This article written by ValueMetrics Corp provides an excellent overview of the rules governing the valuation of ESOPs
ESOP VALUATIONS NEW
DEVELOPMENTS
An ESOP (Employee Stock Ownership Plan) is a
defined contribution pension plan, authorized by ERISA (Employee Retirement
Income Security Act) similar to a profit-sharing plan. In an ESOP, a company
sets up a trust fund, into which it contributes shares of its own stock or cash
to buy shares of its stock. The purpose is to provide liquidity to owners
of closely held companies who desire to exit and an investment in the company
to covered employees. Congress made employee ownership a priority goal,
and provided a number of tax benefits to facilitate and encourage ESOPs.
The ESOP
is funded by the company, not the employees. The ESOP can borrow
money to buy shares, with the company making cash contributions to the
plan to enable it to repay the loan. The company may also be
required to guarantee the loan by the lender.
Regardless of how the plan acquires stock,
company contributions to the trust are tax- deductible, within certain
limits.
Shares in
the trust are allocated to individual employee accounts. As employees accumulate seniority within the company, they acquire an
increasing right to the shares in their account, a process
known as vesting. Employees must be 100% vested within three to
six years, depending on whether vesting is all at once (cliff vesting) or
gradual. When employees leave the company, they receive their stock, which
the company must buy back from them at its fair market value (discounted) or fair
value (undiscounted) as per provisions in the plan, unless there is a public market for
the shares. They may, in the alternative, receive a cash buyout of the
appraised value of their interest. Private companies must have an
annual ERISA compliant independent valuation to determine the price of their shares.
In private companies, ESOP employees must be able to vote
their allocated shares on major issues, such as closing or relocating, but
the company can choose whether to pass through other voting rights, such
as voting for the board of directors, or other issues. In public companies,
employees must be able to vote all issues.
Department of Commerce figures show that there
are in excess of 170,000 companies in the U. S. with 20 to 999 employees, which are
potentially suitable for ESOPs. These are virtually all privately
held. The National Center for Employee Ownership shows that there
are only about 11,000 ESOPs amongst this group. Thus the penetration is
about 6.5%.
With the virtual collapse of credit markets in 2008, exit opportunities
for owners of small businesses have been dramatically and negatively
impacted. Selling a company to an outside party may not be feasible
both for tax reasons and availability of financing. However in some cases
an ESOP is feasible because the seller can carry back a note for all or
part of the purchase price from an ESOP. This can be combined with
institutional debt and possible investment by private equity, to form a
new capital structure that effectively “buys out” the selling shareholder.
Thus a significant increase of ESOPs is expected over the next several
years as retiring “baby boomers” attempt to exit their businesses in this
environment.
TAX CONSIDERATIONS
Without
use of an ESOP, the selling owner can expect serious tax implications. In
a C- corporation he will be
double taxed, with the Federal capital gains rate expected to return to
20% as the Bush tax cuts expire in 2011. State capital gains tax
treatment differs. Some, like California, do not provide for capital gain treatment
and tax as ordinary income. The C-corporation taxes, plus brokerage commissions,
other selling costs, and personal income taxes can reduce the net on the sale by 60% to 70%
(depending on the state) or more. S-corporation owner’s fare better on a sale, but
the total cost of sale is still expected to be 30% to 40% or so, depending on
the state. Both C-corporations and S-corporations can sponsor ESOPs however the
tax advantages to the owners differ, but in both cases may provide significant
benefits.
A C corporation shareholder, who sells at
least a 30% interest to an ESOP, can roll the net sales proceeds into
investments in qualified public securities without any income tax liability.
An S-corporation seller does not get this advantage; however, for S corporations
there is no income tax liability for income allocated to the ESOP.
There are many other tax considerations, but the details of tax
treatment are beyond the scope of this paper.
