Quality of Earnings Engagements Provide Confidence in ESOP Transactions

When an owner decides to sell his or her company to an employee stock ownership plan (ESOP) trust, one of the most impactful factors in the transaction is the company’s value. It is vital that the price reflects fair market value so the seller is compensated appropriately and the participants of the ESOP are not overpaying for the company.

Determining Value

ESOP trustees typically determine a company’s value based on a third-party valuation, which relies on historical financial information and projections of future earnings. Since the valuation is based on financial data provided by the company, the reliability of this data could have a significant impact on the valuation – and ultimately on the transaction price.

Over the past several years, the U.S. Department of Labor has increasingly challenged the valuation used at the ESOP’s inception, arguing that the ESOP is overpaying. The company’s determined value ultimately relies on the quality of the company’s financial data. So, how can an ESOP trustee determine the accuracy of the data? The answer is a quality of earnings analysis.

What Is a Quality of Earnings Analysis?

It is important to note that a quality of earnings analysis is different than an audit. A quality of earnings analysis attempts to measure and quantify the operating results of a business for a designated period of time, generally the preceding 12 months (often referred to as trailing 12 months or TTM). An audit focuses on the financial statements for the annual reporting period, including the notes to the financial statements. An audit also requires an independent auditor to express an opinion on the fair presentation of the financial statements in relation to the applicable accounting principles being used – typically generally accepted accounting principles (GAAP) in the U.S.

A quality of earnings analysis provides the user with information as to unusual, one-time, and non-recurring revenues and expenses that impact the earnings of the business, and it addresses certain risk areas (i.e., sales and use tax exposure), which may impact how one would value the business. A quality of earnings analysis focuses on historical recurring cash flows from the business and what an informed buyer may expect to generate from the business post-acquisition. However, this analysis is intended to be used in connection with other information, including legal due diligence, market studies on the industry, and other assessments to help a buyer make an informed decision for investment.

Benefits of a Quality of Earnings Analysis

Banks that provide the commercial loans used in an ESOP transaction can also request a quality of earnings analysis. Additional comfort can be provided to the lending team, especially in cases where the company has not historically received an audited or reviewed financial statement. A quality of earnings analysis can be a valuable resource for trustees, helping instill confidence in the data being provided to the third-party valuation firm. Additionally, the quality of earnings analysis should reveal any major risk areas, issues, or concerns that could potentially hinder the ESOP transaction.

At the very least, an ESOP trustee should ensure that the quality of earnings analysis addresses whether the historical financial performance is reasonable in relation to the future projections of the company in order to assess whether the assumptions being used are fair and reasonable. A quality of earnings analysis will not only help to assess risk related to the transaction; it generally encourages a fair assessment of the earning potential of the business.

Additionally, a quality of earnings analysis can provide increased confidence in the earnings that are underpinning the financial analysis behind the ESOP formation, and adds support to the due diligence efforts of the trustee and its advisors.