as part of their succession plan should be knowledgeable of the valuation considerations effecting ESOPs and consult with appropriate legal counsel and qualified appraisers. For more information contact your MarksNelson professional. See National Center for Employee Ownership website: www.esop.org, accessed January 17, 2017.
 Rev. Rul. 59-60, 1959-1 C.B. 237.
 Proposed Regulation Relating to the Definition of Adequate Consideration, 53 Fed. Reg. 17,632 (1988),
 See 29 USC §1002(18)(B) and 5 USC 8477 §8477(a)(2)(B).
 See generally Pratt, Shannon P., Valuing a Business – The Analysis and Appraisal of Closely Held Companies, Fifth Edition, New York: McGraw-Hill, 2008, 62 – 63.
 Rev. Rul. 59-60, Section 4.01(a) — (h).
 See generally Reilly, Robert F., and Schweihs, Robert P., Guide to ESOP Valuation and Financial Advisory Services, Second Edition, Chicago: Willamette Management Associates Partners, 2007, 217 – 225.
 See 26 USC 401(a)(28)(C).