Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Written by Scott D. Miller, CPA/ABV, CVA

Originally published in The Valuation Examiner by the National Association of Certified Valuation Analysts, Third Issue 1995.

This is the second article in a series that is dedicated to discussing issues regarding the valuation of the securities of companies that have Employee Stock Ownership Plans ("ESOP"). The first article briefly detailed both the economic philosophy that helped to inspire the creation of ESOPs and the landmark legislation that shapes the plans today. An understanding of the history of ESOPs is essential to gaining a proper perspective on the often unique requirements of an ESOP engagement. We will build on the information contained in the first article by extending our discussion to several institutions that have issued regulations and pronouncements germane to ESOP valuations.

The Federal Government has established extraordinary financial incentives to encourage employee ownership in their companies. Due to the extensive incentives that exist, ESOPs are governed by a considerable number of regulations. Many of the regulations have a direct bearing on the professional providing a valuation of the securities of an ESOP company. It is beyond the scope of this article to discuss all of the regulations that may have a bearing on this matter, but it will consider appropriate pronouncements from three main sources. Those entities include the American Institute of Certified Public Accountants ("AICPA"), the Internal Revenue Service ("IRS"), and the Department of Labor ("DOL").

The AICPA has an interest in ESOPs because of reporting requirements under Generally Accepted Accounting Principals ("GAAP"). ESOPs often incur debt to purchase the securities of the plan sponsor, and the AICPA has a direct interest in promulgating consistent reporting of these often complex transactions. The AICPA has recently released Statement of Position ("SOP") 93-6, Employers' Accounting for Employee Stock Ownership Plans (November 22, 1993).

The IRS maintains an interest in ESOPs due to the fact that contributions to a plan are tax deductible. The contributions may be in one of several forms including cash and stock in the plan sponsor. Typically the stock of the ESOP company is closely held and not actively traded. The "value" placed on the stock for the tax deduction purposes is an issue of great interest to the IRS, and they have appropriate regulations on the subject.

The DOL is involved with ESOPs because they have oversight responsibility for statutory defined employee pension benefit plans under the Employee Retirement Income Security Act of 1974 ("ERISA"). An ESOP is defined as a "qualified retirement plan designed to invest primarily in the employer's securities, thus providing a means for employees to have an ownership interest in the company for which they work". The DOL has issued its own regulations regarding those aspects of ESOPs that they oversee.

AICPA - Establishing Accounting Standards for ESOPs

The AICPA has recently issued SOP 93-6, Employers' Accounting for Employee Stock Ownership Plans, which is effective for fiscal years beginning after December 15, 1993. This supersedes SOP 76-3, Accounting Practices for Certain Employee Stock Ownership Plans. Originally, SOP 76-3 was issued to guide accounting and reporting issues relevant to plan sponsors with leveraged ESOPs. Since the issuance of SOP 76-3 the Federal laws regulating ESOPs have changed several times. Those changes have had a direct impact on the way ESOPs operate, and how they are structured. The dramatic growth in ESOPs, in excess of 10,000 plans today, and their increasing complexity created a need to revisit the accounting standard in light of this expanding environment.

If you are providing an ESOP based valuation, it is important that you become familiar with the reporting issues that are discussed in SOP 93-6. The conclusions in SOP 93-6 cover a wide range of topics on leveraged ESOPs including: reporting the purchase of shares by ESOPs, reporting the release of ESOP shares, the fair value of the ESOP shares, reporting dividends on ESOP shares, reporting redemptions of ESOP shares, reporting of debt and interest, computing earnings per share, and accounting for terminations. SOP 93-6 also discusses non-leveraged ESOPs, pension reversion ESOPs, issues related to accounting for income taxes, and disclosures.

While SOP 93-6 is lengthy and technical, there are a few key items of interest for business valuers. If an ESOP borrows money to purchase the shares of the employer, the ESOP is considered "leveraged". Most ESOPs begin as leveraged plans. The debt associated with the purchase of the shares should be recorded on the balance sheet with a corresponding charge to a contra-equity account. This entry has a pronounced negative impact on the book value of the company. The book value of the company is one indicator of value that should be considered.

When the ESOP related debt is incurred, the stock purchased by the ESOP is typically held as collateral in a suspense account and the stock is referred to as "suspense shares". As the debt is repaid, usually from employer contributions and dividends, suspense shares are released from the suspense account. As the debt is repaid, the contra-equity account is reduced (i.e. the equity in the company increases) having a positive impact on the book value of the business.

It is beyond the scope of this article to discuss in detail the contents of SOP 93-6. The pronouncement is divided into several parts including a narrative on the appropriate accounting treatments of ESOP related transactions, examples illustrating the application of the conclusions, and a discussion of the reasoning leading to the conclusions.

