Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

THE "ESOP": AN INTRODUCTION FOR BUSINESS VALUATORS (PART 3)
Written by Scott D. Miller, CPA/ABV, CVA

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

This series of articles is dedicated to discussing issues regarding the valuation of securities of companies that have Employee Stock Option Plans ("ESOP"). The previous articles are intended to build a basic understanding of ESOPs, so that succeeding discussions will cover specific issues regarding ESOP related issues. In this third installment, the impact of control and minority positions is considered.

We begin with the assumption that the ESOP is either committed to purchase an amount of stock of the plan sponsor, or it already owns stock in the company. Valuation theory supports the contention that a controlling interest in a company is more valuable than a minority or non-controlling interest. The reasons for a controlling interest being more valuable is that the controlling shareholder has more rights and prerogatives regarding the operations of the entity. Those rights and prerogatives may include such things as: setting employment and compensation policy, making acquisitions, selecting vendors, acquiring or liquidating assets, recapitalizing the company, declaring and paying dividends, revising articles of incorporation and bylaws, and establishing buy/sell agreements. The point is that control means the power to impact the company in a manner that may be more favorable to the controlling party.

The actual degree of control depends on many factors, and we mention a number of areas for consideration. Certain limitations may occur due to state statutes. Many states require a simple majority of the stock to approve major actions such as the merger or sale of the company. The actual percentage for control may significantly exceed a simple majority depending on the state laws. Contractual restrictions imposed by such things as loan covenants may impact such items as officer compensation, dividends and asset liquidations. Certain companies in regulated industries, like insurance and utilities, are more difficult to liquidate. If a company is in financial difficulty, the benefits related to control are often limited. The valuation professional will have to make some assessment of a control premium if the circumstances suggest that a controlling interest is being valued.

Department of Labor ("DOL")

We have previously mentioned in Part 2 of this series, the DOL "Proposed Regulation Relating to the Definition of Adequate Consideration", 29 CFR Part 2510, as published in the Federal Register on May 17, 1988. This proposed regulation provides some critical insights regarding the thinking of the DOL on the matter of a control premium in ESOP applications. The ESOP may pay a control a control premium only to the extent a third party would pay a control premium. The DOL takes the position that a control premium is warranted only if the ESOP has both voting control and control in fact. If the ESOP is paying a control premium, the DOL will carefully review the situation to ascertain whether the transaction involving the payment of the premium actually results in the passing of control to the plan.

The DOL cites as an example a situation where an ESOP pays a control premium, but within a short period of time the control is dissipated as the shares are allocated to participant's accounts. The suggestion is that it may be improper for the ESOP to pay a control premium in this instance.

Additionally, the structure of the administration and management of the ESOP may have an impact on the issue of control. In many closely held companies it is common to find individuals that have been shareholders, directors and officers of the company continuing as ESOP fiduciaries and company officials after the ESOP has acquired securities. This common arrangement does not preclude the ESOP from paying a control premium, but the DOL will review such circumstances in light of the total situation to determine if the ESOP has control in fact.

The payment of a control premium by the ESOP may occur even if the plan is purchasing a series of smaller incremental amounts. In this case, the DOL will examine the circumstances to determine the extent of a binding agreement to have the employer pass control to the ESOP within a reasonable time. The mere intention to pass control is not sufficient to justify the ESOP paying a control premium.

While a number of issues relating to the consideration of a control premium have been briefly discussed, it is recommended that a thorough review of the proposed DOL regulation be completed prior to the beginning of any ESOP valuation.

Practical Considerations

The matter of a control or minority position by the ESOP is literally one of the first things that must be determined when approaching an ESOP assignment. Based on the vantage point provided by the DOL as discussed above, the issue of control is potentially far more complex than it may at first appear.

If the ESOP owns less than 50% of the stock in a closely held company, clearly this is a minority position. Even if the ESOP has the opportunity to acquire more than 50% of the stock, the facts and circumstances must be examined to determine if the ESOP has a control position in fact. Correspondingly, an ESOP that already owns more than 50% of the stock may not be in a control position in fact. While a +50% interest in the company appears to be a controlling position, it may not be control in fact. For example, if the ESOP owns more than 50% of the stock, and the plan as a single trustee who was the controlling shareholder prior to the ESOP acquiring the stock, this situation suggests that the ESOP is not in control. The DOL has provided guidance in such cases, and the total circumstances should be reviewed to assess where the actual control resides.

There are situations when the ESOP has +50% of the stock, and is in control, but is still valued on a minority basis. The key element in this case is that the ESOP never paid a control premium for any of its stock even though it has gained a controlling interest in the company. The theory is that the ESOP consists of many small minority account balances with no single account balance in control. Even as the ESOP's percentage of collective ownership continues to grow, the plan is viewed as a collection of minority balances. The ESOP acquired stock on a minority basis, and it redeems stock on a minority basis. One significant advantage to the plan sponsor is the lower total repurchase obligation due to a minority position valuation. Some companies committed to the concept of employee ownership have embraced this valuation philosophy to help keep the company in a position to honor repurchase obligations over the long time horizon.

Assuming that the ESOP is in control both in appearance and in fact, the next issue becomes the level of control premium appropriate over a minority position. It is beyond the scope of this article to discuss specific percentages for control premiums because so much depends on the specific facts of each case. Some general thoughts are offered which apply to the valuation of any closely held company. The relative financial success of the subject company has to be analyzed and the impact of control reviewed. If the Company is smaller with limitations on such basic matters as products, marketing territory, locations and management, then the prerogatives of control are similarly limited. As a company expands in size and complexity, the prerogatives of control may become much greater, and may be worth more on a control basis.

Summary

It is important to recognize that ESOP based valuations are subject to many additional rules, regulations and interpretations that are not often found in other valuation assignments. The issues of control and minority interests in ESOP valuations may be subtle and complex. Informed professional judgment and ESOP experience are essential ingredients to successfully completing assignments.

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