ESOP Feasibility and Valuation Basics Ohio Employee Ownership Center Akron/Fairlawn Hilton Fairlawn, Ohio April 21, 2006 Richard A. Schlueter rschlueter@comstockvaluation.com C VA 1 Levee Way, Suite 3109 Newport, Kentucky 41071 859-957-2300 Fax: 859-957-2305
Financial Feasibility Determine the objective of sellers. Prepare an initial valuation of company stock. Analyze the ability of the company to repay its debt to the lender after the ESOP transaction. Determine if the company has sufficient payroll to enable full deductibility of ESOP loan payments for tax purposes. Determine the likely structure for the transactions. Use of common, super-common, or convertible preferred stock Consider term of loan between ESOP and company. Consider contributions and dividends needed to repay loan. Prepare a valuation as of the closing of the transaction. 2
ESOP Tax Benefits Deductibility of Principal and Interest Deferred Gain on Sale to ESOP S Corporation Tax Exemption
Appraisal Requirements ESOP owned employer securities that are not readily traded on organized exchanges must be appraised by a qualified, independent appraiser. An appraisal is required: when the ESOP makes initial acquisition of stock; at least annually thereafter for plan administration purposes; whenever there is an employer corporation stock sale transaction with a control shareholder or member of a control group; or if the ESOP sells out of its stock position.
Valuation Process Issue engagement letter Gather financial information and other documents Schedule due diligence visit Prepare valuation analysis Issue a draft report containing preliminary analysis, key assumptions and conclusions Review of draft report by client Respond to questions Issue final valuation report
Valuation Principles Fair Market Value Adequacy of Consideration Financial Fairness
Fair Market Value The price at which the company s stock would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts.
Adequacy of Consideration For securities of privately owned companies, adequate consideration is defined as the fair market value of the security, as determined in good faith by the trustee or a named fiduciary under the terms of the plan, in accordance with regulations issued by the Department of Labor.
Financial Fairness Absolute Fairness The ESOP may not pay more than fair market value when it purchases the stock. Relative Fairness The ESOP must receive terms that are fair in relation to terms given to other investors.
Valuation Factors to Consider Nature and history of the business Economic and industry outlook The book value of the stock and financial condition of the business The earnings capacity of the company The dividend-paying capacity Goodwill/Intangible Value Sales of the stock and size of the block being valued The market price of stocks in the same business
Levels of Value Total Equity Value (Controlling Shareholder) Buyer of a Company Control Premium Discount for Lack of Control Marketable Minority Interest Value Price Quoted in the Wall Street Journal Discount for Lack of Marketability Non-Marketable Minority Interest Value Non-Controlling Shareholder of a Private Company
Control vs. Minority Ownership An ESOP that buys more than 50% of the stock may pay a control premium. An ESOP can buy less than 50% of the stock and may be able to pay a control premium if the ESOP will acquire control in a reasonable period of time. The ESOP should have voting control and control in fact in order to justify the control premium. Degrees of control may exist based on the rights granted under the various state laws.
Adjustments to Earnings Interest expense (invested capital approach) Inventory valuation method restated to FIFO Restate to conform with GAAP Non-recurring / extraordinary items Non-operating income & expense Discretionary expenses Owner s compensation & perks Bonus and employee benefit plans
General Valuation Approaches Asset Approach Net Asset Value Method Liquidation Value Method Income Approach Capitalization of historical earnings or cash flow method Discounted cash flow method Market Approach Guideline Company Method Merger and Acquisition Method Prior Transactions
Marketability No established market for closely held companies. Control interests may be marketable. Likely buyers include strategic buyers, financial buyers, company management, ESOP or family members. A buyer for minority interests is difficult to find, particularly if you are looking for a fair value. Most likely buyers for a minority interest are the company, company management, existing shareholders or an ESOP.
