Valuing Your Company Stock When Owned By An ESOP

by Irving Blackman

Blackman-Kallick

Copyright 1994, Irving L. Blackman

One: An Introduction

Two: Advantages and Disadvantages of an ESOP

Three: Valuation Problems

Four: Approaches to Valuation

Five: Sample Valuation Report

Yes! Whether your company is valued because of a sale, a divorce, a merger whatever, the answer is YES.

But when your company is valued because all or a portion of its shares are (or are about to be) owned by a trust created by an Employer Stock Option Plan (ESOP), the danger to your economic health mushrooms. Why? Because a small army of people (for example, plan participants, an independent trustee, the Department of Labor, and even stockholders) can and will sue you. And worse yet, win. With big-dollar judgments.

You could be sued in your capacity as an officer of the corporation, a stockholder, a member of the board of directors, a trustee, or whatever else the lawyers might dream up to make you responsible in some way for the wrong valuation. Worse yet, even when you win, the cost of defending yourself (not to mention the mountain of time required to defend yourself, and the gut-wrenching anxiety) is prohibitive.

So how can you avoid wrong valuation? Interview each potential appraiser.

Eliminate those that have little or no experience with ESOP valuations. Experience-even if the appraiser has done a great number of valuations in your industry-is not the sole test. The real question is, how well will your appraiser's written report and, in particular, the valuation method used to value your company hold up under fire? By fire, we mean when an attacking lawyer is trying to rip the report apart to show it is wrong (and you are liable).

Ask the potential appraiser what methods he/she will use to value your company. Logic should tell you that it will be the same (or at least close) to the type of real buyer that might buy your company in real life. Most closely held businesses are bought by buyers who are much like the seller. They are not bought by publicly held companies (the measure most appraisers use to value ESOP companies).

Okay, you have hired the appraiser. The report is done. Read it, or have a trusted advisor read it. Does the report (and, most important, the value-of-the-company conclusions reached) sound like your company? If not, discuss what changes can be made to make you comfortable with the final report. Sometimes, unfortunately, your best bet may be to go back to square one and hire a new appraiser.

A lot of extra effort? Aggravating? You bet. But it's better than accepting what you know in your heart might be a wrong valuation.

This special report will take you a long way toward giving you the knowledge necessary to protect you and your company from ever accepting a wrong valuation report.

The valuation of stock contributed to and distributed from an Employee Stock Ownership Plan (ESOP) is of critical importance. Unfortunately, there is little guidance for the valuation process in case law or legislation. All that is stated in those sources is that if the valuation is done improperly, there will be heck to pay by the closely held corporation sponsoring the ESOP. But before explaining that, a discussion of what an ESOP is and how it functions is in order.

An ESOP is a tax-qualified employee benefit plan. It is a stock bonus plan or combination stock bonus and money purchase plan, which is an individual account plan designed to invest primarily in qualifying employer securities. Since the ESOP is a qualified plan, it is subject to the Employee Retirement Income Security Act (ERISA).

However, an ESOP may borrow money and enter into transactions with related parties to acquire employer securities in what would otherwise be prohibited transactions.

A leveraged ESOP borrows money to buy stock from one or more existing shareholders or the corporation. The corporation usually guarantees the loan. The company also makes annual deductible contributions to the plan. Thus, the loan is paid back with pre-tax dollars.

The following is a thumbnail description of an ESOP operation. First, the ESOP purchases the employer's stock from the shareholder. The ESOP borrows the money from a bank, pledging the stock as security. It then holds the stock for the benefit of participants, who have, in general, the same rights and privileges as any other stockholder. The stock is then distributed to the participants when they are eligible to receive it under the terms of the plan. The ESOP or the corporation can then reacquire the stock from the participant or his/her beneficiary. It is this flow of stock to, from, and back to the ESOP or the corporation, combined with the tax rules applicable to each transaction, that makes the entire concept an exciting tool.

 

ADVANTAGES OF ESOPs

1. Employers can take deductions for stock. Each year, the employer can deduct the fair market value of employer securities contributed within the applicable ceiling -- 15% if it is a stock bonus plan and 25%if it is a combination stock bonus plan and money purchase plan.
2. The shareholder can bail out. No cash contribution is necessary; the shareholder can sell his/her stock. The sale results in a capital gain. Installment reporting is available to the selling stockholders.
3. Redemption is easier. The requirements of Sections 302(b) and 303 (to avoid dividend treatment on redemption) are not applicable to trust purchases.
4. An ESOP may improve employee morale.
5. An ESOP provides a market for stock held by shareholders of a closely held corporation. In addition, if the ESOP were not used, a purchaser of such stock, whether the employer or a third party, would have to use after-tax dollars to fund the purchase.
6. An ESOP is superior to public sale of stock because it is cheaper, involves no public disclosure, and requires no SEC registration if the plan is noncontributory.
7. As a financing vehicle, an ESOP can be used to refinance an existing debt of the employer, raise capital for any purpose, or acquire a target company.

