How Annual ESOP Share Price Is Determined
Employee Stock Ownership Plans (ESOPs) are becoming more and more common. Being part of a company that is an ESOP can be very exciting and rewarding. However, ESOPs can sometimes be complicated and employees often have many questions about how the ESOP structure works. A very common question relates to how the shares of an ESOP are valued.
Typical stock of a public company is valued on a public stock exchange. However, ESOPs are typically private companies whose shares are not traded on any type of active market or public exchange. How ESOP shares are valued is a little different and a little more complex.
The Department of Labor requires that an ESOP value its shares at least annually, using the Internal Reveue Service’s (IRS) standard value of Fair Market Value (FMV). The IRS defines FMV as the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts. So how does an ESOP determine what its’ shares would sell for on the open market 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 all of the shares of the company that are held in the ESOP. If, for some reason, the trustee were to set the share price at something different than the value provided by the third-party independent valuation firm, the trustee would have to explain why they differed from the valuator. This is not very common, but it is important to note that ultimately the trustee is the one that 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 data on customers, competitors, products, employees/management, facility changes, and historical and prospective financial figures.
- A meeting is then held with management, the trustee, and the valuator where the historical results and future expectations are discussed. This meeting helps the valuator and trustee understand the company’s business results and the pulse of the industry. It also informs the valuator about the details behind the financial performance and the assumptions that management used in its prospective information.
- 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. Only the trustee can set the share price. After an understanding of the analysis is reached, the trustee sets the annual share price.
How Value Is Determined
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.
Most annual ESOP appraisals will have an income approach, which has two potential methods: the capitalization method and the discounted cash flow method (DCF). Both methods attempt to capture the forward-looking cash flow generating capacity of the company and also factor in the relative perceived risk of achieving the 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 forecast to estimate future cash flows which are then discounted back to present value.
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 method (GPC) 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 start with the value at which they were acquired or sold and then make similar qualitative and quantitative assessments to adjust the value of the subject company.
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.
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 determine the impact of the qualitative and quantitative assessments.
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 extra cash or marketable securities. 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 will impact value, and is normally included in the analysis.
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.