A
drawback of selling to an ESOP may be that the shares are subject to a minority discount
to meet the “adequate consideration” conditions, thus providing a lower
gross price per share than the gross sales price to competitive outside
buyers. But after the comparative tax consequences are analyzed it is
quite probable that the net after-tax proceeds of the sale could be
significantly higher with a sale to an ESOP.
VALUATION – AN ESSENTIAL COMPONENT OF AN ESOP
IRS Code
Section 401(a)(28)(C) requires a non-publicly traded company to obtain
a qualified appraisal of the ESOP shares:
Each time the plan acquires shares, and At the
end of each plan year thereafter.
The
Pension Protection Act of 2006 requires such appraisals, and the appraisers to
be
qualified under its regulations. The
applicable standard is Fair Market Value. The two significant issues
affecting compliance with ERISA are the concept of “adequate consideration” and
appropriate discounts in value for lack of marketability (DLOM).
“Adequate consideration” means that the ESOP may not pay more than qualified Fair Market Value for shares it acquires for the ESOP. Both ERISA (Department of Labor) and the IRS acknowledge that these shares should be discounted in value for lack of control, and for lack of marketability if appropriate. A “control” interest is problematic in that though the ESOP may obtain numerical control, it may not be able to practically act on such control due to limitations imposed by the ESOP or other corporate documents. For instance, though the trust may represent a majority interest, the covered employees may not be able to vote on significant issues by limitation of the ESOP or other documentation. Further, because the ESOP’s interest is voted by the trustee, there may be no way the employees can vote to determine the trustee’s action, nor to remove the trustee. The effect of this is that the appraiser must take into account a number of issues which have been more or less “codified” by applicable court decisions:
Adjustment
for excess compensation to employees. Because the IRS permits large
tax deductable contributions to the plan, which effectively increase employee costs for tax purposes, an analysis must be made to
determine if a premium exists, and to appropriately adjust the income statement
upon which the basic appraisal of the company is made. If this is
not done, the basic fair value equity may be significantly understated.
Complete
analysis of the control and marketability issues. Many appraisals, especially in the past, dealt with the concept of “control
premiums.” This concept comes from analysis of publicly traded securities, and
really has no relevance to exempt private securities. In these securities
the fair value equity of the stock (without discounts) automatically
reflects control.
In
privately held companies, the control premium is merely the difference
between the fair value equity (equity value of 100% ownership) and the value
of minority interests after discounts
are applied. Also, stock of the same class may be issued with or without voting rights.
Lack of voting rights can cause impairment in value.
The question of de facto control vs. numerical
control must be thoroughly addressed. For instance, even though an
ESOP may hold a majority interest in the number of outstanding shares, the
question of who is empowered to vote those shares arises. The
employees usually have no say in the selection of the trustee. And the trustee
may be a controlling officer of the company, which could present a potential conflict of interest.
REQUIREMENTS OF ERISA AND PROPOSED REGULATIONS
ERISA
sets forth requirements for the trustee to exercise due diligence and good
faith in valuation of assets for which there is no active market. Proposed
Regulation 2510.318(b) and proposed 29 CFR 2510.3-18 to ERISA expand on the definition of
“adequate consideration”, and though not yet officially enacted, industry
and government almost universally adopted the same criteria to use until
enacted.
Under
ERISA, “adequate consideration” means the fair market value of the asset
as determined in good faith by the trustee or named fiduciary pursuant to
the plan and in accordance with regulations promulgated by the Secretary of Labor.
The proposed regulation delineates the scope of
this regulation by establishing two criteria, both of which must be met
for a valid determination of adequate consideration.
First,
the value assigned to an asset must reflect its fair market value as determined pursuant to proposed § 2510.3-18(b)
Second, the value assigned to an asset must be the product of a determination made by the fiduciary in good faith as defined in proposed §2510.3-18(b) .
For the
first criterion the definition of fair market value is set forth as: “…the price at which an asset would change hands
between a willing buyer and a willing seller when the former
is not under any compulsion to buy and the latter is not under any compulsion to sell, and
both parties are able, as well as willing, to trade and are well- informed
about the asset and the market for the asset.” (It should be noted that this definition
is consistent with that adopted by most appraisal organizations, and is also consistent
with the IRS code and IRS Revenue Ruling 59-60, and the Uniform Standards for
Professional Appraisal Practice.)
