FAQs about valuations of ESOPs

Some FAQ's for Employee Stock Option Plans (ESOP)
...Why do we need to engage an outside party to value our ESOP shares?
From a strictly regulatory standpoint, a valuation of ESOP shares by an independent third party is required by the Department of Labor (DOL) and the Internal Revenue Service (IRS).  The regulatory requirement stems from the practical need to insure that the value is determined by a party who does not have a personal or financial interest in the valuation result.  The valuation, moreover, should be performed on behalf of the ESOP trustee since it is the duty of the trustee to insure that transactions with the ESOP are consummated at “fair market value.”

What is meant by “fair market value”?
Fair Market Value (FMV) is a concept and not a price that emerges from application of some standard formula.  In simple terms, FMV is the price for which property would sell under the existing market conditions for such property as established in arms-length negotiations between knowledgeable and independent parties.  The “market” implied in definitions of FMV encompasses all potential buyers and sellers of the property involved. 

How is “fair market value” determined?
There are many method used in the determination of FMV.  The nature of the property being evaluated determines what methods are appropriate.  For example, the FMV of a single family home is determined by the price for which similar property is selling in the area in which such property is located.  The FMV of business interests that is generating earnings, however, is determined to a large degree on the basis of what a knowledgeable buyer would be willing to pay for the earnings stream considering available rates of return on relatively risk-free investments and the risks associated with the investment being appraised.  Although not the only method that might be considered, the present value of future earnings using a risk adjusted market rate is one of the most common approaches, referred to in business valuations as Discounted Future Earnings (DFE).

Reference to the results of mathematical formulas is not the sole determinant of FMV.  The judgment and experience of the valuation analyst is also a critical element since there can be many factors that can not be quantified by reference to the underlying financial information alone.

What is meant by a “control premium”?
A control premium is that amount which a buyer may be willing to pay to acquire a controlling interest in a business over and above the value of the interest based solely on the underlying financial factors.  The element of control, in this case, has a value which is added to the value that can otherwise be ascribed to the assets and earnings of the business.  The payment of a control premium in the purchase of a business does not necessarily add any value to the business.  Synergy value, unlike control, is susceptible to being measured in more concrete terms of increased financial benefits to the buyer over and above those being enjoyed by the selling parties.  Examples are the prospects of increased sales of the buyer’s products to the seller’s customer base or lower overall materials costs due to volume purchase discounts, etc.  Whether or not a control premium is appropriate in the purchase of shares by an ESOP must be determined on the facts in the individual case.  Moreover, since the ESOP generally doesn’t control a company itself, there is much debate as to whether or not an ESOP can pay a control premium for shares purchased, even if purchasing a controlling percentage.

How do ESOP valuations differ from valuations for other purposes?
Because of the regulatory requirement established in the Employee Retirement & Income Security Act of 1974 (ERISA) that an ESOP pay no more than “adequate consideration” in the purchase of employer securities, ESOP valuations must support the decisions of the trustees and must also withstand review by DOL and the IRS.  Valuations that are subject to being reviewed by third parties, whether for ESOP or other purposes, must include considerable discussions on the methods and factors employed as well as explanatory information on the sponsoring company’s financial and operating history and the industry in which it competes.  For similar reasons, valuations supporting tax related values for gift and estate or charitable deduction purposes must also include considerable background detail so that potential third party reviewers will have a clear understanding of the process leading up to the value conclusion.  In addition, ESOP regulations place various obligations on the sponsoring employer and allow for limitation of the voting rights of ESOP shares.  These, and other features specific to the ESOP require special consideration in the determination of the fair market value of ESOP owned securities of privately held companies...

Source is this firm GROCO CPA