Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Marketability Issues in the Valuation of ESOPs
Written by Scott Miller, CPA/ABV, CVA and John Hayes, CPA

Originally published in CPA Expert, a publication of the American Institute of Certified Public Accountants, Summer 1996.

The passage of the Employee Retirement Income Security Act of 1974 ("ERISA") brought into existence a host of qualified retirement oriented benefit plans. These qualified plans enjoy tremendous financial incentives intended to increase the effective savings rate in this country. Employee Stock Ownership Plans ("ESOPs") were given official sanction with the passage of ERISA. Since 1974 the number of ESOPs has continually grown, and there are over 10,000 ESOPs today.

The greatest percentage of ESOPs are in closely held companies. This fact reflects the strong financial incentives Congress specifically created to encourage employee ownership in closely held companies. Closely held companies typically are valued on a much lower basis than comparable publicly held companies due to a lack of market for their stock. There are unique features in an ESOP that have a direct bearing on the marketability of the stock for valuation purposes.

There are two important features regarding ESOPs for the purposes of this article. First, departing employees from an ESOP have a "Put" option for their stock back to the company. This means that the company is obligated to purchase the stock of a departing employee, if the individual elects to make that decision. Second, this requirement on the part of the company to make a market for its own stock continues as long as the ESOP exists. This long term obligation is referred to as the "Repurchase Liability". The existence of the employee's "Put" and the company's "Repurchase Liability" are closely linked, and it is appropriate to weigh both of these aspects when considering the marketability issues in valuing the stock of an ESOP company. The Department of Labor has issued proposed regulations regarding Adequate Consideration which covers these points.

Marketability, Closely Held Companies and ESOPs

The market approach to valuing closely held companies commonly begins by examining comparable publicly held companies to the subject of the valuation. Public companies on major stock exchanges have a tremendous advantage. They offer the owner of the security a ready and liquid exit vehicle if the shareholder wishes to convert the equity into another investment. Closely held companies generally have no ready market for their securities. This lack of a ready market is referred to as the "lack of marketability". The generally illiquid stock in a closely held company typically commands a significant discount from the price of comparable public companies as a result.

Closely held ESOP companies have a requirement to make a market for their stock. One theory of valuation suggests that this repurchase obligation substantially enhances the value of the stock in a closely held company because a market in fact exists. Additionally, the ability of the closely held ESOP company to honor the repurchase obligation is enhanced because it may elect to repurchase the stock with pre-tax dollars by making a contribution to the ESOP in the same amount as the repurchase obligation. Due to these factors, the discount for lack of marketability may be reduced, and the overall value of the stock will be higher.

The practical application is likely to be far more complex. While the ESOP company has the obligation to make a market for its stock, it must be kept in mind that the obligation extends as long as the company has the ESOP. The repurchase obligation continues through economically favorable times and the deepest recessions. It is appropriate to consider a longer term approach to assessing the ability of the ESOP company to honor the repurchase obligation over time. Most closely held companies go through cycles, and those fluctuating results may negate the potential increase in value suggested by having the company make a market. After all, the market produced by the ESOP company is only as good as the company's financial health.

What is the correct answer regarding the impact of the "Put" and the repurchase obligation on the marketability discount? There simply is no easy solution. The resolution of the issue will vary by each ESOP application depending on the individual circumstances. The following factors will be helpful in determining the level of marketability discount that is appropriate.

Financial Strength of the Company

This obvious point is far more subtle than first glimpse. The overall long term financial health of the company should be considered. The marketability discount may be reduced if the ESOP company contains representative characteristics such as: stable products and services, determinable demand, not subject to rapid technology obsolescence, low to moderate capital requirements, history of generating excess cash, and strong gross margins. The marketability discount may be increased if the ESOP company contains representative characteristics such as: highly seasonal or cyclical products, rapidly expanding markets, high capital intensity, deteriorating markets, highly competitive market, and volatile margins.