The
second criterion sets forth the following:
The valuation must be set forth in a written
document
the “good
faith” requirement establishes an objective standard of conduct,
rather than an inquiry into the state of mind of the Trustee
the
fiduciary making the valuation must itself either be independent of all
the parties to the transaction or must rely on the report of an appraiser
who is independent of all the parties
if
donated property, the valuation should follow Rev. Proc 66-49 (IRS
Revenue Ruling 83-20) which sets forth the format required by the IRS for
valuation of donated property, or
If the
property is to be purchased, it requires that Revenue Ruling 59-60 shall apply.
This
documentation must contain, at minimum
a. A
summary of the qualifications of the appraiser,
b. A statement of the asset’s value and a
statement of the methods used in determining that value, and the reasons used to
determine the value,
c. A full description of the asset being valued,
d. The factors taken into account in making the
valuation, including any restrictions understandings, agreement or obligations limiting the
use or disposition of the property,
e. The purpose for which the valuation was made,
f. The relevance or significance accorded to the
valuation methodologies taken into account,
g. The nature of the business and the history of
the enterprise from its inception,
h. The economic outlook in general, and the
outlook for the specific industry in particular,
i. The book value of the securities and the
financial condition of the business,
j. The earning capacity of the company,
k. The dividend-paying capacity of the company,
l. Whether or not the enterprise has goodwill or
other intangible value,
m. The market price of securities of
corporations engaged in the same or a similar line of business (later expanded to
include similar fee holdings),
n. The marketability of the securities, or lack
thereof,
o. Whether or not the Seller would be able to
obtain a control premium from a third party.
Under the
Pension Protection Act of 2006, and in ERISA regulations, the
appraisal procedures must be in strict compliance with the Uniform
Standards for Professional Appraisal Practice, (“USPAP”) Standards 9 and
10 which apply to Business Appraisal procedures, and Business Appraisal
Reports, respectively.
MINORITY DISCOUNTS
ESOP fiduciaries and financial professionals
involved with the administration of the ESOP need to be aware of
the effects of court cases relating to the valuation of minority interests
in small businesses and related securities. Cases brought to the Tax
court in recent years have shed
light on the relatively obscure subject of discounted values caused by
reduced marketability and control for minority interests. The cases will
be pointed out in this article.
Prior to
these cases, appraisers generally treated valuation of such discounts as
a relatively minor adjunct to the valuation of the basic (majority)
position. Many either
used “industry standards” for marketability
discounts of, say, 35% without support, or they attempted to support
these values with statistics from studies of restricted stock of public
companies which can be sold, usually at a discount, from their unrestricted brethren, and by IPO
studies of stock values before and after the Initial Public Offering. The
courts have virtually all rejected such valuations in the case of closely
held securities, and laid down some principles which, if adhered to in
appraisals, should significantly limit the chances of litigation.
And, if litigated it should significantly enhance the chances of
winning.
Further, some valuators argued that because ERISA provides an implied “Put” option for the employee to sell his stock back to the company, that there is no minority interest generated impairment of value to the ESOP. This is wrong because the Put is a contract between the company and the employee, not the ESOP and the employee; and the ESOP has no right to put the stock to the company.
Further, some valuators argued that because ERISA provides an implied “Put” option for the employee to sell his stock back to the company, that there is no minority interest generated impairment of value to the ESOP. This is wrong because the Put is a contract between the company and the employee, not the ESOP and the employee; and the ESOP has no right to put the stock to the company.
VALUATION PRINCIPLES
All
appraisals are a defensible opinion of value, prepared by an expert, for an
ownership interest. Such an
ownership interest is often referred to as a “bundle of rights.” Normally ownership
in fee contains the most valuable bundle of rights, and lesser forms such
as ownership of a security interest, lease, license, minority interest, or
other such instrument will reduce the bundle of rights – and hence the value.