EXAMPLE: P Corporation wants to acquire T Corporation. T forms an ESOP. The ESOP borrows the necessary funds to purchase 90% of T's outstanding stock. P purchases the other 10% and has voting control.

Of course, the theory is that the 90% trustee-ESOP-owner will be forever friendly to P, the minority stockholder.

8. An ESOP may solve a Section 531 problem: Occasionally, a corporation is backed into a Section 531 corner-unreasonable accumulation of surplus. The only alternatives are dividends or almost certain Section 531 penalties-neither choice has much to recommend it. A nonleveraged ESOP, on the other hand, allows a new choice. The corporation can contribute to the ESOP (eliminating or reducing the Section 531 problem) and have the ESOP bail out the stockholder, who now has a capital gain as opposed to a dividend. All are good strokes.
9. An ESOP may be used to accomplish antitrust-required divestitures by selling the corporation to the ESOP. Public companies may also use the ESOP to go private.
10. Contributions by a corporation to a leveraged ESOP that are used by the plan to pay loan principal and interest are allowed separately as deductions to the corporation. The deduction for contributions used to pay loan principal is limited to 25 percent of the compensation of all employees under an ESOP. An unlimited deduction is permitted for amounts used to pay interest on the loan.
11. The owner of a closely held corporation can take advantage of a tax-free rollover. The shareholder sells stock to the ESOP, and as long as the ESOP owns at least 30 percent of the corporation after the sale, the sales proceeds may be reinvested within one year in securities of other domestic operating companies. The gain on the sale is deferred until the rolled-over securities are sold.

EXAMPLE: Rick Rich owns 100 percent of Success Co. Rick sells $2.2 million of his stock to Success' ESOP. Rick reinvests the proceeds in a tax-free rollover, which he holds until death. Rick's heirs get a step-up in basis and never pay income tax on the gain.

PLANNING POINTER

Elderly shareholders may prefer a rollover into bonds rather than stock.

They should choose bonds with a maturity well beyond their life expectancy. This move effectively locks in the gain, and in addition, gives the taxpayer assets he can hold until death to avoid income taxes on the gain entirely.

12. A lending institution is required to include in its taxable income only 50 percent of the interest received on an ESOP loan. As a result, the ESOP or the employer can borrow at a lower interest rate than other borrowers. Such loans are called "security acquisition loans."
13. The employer can deduct dividends paid on employer securities that are used to make payments on an employer security acquisition loan.

DISADVANTAGES OF ESOPs

1. Dilution can lead to loss of control by nontrust stockholders and can reduce the proportionate share of company equity held by pre-ESOP shareholders.

If new stock is issued or if existing stock is sold to the trust, the problem is the same-some control is lost. If, perchance, the trust gets over 50 percent of voting stock ownership, control may be shifted away from the nontrust stockholders if the trustee becomes unfriendly, or if an Internal Revenue Code (the Code) amendment puts voting rights into the hands of employee participants.

If new stock is issued, the proportionate share of company equity held by the pre-ESOP shareholders is reduced. Once these shares leave the hands of the employer, the dilution (short of reacquisition) is permanent. Future economic benefits (increase in share value) must be shared with the owners of the stock held or distributed by the ESOP.

2. An ESOP is expensive to set up and administer.
3. At best, the annual valuation of the stock of a closely held corporation is a problem. TRA-86 requires an annual independent appraisal for employer stock held by an ESOP. Most well-run ESOPs have had an annual appraisal in the past, but now it is required.
4. The following are the current voting rules:

Publicly traded. The voting rights on all shares allocated to individual participant accounts are passed through to the participants. Shares held in a suspense account pending repayment of an ESOP loan are generally voted by the trustee or other plan fiduciary.

Closely held businesses. The voting rights on allocated shares must be passed through to participants only with respect to major corporate transactions such as merger, recapitalization, or sale of substantially all the company assets.

For normal corporate matters, such as election of the board of directors, the allocated shares are voted by the trustee or other plan fiduciary. As a practical matter, this allows the non-ESOP shareholders (in general, the same shareholders who controlled the corporation before the creation of the ESOP) to maintain absolute control of the day-to-day business operations.

Nonallocated shares held in a suspense account pending repayment of an ESOP loan are voted by the trustee or other plan fiduciary.

5. The value of employee retirement benefits depends on unknown factors in the marketplace, which could seriously jeopardize, or even wipe out, any hope of employee retirement security.
6. The employer has a significant repurchase liability generated as people die, leave, or retire from the company. The corporation cannot just give employees stock and say, "Pleasant retirement." The law requires that the company (or the ESOP) buy the shares back at fair market value.
7. TRA-86 creates a new diversification requirement that increases the repurchase liability. When a participant reaches age 55 and has 10 years of participation in the ESOP, he/she has the right to elect to diversify up to 25 percent of his/her account balance for a six-year period. Each plan year counts as a separate election period. At age 60, the percentage becomes 50 percent for the purpose of a one-time diversification election.