Marketability Discounts for ESOPs Marketability Discount, as defined by the American Society of Appraisers is an amount or percentage deducted from an equity interest to reflect lack of marketability. Under ERISA, an ESOP participant may require the employer to purchase his non-publicly traded ESOP stock at the appraised fair market value. ESOP Marketability Discounts impacted by: Level of control Ability of company to redeem stock Extent of pre-funding of repurchase obligation
Conclusion on Value No set formula Consider central tendency Do methods support each other? If not, identify why and select most appropriate method Will method give reasonable consistent results over time? Income approach Often receive greatest weight Availability/reliability of forecast Market approach Quality/comparability of market data Consistency of market multiples Asset approach Often a floor value
Valuation Report Content Valuation Opinion Letter Executive Summary Company Profile Economic and Industry Outlook Financial Performance Identification of Guideline Companies Valuation Methods Discount for Lack of Control and Marketability Reconciliation and Conclusion on Value
ESOP Repurchase Obligation Company is required to repurchase the stock of a terminated ESOP participant. Examine impact on value of 1) the company as a whole; 2) per share value; and 3) value of plan accounts. Redemption by company Repurchase by ESOP The repurchase of shares requires planning as cash flow is needed to fund this future obligation.
Pre- vs. Post- Transaction Value Depending on the structure of the ESOP transaction the value of the stock may decrease if leverage is used in the transaction. The reduction in value may be reduced through the use of Super Common or Convertible Preferred Stock or through the substitution of ESOP benefits for other existing benefits.
Overview Obtaining an independent and defensible valuation is the first step in determining the financial feasibility of an ESOP. An appraisal is required at the date the ESOP purchases or sells stock. Annual valuations are required for plan administration purposes. The trustee of the ESOP needs to conduct a review of the valuation report and access the reasonableness of its conclusions.
Biography RICHARD A. SCHLUETER, ASA Managing Director Rick is a Senior Member of the American Society of Appraisers and is a cofounder of ComStock Valuation Advisors, Inc. He has over 25 years of experience in the valuation and management of closely held business interests, as well as securities comprising their capital structure. He has extensive background in trust and estate planning, Employee Stock Ownership Plans (ESOPs), litigation support, and related financial advisory service. He has acted as an arbitrator and has served as an Expert Witness or Consulting Expert regarding financial issues in the United States Federal Tax Court and the United States District Court. Prior to co-founding ComStock, Rick was a Vice President for Valuemetrics, Inc., a national financial advisory firm. He was a regional manager with responsibility for the firm s Cincinnati office. Rick served in the trust industry with responsibilities in the administration and valuation of closely held businesses held in a fiduciary capacity. He was an Assistant Vice President of Harris Trust and Savings Bank, where he was primarily responsible for preparing and reviewing valuation studies for trust and estate holdings. He has extensive experience in preparing valuations for Gift and Estate Tax purposes and has also prepared valuations and custom financial analysis for the purpose of assisting the corporate fiduciary in making asset management decisions. Before joining Harris Trust and Savings Bank in 1986, he worked as a Personal Trust Officer for The Central Trust Company, N.A. of Cincinnati, Ohio, specializing in the valuation and administration of closely held business interests. Rick is a member of the Institute of Business Appraisers and a former Designated Certified Review Appraiser of the National Association of Review Appraisers & Mortgage Underwriters. He served as the past President and Vice President of the Business Valuation Association. In addition, he formally served on the International Board of Examiners for the American Society of Appraisers. Rick s continuing education includes participation at the National Trust Closely Held Business Association workshops, the ASA Advanced Business Valuation seminars, the ASA International Appraisal Conference Advanced Business Valuation seminars, University of Miami Heckerling Institute on Estate Planning, and the ESOP Association conferences. In addition, he has spoken on valuation topics before the ESOP Association, the National Center for Employee Ownership, the National Trust Closely Held Business Association, the Business Valuation Association and various seminars sponsored by banks and law firms. Rick holds a M.B.A. in Finance from Xavier University and a B.S. in Management from the University of Cincinnati, where he graduated magna cum laude. He has taken specialized coursework including Small Business Consulting, Small Business Operations, Problems in Corporate Finance, Personal Financial Planning, and Taxation of Partnerships and Corporations.