Further, contractual restrictions on marketability or control of
such minority interests results in a reduction of value. If the asset to be valued is a minority interest, and/or if it is
subject to restricted marketability, and/or lack of control, appropriate discounts to
value must be applied.
Over the
years, many appraisers have adopted policies that separated the lack of control discount
from the lack of liquidity or marketability discount. However, this
appears to be a difference without a distinction. All discounts from value
appear to be, in the end, evidence of impairments in marketability. The fact that such
discounts, even if treated as
separate discounts, are multiplicands which are
multiplied by each other to derive a final discount figure
illustrates this point.
Though
the appropriateness of applying such discounts in these situations has
been universally accepted by
the IRS and the courts, recent court decisions have shown a fair amount of disagreement over
the means of quantifying the appropriate discounts. (IRS Revenue
Ruling 77-287 deals with marketability discounts for “restricted securities,”
but it is silent on “exempted securities,” which make up the vast
majority of privately held
securities. Both are defined and described
in the Securities Act of 1933.) The cases indicate a complete
analysis is required.
To
quantify the “marketability discount,” because of a lack of available specific
data, some appraisers have been
relying on two sources of data from public company transactions: Initial
Public Offering Studies, and Restricted Stock Studies to defend their discount
opinion. The “standard” discount often derived from these studies is
typically between 30% to 40%. Three cases against the Commissioner in
2003 found that such studies, based upon data from public companies, were not
sufficient basis to value closely held private (exempt and unregistered)
ownership. Upon a deeper look the reasons are fairly obvious:
Initial
Public Offering Studies (IPO) show the difference in the price of a stock before
the offering and after, and an appraiser may attempt to infer that this
is direct evidence to support a marketability discount for an exempt
security. This is erroneous for the following reasons:
Stock values of privately held companies typically
are based upon investment value – that is, an investor will be interested in both
the current return, and the amortization factor (risk abatement factor)
which indicates how long it will take to recover the initial investment.
This is necessary because of the high degree of illiquidity of non-public
securities.
The IPO price, on the other hand, reflects a
speculative value – that is, the investor is looking mainly towards price
appreciation. By its nature once publicly traded, the stock should have high
liquidity, so recovery of the investment
is not an investment concern. Thus, this study is relevant only to companies anticipating
an IPO. Unfortunately these companies represent less than 1% of the
companies extant in the U.S.
Restricted
Stock Studies deal with stocks of public companies that have
been temporarily restricted from sale for two years (later for one year)
in the public markets (usually by virtue of securities regulations under
Rule 144). Nonetheless, there is no prohibition in selling these
securities in private transactions where they usually sell at an average
of 30% or so less than publicly traded stock. But these are
applicable only to normally publicly traded stocks that have only a
temporary restriction from public markets, and not on the general
”permanent” illiquidity problem faced by small privately held companies which would make
them far less marketable.
Control
discounts, (or more appropriately control-based marketability discounts)
for privately held companies exist because in privately held companies the
only practicable way to recover the investment is liquidation (sale) of the
company. Without control, an investor does not have
the right to exercise this option. Thus minority interests in
closely held companies are very difficult to sell and even some majority
(by percentage ownership) interests which have their control impaired by
agreement have a much lower market value than those which are not
impaired. In practice, in the past appraisers have often attempted to base
discounts for lack of control on control premium studies of
public companies. But they are not the same as for private companies
at all, and the dynamics of value discounts are not appropriate for them.
The case
of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use
of irrelevant data is unacceptable, and sets forth some basic factors
which might comprise the discount, but specified that this list was not
exclusive, and other factors may (and should)
apply as the situation dictates. It basically states that a complete
analysis must be done which is relevant to the subject. The factors listed to
be evaluated included but were not limited to:
Private vs. public sales of stock
Financial statement analysis
Dividend policy
Nature of the company, history, position in the industry and
economic outlook
Management
Amount of control in transferred shares
Restrictions on transferability of stock
Company’s redemption policy
Costs associated with making a public offering
IRS
Revenue Ruling 77-287 deals with marketability discounts for “restricted securities”,
but it is silent on “exempted securities,” which make up the vast majority
of privately
held securities. Both are defined and described in the Securities Act of
1933.