Internal Revenue Service - Tax Implications of ESOPs

When ERISA was passed in 1974, there were many tax implications in the legislation. When the value of stock in a closely held company became an issue, the IRS looked for guidance in previously issued Revenue Ruling 59-60. Revenue Ruling 59-60 was originally issued in 1959 to provide some definitive guidance on business valuations for gift and estate tax purposes.

Section 20.231-1(b) of the Estate Tax Regulations and section 25.2512-1 of the Gift Tax Regulations define fair market value as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Additionally, courts have added that the buyer and the seller are assumed to be able as well as willing to trade, and to be knowledgeable about the market for the property.

The determination of fair market value will depend on the circumstances in each case. The IRS rejects the use of a formula to determine fair market value because there are often a large number of factors impacting the determination of value. The business valuer is advised to consider all available financial data and all relevant factors affecting the determination of fair market value. As guidance, the IRS requires that the following factors be considered at a minimum:

(1) The nature of the business and the history of the enterprise from its inception. The history of the company should detail such things as the stability or instability of the enterprise, the growth and diversity of its operations and other facts appropriate to reached an informed conclusion regarding the degree of risk inherent in the business.

(2) The economic outlook in general and the condition and outlook of the specific industry. The prospective economic conditions at the date of the valuation both in the national economy and the industry which the company is allied need to be considered. It is also helpful to know if the company is more or less successful than its competitors in the same industry, and how the industry is doing against competing industries.

(3) The book value of the stock and the financial condition of the business. Balance sheets for at least two years immediately preceding the valuation date, and preferably more if available, should be reviewed. It is appropriate to determine financial performance measurements such as the liquidity of the company (current ratio), gross and net book value of principal assets in the company, working capital, long term indebtedness, capital structure and net worth.

(4) The earning capacity of the company. Profit and loss statements should be obtained for at lease five years and they should show gross income by principal items and principal deductions from gross income including such major items as operating expenses, interest, depreciation and depletion, and taxes among others. You should be able to determine the net income available for dividends and be able to separate recurrent from non-recurrent items of income and expense.

(5) The dividend paying capacity. Consideration should be given to the dividend capacity of the company rather than the actual dividends paid. Many closely held companies pay no dividends, although they have the capacity to do so.

(6) Whether or not the enterprise has goodwill or other intangible value. Goodwill ultimately is based upon the earning capacity of the company. Therefore, the existence of goodwill is a function of the excess of net earnings over a fair return on the net tangible assets.

(7) Sales of the stock and the size of the block of stock to be valued. The transactions must be carefully analyzed to determine if they are at arms-length. Without a public market for the shares of a closely held company, this analysis requires careful consideration of all the factors surrounding the transaction including the size of the sale in relation to total outstanding shares or "blockage". A minority interest in a closely held company is typically more difficult to sell than a publicly held security, and a controlling interest in a company may justify a higher value for the block of stock.

(8) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market. This requirement seems very reasonable at first examination, but it is important to select only comparable companies for the analysis. It is often very difficult to compare publicly held companies with closely held concerns on such basic matters as products and services, geographic coverage, competitors, market profile, market conditions, sales, assets, reputation, capital structure, marketing capabilities and management skills.

Revenue Ruling 59-60 is a landmark for virtually all business valuations having a tax implication. The ruling is further supported by a number of court cases that have interpreted various sections. The intention of Revenue Ruling 59-60 is to provide guidance on business valuations for gift and estate tax matters. Revenue Ruling 59-60 does not address a number of specific requirements inherent in ESOP related engagements.

Department of Labor - Responsibility for ERISA Compliance

Guidance for valuing the shares in an ESOP came primarily from the IRS. The IRS required that the ESOP not pay more than the fair market value for the securities of the employer. The IRS and the DOL cooperated on the valuation of ESOP securities, but the DOL issued its own "Proposed Regulation Relating to the Definition of Adequate Consideration", 29 CFR Part 2510, as published in the Federal Register on May 17, 1988. A final regulation has not been issued to date, but practitioners must consider it carefully in discharging their responsibilities.

The DOL Proposed Regulation is divided into four major parts: (1) a definition of "adequate consideration", (2) a definition of "fair market value", (3) the requirements for acting in good faith, and (4) requirements for written documentation.

The first part of the Proposed Regulation applies to securities where no well established market exists. The concept of "adequate consideration" means the fair market value of the asset as established in good faith by the ESOP trustee or named fiduciary. An ESOP is prohibited from paying more than the adequate consideration for the securities it receives. There are two main criteria that must be met for a valid determination of adequate consideration. The assigned value of the asset must reflect its fair market value as defined by the regulations, and the assigned value must be the result of the fiduciary acting in good faith as defined by the regulations. Clearly, the DOL wants to link the determination of fair market value and good faith to assure that the valuation reflects all appropriate market considerations.

The second part of the Proposed Regulation defines "fair market value". Generally stated, fair market value as defined by the DOL is substantially the same as the definition established by the IRS, and discussed above. The DOL recognizes that the fair market value of an asset is likely to be a range of value, and not just one set figure. The DOL requires that the value established for an asset fall within an acceptable range.