The value of the employee's "Put" and the obligation of the ESOP company to make a market for the stock is only as viable as the long term economic health of the plan sponsor. If the ESOP company is viable today, but five years from now the future is uncertain, it is appropriate to give consideration to this uncertainty.

The overall ability and likelihood of the ESOP company meeting its stock repurchase obligations is a function of providing liquidity when needed. The ability of the company to maintain a debt capacity for future contingencies should also be considered. In the absence of current cash flow that cannot meet the repurchase obligation, the debt capacity of the company is often an good indicator of the ability to successfully honor future commitments.

Review ESOP Documents & Other Appropriate Records

The ESOP regulations permit plan sponsors a certain degree of latitude in meeting repurchase obligations. ESOP companies may have opportunities to delay or defer stock redemptions based on a number of factors such as the participant's age, the size of the block of stock being redeemed, or the dollar amount. Companies may elect to spread stock repurchases over several years, or after a plan participant attains a certain age. The intention of these provisions is to enable the company to meet obligations over a variety of economic conditions. There is an issue regarding marketability as it relates to the initial ESOP transaction and subsequent annual updates. Once stock is in the ESOP, an employee has a "Put" to the plan, and a market exists. According to this approach, annual updates may have a reduced marketability discount because the market is now established. When the initial ESOP transaction occurs, it is unlikely that either the ESOP or the selling shareholder has a "Put". This theory suggests that due to the lack of a market, stock in an initial ESOP transaction may be subject to a higher marketability discount.

Most ESOPs allow the departing plan participant a fairly narrow window to "Put" the stock back to the company. Once the window is closed, often only 60 days after proper notice is given to the employee, the company is not obligated to repurchase the stock. In practice, departing employees may not have a significant guaranteed market for their stock if the narrow window is ignored. Employees may be compelled for practical reasons to Put their stock to the company in the middle of an economic recession.

Assess the History of Prior Stock Repurchases

It is appropriate to ask the ESOP trustee if the repurchase obligation has been formally addressed. If the repurchase liability has been studied, determine what action been taken to provide a source of liquidity to meet future obligations. A recent study of closely held ESOP companies conducted by the National Center for Employee Ownership ("NCEO"), suggests that a substantial percentage of those companies do not have a repurchase plan. The data indicates that newer ESOPs are less likely to have a repurchase plan while older ESOPs are more likely to have a repurchase plan. The same survey suggests that almost half of all such companies repurchase stock from current cash flow.

Due to these factors, the actual stock repurchase history of the ESOP company may be very beneficial in determining the level of marketability discount to be applied. Newer ESOPs may not have a significant repurchase obligation due to the fact that few of the participants are vested, and fewer are expected to retire in the near term. Older ESOPs often have just the opposite concerns. Many of the participants may be substantially or fully vested, and many may be planning on retiring in the next few years.

Minority and Control Positions

Another facet of consideration is the power of the ESOP. If the ESOP is in a minority position, perhaps a greater marketability discount applies because the ESOP cannot compel the Company to provide for the future liquidity requirements of the plan. An ESOP with control is in a better position to direct the resources of the company to honor the repurchase liability. Financially stressed ESOP companies may have few options regardless of control issues, and significant marketability discounts may be appropriate.

Practical Considerations

An ESOP valuation is a dynamic document. The valuation is typically effective at one date in time, but it often applies to ESOP transactions throughout the course of a full plan year. The valuation will be completed year after year, during recessions and economic expansions. This long term orientation imposes the obligation to view the ESOP company in a different light than just a valuation at a single point in time. The value of the stock in a closely held company by definition suffers from a lack of marketability. This inherent disadvantage may not be overcome by the special features of an ESOP that are intended to facilitate the creation of a "market". The market that is created by the ESOP company competes for resources with all of the other capital demands placed on the company. The judgment of the valuation professional is essential in assessing the marketability discount that is appropriate in each individual ESOP application.

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