How Is the Annual Price of Your ESOP Shares Determined?

You may be fortunate to be employed at one of the 6,500 companies in the U.S. that sponsor an employee stock ownership plan (ESOP). If not, perhaps you will be in the future, since ESOPs are increasingly attractive retirement plans that exhibit bipartisan support. Outside of ESOPs, very few employees have the unique long-term benefit of equity-like incentives with their employers, since those benefits are typically reserved for those in the C-suite.

Being part of an ESOP company can be very exciting and rewarding. But those sharing in this broad-based benefit can also find it challenging to understand how the ESOP structure works and why the share price fluctuates through the years.

Unlike the securities of public companies that are valued on a stock exchange, most ESOPs are private companies whose share values must be determined in a different way. While the prices of public companies fluctuate constantly throughout each trading day, the share price of a private ESOP company generally changes once a year – on the fiscal year-end date of the benefit plan, which is also referred to as the “valuation date” for the appraiser.

The Department of Labor requires that an ESOP value its shares at least annually, using the IRS’s standard definition of Fair Market Value (FMV), which is essentially “the price at which property would change hands between a willing buyer and seller, neither having the compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” So how is the value of an ESOP company determined if it is not actively traded on an open market?

In short, the trustee of the ESOP sets the share price based on a recommendation from an independent third-party valuation firm. The trustee serves as the legal shareholder for the shares of the company held by the ESOP. If, for some reason, the trustee sets the share price at something different than the value provided by the third-party independent valuation firm, the trustee would have to explain why he or she differed from the valuator. This is not common, but it is important to highlight that the trustee is the one that formally sets the share price.

When the trustee hires a third-party independent firm to value the shares of the company, that valuation firm typically goes through several steps to determine the value of the shares:

• Information is first gathered from the company, such as customer and competitor data, products and services, employees/management, facility changes, potential capital needs, and historical and prospective financial figures.
• A meeting is then held with management, the trustee, and the valuator wherein the historical results and future expectations are discussed. This meeting helps the valuator and trustee understand the company’s business results and the state of its industry. It also informs the valuator about the details behind the financial performance and the assumptions that management used in its financial projection. It is important to discuss the projection versus historical trends, as well as compare the projection to the prior projection set(s) to understand the changes and operating outlook. It is also critical to identify and quantify any extraordinary items of income or expense, especially due to extraordinary events like the impacts of COVID-19. Such figures might be adjusted during the valuation process in determining a “normalized” level of cash flow.
• Next, the valuator examines all information that has been gathered, performs one or more calculations of value (as described below), and writes a report with a step-by-step description of how the valuator reached the value conclusion. The report includes specific details on the calculations that were used and why, as well as an in-depth description of the company’s operations and marketplace. The valuator sends the completed report to the trustee.
• Finally, a meeting is held between the trustee and valuator to discuss the report and value conclusion. This is an opportunity for the trustee to ask questions about the analysis and findings. Often the valuation report is shared with management, but they do not have the authority to change the valuation conclusion. After an understanding of the analysis is reached, the trustee sets the annual share price.

How Value Is Determined

Similar to determining the value of a privately-held company, a third-party valuation firm may use up to three approaches to determine the value of the ESOP shares: the income approach, the market approach, and/or the asset approach. It is not uncommon for a valuator to determine the value using more than one method and then compare and contrast the results to determine a final opinion of value.

Income Approach

Most annual ESOP appraisals will have an income approach, which utilizes two potential methods: the capitalization method and the discounted cash flow method (DCF). Both methods attempt to capture the forward-looking cash flow generation capacity of the company. Each method also factors in the relative perceived risk of achieving those expected future cash flows.

• The capitalization method looks at historical results to serve as a proxy of future expectations. Historical results are divided by a capitalization rate to determine the value.
• The DCF method relies upon an explicit, multi-year forecast to estimate future cash flows which are then discounted back to present value.

Market Approach

Commonly used, but not as often as the income approach, is the market approach. The market approach also has two generally accepted methods: the guideline public company (GPC) method and the transaction method.

• The GPC method tries to identify publicly traded companies in the same industry that ideally are direct competitors and are not substantially larger than the subject company. The valuator makes both qualitative and quantitative adjustments to the market pricing of the identified publicly traded companies to estimate how the market might value the subject company were it publicly traded.
• In the transaction method, the pricing of similar companies that were acquired or sold is reviewed. The valuator will compute and assess the valuation multiples at which they were acquired or sold to determine what multiples should be applied to the metrics of the subject company. Qualitative and quantitative factors are considered in adjusting and selecting the appropriate multiples during this process.

Asset Approach

Least commonly used in an ESOP appraisal is the asset approach. This approach tries to assess the market value of the company’s assets and subtracts the estimated market value of its liabilities. The remainder is the equity value of the company. This method might be used for an asset-intensive company that cannot generate consistent, adequate cash flow.

How To Determine the Right Approach

The valuator must use professional judgment to utilize the appropriate method(s) given the situation involved. Additionally, within each method, the valuator must use professional judgment to set capitalization rates, discount rates, identify similar companies and relevant transactions, and determine the impact of the qualitative and quantitative assessments. When given projections from management, it is crucial to examine the past performance of the company and to understand the outlook in order to evaluate the likelihood of the company achieving its projections. Considering the judgment involved, you can imagine how different appraisers can reach different conclusions about the same company: that is one reason why it is important to select an appraiser with adequate experience and credentials.

In addition to the methods described above, the valuation will take into consideration whether the company has assets above and beyond what is needed for reasonable operation, such as excess cash, marketable securities, or even excess working capital. If the company owns real estate, or has outstanding stock options, warrants or contingent liabilities, these factors will also be factored into the analysis. One final element of the valuation relates to the “marketability” of the shares. The lack of an active market for the buying and selling of company shares must be considered in determining fair market value.

KSM Can Help

ESOP valuation may be somewhat complex but should not be intimidating. Having a trusted, experienced advisor to thoroughly explain the process every step of the way will help alleviate some of the anxiety surrounding this process. And if you work for an ESOP company, you may be curious to ask and learn how the external trustee and appraiser are valuing your shares. For more information, please contact your KSM advisor or complete this form.