ESOP Specific Valuation Issues

An ESOP company’s legal obligation to repurchase shares from terminated participants presents a valuation issue unique to ESOPs.

We believe that the primary link between the repurchase obligation (RO) and stock value is the relationship between RO and retirement benefits. While the RO can impact the stock value in other areas, such as liquidity and ability to reinvest in growth, these other connections are tangential in most cases.

The RO impacts value by way of its impact on retirement benefits expense. For ESOP companies, we take care to understand the true economics of the Company’s retirement benefit expense structure. Because of nuances in ESOP accounting, we may need to make adjustments to historical earnings to appropriately reflect the economic impact of retirement contributions. With an understanding of historical benefit patterns, we reflect appropriate expectations of future benefits levels into the projections based on historical patterns, management’s expectations, and the Company’s contribution and repurchase policy.

We believe that this methodology is consistent with the ESOP Association’s Valuation Advisory Committee’s recommendations on best practices.

Another issue is the matter of control.  While control is a topic that is not unique to ESOP valuation, its treatment in an ESOP context can sometimes be different than in other realms.  The general issue is what additional value, if any, comes from having control of a company?  There is general consensus in the valuation community that control can demand a premium in value.  However, methods to measure such a premium have evolved in recent years, with the ESOP community sometimes adopting changes at a faster rate than others.

We believe that the value of control is best reflected in the earnings figures used to value a company.  If there are meaningful changes that a control owner would make to increase profitability, then such changes should be reflected in the profitability used for the valuation in order to reflect a control value.  If there are no significant changes that a controlling owner would be expected to make, then there may be no premium for control.

In the case of an ESOP, we believe it is important to be careful to reflect only control changes that would be expected to actually occur under the ESOP’s control.

In earlier decades, it was common for valuation practitioners to apply an explicit premium for control to the valuation of ESOP stock.  The ESOP valuation community has increasingly come to recognize the flaws in such methodology, including the inability to dis-aggregate strategic premiums from the source data, and the potential for double-counting when the valuation already reflected the economics of control.  For these and other reasons, we do not apply control premiums in our valuations of ESOP stock.

Taxes are another area that have unique application to ESOP valuation.   There are certain tax benefits that can be achieved only under ESOP ownership.  We believe that the DOL and the thought leaders in the ESOP valuation community agree that an ESOP should not pay shareholders for unique tax benefits that will only be achieved under ESOP ownership.

While ESOP tax savings will actually be realized by the company in many cases, a trustee who relies on a valuation for an ESOP stock purchase that includes such future savings, knowingly or not, is taking a position that is not supported by the DOL and the majority of the ESOP community.