Diversification means that a company can either distribute owned shares to the eligible participant or make available, within the ESOP, the opportunity to transfer the appropriate portion of the account to one of three investment funds. These diversification rules apply only to employer stock acquired by the ESOP after December 31, 1986. The diversification must be completed no later than 90 days after the close of the election period. This is a tough rule for the closely held business because the repurchase liability is created sooner. Since there is no market in which to turn the shares into cash, to the extent a participant elects diversification, the company must repurchase the shares to be diversified.

8. ESOP participants entitled to benefits can demand those benefits in the form of employer securities. However, participants forfeit their right to employer securities for the portion of their account that they elect to diversify.

If the ESOP trustee causes the ESOP to purchase employer stock at a price greater than its fair market value, the purchase can be a violation of the trustee's fiduciary duties.

If the employer corporation contributes stock to the ESOP and claims a deduction for the contribution greater than the fair market value of the stock, the deduction will be disallowed by the amount of the excess claimed. Worse yet, an excise tax can be imposed upon the principal shareholder or employer who sells stock to an ESOP at greater than fair market value.

If a plan participant sells shares back to the ESOP or the employer corporation at a put option priced at less than its fair market value, the participant may have a cause of action against the ESOP or the employer.

An interesting case that illustrates these principles is Donovan v.Cunningham (716 F.2d 1455, CA-5; 1983). In that case, the issue was whether the ESOP trustees had caused the ESOP to purchase employer stock from the employer corporation's sole shareholder for more than its fair market value.

The trustees had obtained an appraisal of the value of the stock from an independent appraiser, which is a statutory requirement for ESOP purchases. The Secretary of Labor, who had brought the suit against the trustees for their alleged violation of labor laws pertaining to ESOPs, disagreed with the appraisal report.

First, he claimed in his suit that the report was not updated and was made a considerable time before the purchases took place. He claimed that the report needed to be updated to take into account the impact of the ESOP on the value of the company stock and to reflect the difference between the actual operating results of the company following the appraisal and those that had been projected in the appraisal report itself.

Second, the secretary argued that the valuation in the appraisal should have been discounted to account for the ESOP's purchasing only a minority interest in the employer corporation. It must be admitted that this conclusion is a blow. Many commentators have maintained that no discounts should be taken when valuing ESOP stock: after all, the ESOP provides a marketplace for the stock. This case punctures this time-accepted logic.

The appellate court ruled for the secretary, holding:

Under [legislation], as well as at common law, courts have focused the inquiry under the "prudent man" rule on a review of the fiduciaries' independent investigation of the merits of a particular investment rather than on the evaluation of the merits alone. As a leading commentator has put it, the test of prudence is one of conduct and not a test of the result of the performance of the investment. The focus of the inquiry is how the fiduciary acted in his selection of the investment and not whether his investment succeeded or failed.

By this standard, the appellate court found the appraisal report to be lacking, because it failed to identify the facts and assumptions that justified its final valuation figure. Not only that, but the trustees failed to determine whether the appraisal report still had validity at the time of the purchases.

The lesson of this case is that a mistake in valuation methodology can be costly from a legal standpoint when valuations are done for ESOPs. As the Donovan court admonished, "valuations must be made in good faith and based on all relevant factors for determining the fair market value of securities." Be careful and thorough! The secretary of labor is watching you!

The danger inherent in the valuation of employer securities contributed to an ESOP is that the Pension Reform Act of 1974 imposed upon the fiduciary or trustee running the ESOP a duty to run the plan solely in the interest of the plan participants and beneficiaries. This means that when buying employer securities for the ESOP or purchasing them back from plan participants, the trustee must do so with care, skill and diligence, paying as little as possible for the contributed shares and purchasing the shares back from participants at their fair market value.

A plan fiduciary who violates this fiduciary duty is personally liable to compensate the ESOP or others for any losses suffered because of his or her mistakes in dealing in the ESOP's employer stock. In many cases, the trustee is somehow affiliated (stockholder, officer, employee) with the employer corporation, especially in the case of a privately held business.

Although the fiduciary is responsible for his/her own due diligence, the valuator must also do due diligence. At a minimum, the valuator needs to verify the existence and condition of the company's physical plant, usually by conducting a site visit. The valuator should also interview management to gather necessary information(but what is necessary will vary for each valuation). Below is a listing of the type of information needed.

A. GENERAL INFORMATION

B. ANALYSES OF KEY FACTORS

C. PROJECTIONS

• The sales breakdown by divisions and product lines in terms of dollars and units of sales
• Economy will improve, get worse, etc.
• Capacity expansion requirement (e.g. more space, technicians, salespeople), competition, etc.
• The real growth rate and any increase in market share
• Price increase (i.e. inflation), profit margin, etc.
• Technological competitiveness and ability to supply new products demanded by the marketplace.