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ESOP Valuations - Q & A
1. Why do we need to engage an
outside party to value our ESOP shares?
2. What is meant by “fair
market value”?
3. How is “fair market
value” determined?
4. What is meant by a
“control premium”?
5. How do ESOP valuations
differ from valuations for other purposes?
6. What is the cost of an ESOP valuation?
7. Is FTSI considered an
independent party for ESOP valuation purposes?
1. Why do we need to engage an
outside party to value our ESOP shares?
From a strictly regulatory
standpoint, a valuation of ESOP shares by an independent third party is
required by the Department of Labor (DOL) and the Internal Revenue Service
(IRS). The regulatory requirement stems from the practical need to
insure that the value is determined by a party who does not have a personal or
financial interest in the valuation result. The valuation, moreover,
should be performed on behalf of the trustee of the ESOP trust since it is the
duty of the trustee to insure that transactions with the ESOP are consummated
at “fair market value.”
2. What is meant by “fair
market value”?
“Fair Market Value” (FMV) is a
concept and not a price that emerges from application of some standard
formula. In simple terms, FMV is the price for which property would sell
under the existing market conditions for such property as established in
arms-length negotiations between knowledgeable and independent parties.
The “market” implied in definitions of FMV encompasses all potential
buyers and sellers of the property involved. The term “market value”
is synonymous with FMV.
3. How is “fair market
value” determined?
There are many method used in the
determination of FMV. The nature of the property being evaluated
determines what methods are appropriate. For example, the FMV of a
single family home is determined by the price for which similar property is
selling in the area in which such property is located. The FMV of
business interests and property that is or has a potential to generate
earnings, however, is determined to a large degree on the basis of what a
knowledgeable buyer would be willing to pay for the potential future earnings
stream considering available rates of return on relatively risk-free
investments and the risks associated with the investment being
appraised. Although not the only method that might be considered,
the present value of future earnings using a risk adjusted market rate is one
of the most common approaches.
Reference to the results of
mathematical formulas is not the sole determinant of FMV. The judgment
and experience of the party performing the valuation is also a critical
element since there can be many factors that can not be quantified by
reference to the underlying financial information alone.
4. What is meant by a
“control premium”?
A control premium is that amount
which a buyer may be willing to pay to acquire a controlling interest in a
business over and above the value of the interest based solely on the
underlying financial factors. The element of control, in this case, has
a value which is added to the value that can otherwise be ascribed to the
assets and earnings of the business. The payment of a control premium in
the purchase of a business does not add any value to the business.
Synergy value, unlike control, is susceptible to being measured in more
concrete terms of increased financial benefits to the buyer over and above
those being enjoyed by the selling parties. Examples are the prospects
of increased sales of the buyer’s products to the seller’s customer base
or lower overall materials costs due to volume purchase discounts. Whether or
not a control premium is appropriate in the purchase of shares by an ESOP must
be determined on the facts in the individual case.
5. How do ESOP valuations
differ from valuations for other purposes?
Because of the regulatory
requirement established in the Employee Retirement & Income Security Act
of 1974 (ERISA) that an ESOP pay no more than “adequate consideration” in
the purchase of employer securities, ESOP valuations must support the
decisions of the trustees and must also withstand review by DOL and the IRS.
Valuations that are subject to being reviewed by third parties, whether for
ESOP or other purposes, must include considerable discussions on the
methods and factors employed as well as explanatory information on the
sponsoring company’s financial and operating history and the industry in
which it competes. For similar reasons, valuations supporting tax
related values for gift and estate or charitable deduction purposes must also
include considerable background detail so that potential third party reviewers
will have a clear understanding of the process leading up to the value
conclusion. In addition, ESOP regulations place various obligations on
the sponsoring employer and allow for limitation of the voting rights of ESOP
shares. These, and other features peculiar to the ESOP require special
consideration in the determination of the fair market value of ESOP owned
securities of privately held companies.
6. What is the cost of an ESOP
valuation?
The fees charged for ESOP
valuations vary considerably from one valuation firm to the next. There
is no set industry standard or prescribed range. This is due to the wide
variation in the amount of work that may be involved between one engagement
and another. As a general rule, the cost of an initial valuation for a
newly formed ESOP will be higher than the subsequent annual update valuations.
This is because of the amount of time and work involved in gathering and
analyzing all of the financial, industry and other pertinent information for
the initial report. The update, on the other hand, need only focus on
changes in financial and other factors that have occurred since the prior
report.
** Get a quote for your
valuation project, click here.
Initial Limited Valuations For
ESOP Feasibility and Planning Purposes
Because few companies are willing
to adopt an ESOP before determining whether or not the value of company stock
will support management objectives, FTSI offers a Limited Valuation at a very
economical fee. Since this valuation is for company management purposes,
all of the time consuming company and industry background report writing can
be eliminated. The company’s management is fully aware of these
matters and need not pay for the privilege of reading about them in a
valuation report prepared exclusively for management’s eyes only. All
pertinent factors are considered in the analyses leading to the value
conclusion, however, and all requisite financial data and valuation methods
used for a full report are outlined in the Limited Report.
Our On-line Valuation Information
Entry feature is not only a convenience for the client, this feature enables
us to offer attractive fees by eliminating a major portion of the time
otherwise required in preparing, transmitting and tracking valuation
information requests. This feature also enhances turn-around time from
our e-Proposal acceptance by the client to report completion.
If the valuation client for the
Limited Valuation report proceeds with the adoption of an ESOP, FTSI will
credit the cost of the Limited Valuation against the full report fee should
the client engage FTSI to prepare the full initial report.
ESOP Update Valuations
The On-Line Valuation Information
Entry feature for updates functions in the same manner as that for Limited
Valuations. The straight-forward question and answer arrangement with
space for explanatory comments will cover most of the routine update
information gathering requirements. The assigned valuation analyst will
contact the appropriate party for any necessary additional information and to
discuss the results of the preliminary analyses.
7. Is FTSI considered an
independent party for ESOP valuation purposes?
FTSI offers consulting services on
the feasibility and subsequent operational strategies for ESOP’s as part of
the Limited Valuation process if such is requested by the client. We do
not, however, derive income from the drafting of plan documents, plan
submissions to the IRS, and other activity involved in the adoption of an ESOP
by the client. Neither does FTSI offer annual ESOP administrative
services. Accordingly, we have no pecuniary interest in the client’s
decision relating to the adoption of an ESOP nor the continued operation of
the plan. FTSI is an independent party for ESOP valuation purposes.
repurchases. Recognition of the need to formulate changing strategies for changing
circumstances should be made at the outset when the plan is initially adopted.
Unfortunately, many ESOP consultants who specialize in ESOP installations
avoid mention of the need for such long term strategy considerations for fear
the prospective ESOP client will be distracted from the prospect of the
ostensible free lunch.
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