The third part of the Proposed Regulation addresses the requirement for the ESOP trustee or fiduciary to make a determination of adequate consideration in good faith. This good faith requirement is intended to establish an objective standard of conduct. There are two main factors that must be present to establish good faith. First, the fiduciary must apply sound business principals of evaluation and conduct a prudent investigation of the appropriate circumstances prevailing at the time of the valuation. Second, good faith may only be demonstrated when the valuation is made by persons independent of the parties to the transaction (other than the plan). This means that the valuation must be made by an independent fiduciary or a fiduciary relying on the report of an independent appraiser. If the fiduciary does not have the personal experience or expertise to make the valuation under consideration, the fiduciary should not undertake the assignment. Most commonly, fiduciaries rely on the valuation reports of professionals. The Proposed Regulation notes that the fiduciary or the appraiser must in fact be independent of all parties in the transaction other than the plan.

The issue of "independence" of the appraiser is in part established by such factors as: having the appraiser appointed by the fiduciary, the fiduciary maintaining the right to terminate the appointment, and the plan is established as the appraiser's client. The definition of independence by the DOL and CPA practitioners contains differences. Generally, CPA practitioners have standards of independence that are based on independence "in fact" and independence "in appearance". With regard to ESOP valuations, most CPA practitioners take the position that independence is breached if they performed both the ESOP valuation and provide other significant services to the employer such as preparing financial statements and tax returns.

The fourth part of the Proposed Regulation establishes the requirements for written documentation when the determination of fair market value is being made. The DOL has adopted substantially all of the requirements of Revenue Ruling 59-60 due to its wide familiarity with plan fiduciaries, professionals, and the business community. The general parameters of Revenue Ruling 59-60 were briefly discussed above. The DOL has added a number of other reporting requirements specific to ESOP valuations. Those requirements include such things as: (1) a summary of the qualifications of the person making the valuation, (2) a statement of the asset's value and the methods used in determining that value, (3) a full description of the asset being valued, (4) the factors taken into account in making the valuation including any restrictions, understandings, agreements or obligations limiting the disposition of the asset, (5) the purpose for which the valuation was made, (6) the significance and relative weight of each of the valuation methodologies considered, (7) the effective date of the valuation, and (8) the signature of the person making the valuation and the date the report was signed in cases where a valuation report has been prepared.

The fourth part also includes a discussion of valuation considerations specific to ESOPs. First, the appraiser must consider the marketability or lack thereof of the securities of the plan sponsor. Typically the plan purchases securities that are subject to "put" rights on the part of plan participants (i.e. plan participants can elect to sell the stock back to the ESOP). The appraiser typically considers a lack of marketability discount for the securities of a closely held company, but the DOL also wants the appraiser to additionally consider the extent to which such "put" rights are enforceable, as well as the company's ability to meet its obligations with respect to the "put" rights. This means the appraiser must give some consideration to the ability of the plan sponsor to make a market for the ESOP shares. If it is determined that there is a question about the ability of the plan sponsor to meet its "put' obligations, consideration should be given to an additional discount, often referred to as a discount for lack of liquidity.

Another consideration for the appraiser to weigh is the ability of the selling shareholder to obtain a control premium with regard to the block of securities being valued. In the case of a shareholder selling to an ESOP, the actual control must exist both in form and substance. The purchaser's control should not dissipate within a short period of time subsequent to the acquisition. The DOL is interested in assuring that ESOPs paying a control premium receive the benefits that a control position confers on the owner of the stock.

The DOL list is non-exclusive and the ESOP fiduciary has the obligation of considering all relevant facts in the valuation of the employer's securities. The DOL Proposed Regulation addresses a number of specific issues impacting the ESOP valuation, and it details the requirements for the contents in a written report..


The intention of this article is to provide valuation professionals with a brief overview of the major entities that have published regulations and announcements relevant to ESOPs. Those pronouncements have a direct bearing on ESOP valuation engagements. The full impact of the regulations is beyond the scope of this article. The regulatory environment is so complex and detailed, many of the points mentioned here are worthy of a separate article exploring a single issue.

ESOPs may be enormously beneficial for plan participants and their sponsoring companies. The ESOP was created by Congress under the ERISA Legislation and intended to be a qualified long term retirement benefit for plan participants. The financial incentives extended by Congress to encourage ESOPs also gave rise to a closely regulated environment. For the professional providing services to an ESOP fiduciary or an ESOP committee, there are a significant number of rules and regulations specifically intended to apply to ESOPs. It is advised that a thorough understanding of the applicable rules be mastered prior to accepting ESOP valuation engagements.

Additional ESOP topics will be discussed in succeeding issues. Those topics will begin where we are ending with this article. A basic understanding of the appropriate framework is required before considering more detailed discussions and applications of the regulations.

Enterprise Services, Inc. Business Transitions and Valuations
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