An ESOP (Employee Stock Ownership Plan) is a type of employee benefit plan that gives employees stock options and allows them to buy shares in the company at a set price.
There are several objectives behind an ESOP, including but not limited to providing business owners with an alternative exit strategy by handing their company over to the hands of a trusted management team who have a vested interest in the company’s success and survival.
Additionally, a well-devised ESOP should also motivate employees to perform better and improve shareholders’ value, encourage your best employees to stay, while also attracting desirable candidates to join your company.
We have covered these and more benefits of implementing an ESOP plan in greater detail in a previous post that you can check out here, including the tax advantages derived from an ESOP structure. In this post, however, we want to talk you through one of the most important steps involved in setting up an ESOP: an ESOP valuation.
What Is An ESOP Valuation?
To establish an ESOP, the company requires an independent valuation. In simple terms, an ESOP valuation is a review or assessment of the company’s financial position and worth for feasibility purposes.
This assessment is conducted by an independent appraiser – independent because it is of the utmost importance that the appraiser is not affiliated with nor has any present or even future financial interest in the company for which the ESOP valuation is provided.
The Three Types of ESOP Valuations
1. A preliminary valuation:
An initial assessment provides an estimation of the company’s value. Not only does this give you an approximate indication of value and feasibility, but it also enables you to compare your proposed ESOP with any alternatives available.
2. Fair market valuation:
A fair market value, or FMV, is the price a financial buyer would pay for the company on the open market. As such, a fair market valuation is a comprehensive assessment and includes a summary of qualifications, purpose of valuation with disclaimers, methodology and reasoning, description of the company within its industry and economic, earnings, relevant discounts, and other relevant facts.
This data is then used to inform the company’s feasibility, structuring, and financing considerations.
3. Annual valuation:
ESOPs contain a ‘put option,’ which allows plan participants, retired participants, and beneficiaries to sell distributed ESOP shares back to the trustee at fair market value. Moreover, most ESOP-owned businesses aren’t actively traded in the public markets.
With these two thoughts in mind, ESOP-owned shares are required to be valued at least once a year, which is how we come to the third type of assessment – the annual valuation. This, too, is conducted by an independent appraiser in order to fairly determine the market price for employee-owned shares.
Thankfully, an annual update is less time consuming and less costly than the initial or fair market valuations if you stay with the same team to guide and assist you, who will then be familiar with the company and its financial data.
Why Is An ESOP Valuation Necessary?
An ESOP valuation is absolutely vital to the employee ownership process for several reasons. The simplest and primary explanation for why the valuation is so important is because it enables you to learn the true value of your ESOP. The information gleaned can be used to verify if the plan is possible in the first place, and worthy of the effort in the second.
For that reason, when your company starts its journey of exploring an ESOP, the valuation process is crucial.
In addition to determining the overall feasibility of the plan, an ESOP valuation is also necessary for accounting purposes as well as for tax purposes, whereby the valuation allows you to calculate the prerequisite payable taxes by employees.
There are a variety of other reasons that we haven’t gone into here, both minor and major. Many of these are specific to your company unique requirements, and our team at Excel Legacy Group will rely on their expertise to pinpoint how and where the valuation process is central to your ESOP.
Who Is Involved In ESOP Valuations
You may be wondering who should be involved in your company’s ESOP, particularly given that ESOPs are subject to the Employee Retirement Income Security Act of 1974 (ERISA).
We can tell you that the three main players include:
- ESOP Trustee: The primary representative of an employee trust who has a fiduciary obligation to all plan participants, ensures that the terms of the ESOP is executed, and is liable when claims related to share pricing are brought against an ESOP.
- Independent Appraiser: The trustee seeks the professional help from an appraiser who is not influenced by the company or its shareholders and establishes a fair market valuation and pricing for ESOP-owned shares that is then shared with the trustee.
- US Department of Labor: Not only does the DOL provide federal oversight of all ESOPs in accordance with ERISA by regulating plan procedures and reviewing the activities of plan professionals, but it also verifies that the ESOP sale and subsequent valuations reflect fair market value.
ESOP Valuation Methods
There are two approaches that are used to complete an ESOP valuation, including the intrinsic value method and the fair value method.
The intrinsic value:
The intrinsic value is the excess of the market price of the share under ESOP over the exercise price of the option. To determine the intrinsic value, you can use one of three options – income, asset, or market.
- Income approach: Relies on a company financial forecast to make predictions and assumptions about the future.
- Asset approach: The simplest and easiest for companies with many tangible assets and low cash flow in that it assumes a company’s value is equal to the market value of its assets, subtracted by the market value of its liabilities.
- Market approach: Bases a company’s worth on what similar companies have sold for. A great ESOP valuation example is found in real estate, where realtors pull comparable data on houses in an area and make adjustments on how your house compares to those. This is what valuation experts do using the market approach.
The fair value:
The fair value method relies on an option pricing model, like a Binomial model, the Black Scholes formula, or the Monte Carlo method. The method chosen depends entirely on the desire for accuracy and the complexity of the scheme.
- Bionomial model: This is the far more advanced of the three options and relies on computational techniques to project the share price, using ‘up’ and ‘down’ probabilities. It is a robust method that allows for more complicated rules and events during the vesting period.
- Black Scholes formula: This method is widely used and best suited for smaller schemes with simpler rules, however it must be said that this method doesn’t allow for complicated processes.
- Monte Carlo method: By far the most accurate method, allowing for any level of complexity of the scheme and even pre-vesting events (like stresses in the market). As like the Bionomial model, the Monte Carlo involves projecting the share price, but it isn’t restricted by the set ‘ups’ and ‘downs’ probabilities.
There are advantages and disadvantages to each of these methods in determining the fair market value of a company. That’s why it’s best to turn to the experts who are well-placed to advise you on which method is better suited to your company and ESOP.
Let Excel Legacy Group Help
We have heard it said that valuation is a blend of art and science. We couldn’t agree more, relying on ESOP consulting, financial, investment banking and legal expertise, combined with our professional judgment to assist companies in creating and maintaining successful, sustainable employee ownership results.
As a national ESOP firm, our strength lies in being able to balance the needs of owners, managers, the company, and its employees in order to ensure long-term corporate sustainability with substantial employee ownership.
Let our ESOP experts guide you through this essential process.
Talk to us today.