ASSESSING EFFECTS ON SMALL VERSUS LARGE
COMPANIES
To put
this in perspective the following table shows the number of businesses in
each group by employee size extracted from County Business Patterns, 2007,
published by the Bureau of Census, for the USA (total of 7.5-million
companies). It shows the overwhelming proportion of small (usually
SEC exempt) companies.
Less than 10 employees 79.0%
Less than 20 employees 90.0%
Less than 100 employees 99.0%
Less than 500 employees 99.7%
More than 500 employees 0.3 %
The dynamics of marketability discounts for the
99% of small businesses with less than 100 employees is simply not reflected in the
studies based upon public companies. The cases of McCord v.
Commissioner, 120 T.C. 358-2003, Lappo v. Commissioner, T.C.M 2003- 258 and Peracchio v. Commissioner, T.C.M 2003-280 all
rejected the “cookie cutter” approach to discounts based upon data from public
companies.
Discount data from public companies is available,
and there are several studies available which document appropriate
discount rates for them. However for small, closely held companies,
this data is not available. Minority interests in such companies are
extremely difficult to sell and there are virtually no active markets.
CONTROL DISCOUNTS AS APPLIED TO FAMILY MEMBERS
OWNING SHARES
IRS Revenue Ruling 93-12 applies in this
instance. Prior to the issuance of Revenue Ruling 93-12, the IRS held a position that when transfers of stock
comprised a controlling interest within the family unit as a whole, even
though individual gifts of
stock might not grant a controlling interest,
per se, that discounts in value for the lack of control were not allowed.
IRS Revenue Ruling 93-12 reversed this position, and holds that
in the case of gifts of stock the following policy is in effect:
"If a donor
transfers shares in a corporation to each of the donor’s children, the
factor of corporate control in the
family is not considered in valuing each transferred interest for purposes
of Section 2512 of the Code, for Estate and Gift Tax purposes, the Service
will follow Bright, Propstra, Andrews and Lee in not assuming that all
voting power held by family members may be aggregated for purposes of
determining whether the transferred shares should be valued as part of a
controlling interest. Consequently a minority discount will not be
disallowed (emphasis added) solely because a transferred interest, when
aggregated with interest held by family members, would be part of a
controlling interest.”
This would
be the case whether the donor held 100 percent or some lesser percentage
of the stock immediately before the gift. In appraisal practice, the
appropriate discounts for Lack of Control and Restricted Marketability are
applied consecutively and cumulatively.
BUILT IN CAPITAL GAINS
The case of Estate of Dunn v. Commissioner, 301F
3rd 339 (5thCir. 2002) reversed a previously held notion that a built in
capital gains tax which is attendant to a low-basis high asset value situation
established that the value should be reduced dollar for dollar for the capital
gains tax liability. Estate of Jelke v. Commissioner, T.C.M 3512-03 U.S.
App 11 th Cir. 2007) found an assumption must be made for immediate liquidation
rather than spreading the gain over the expected life of the investment.
This now places four Circuit Court of Appeals on the side of taking a
dollar for dollar deduction for Built-In Capital Gains tax in a Corporation.
See Estate of Eisenberg v. Commissioner, 74 T.C.M. (CCH) 1046 (2 nd
Cir. 1997), Estate of Welsh v. Commissioner, 208 F. 3d 213 (6 th Cir. 2000),
Estate of Jameson v. Commissioner, 267 F. 3d 366 (5th Cir. 2001), Estate of
Dunn v. Commissioner, 301 F. 3d 339 (5th Cir. 2002), and Estate of Jelke v.
Commissioner,T.C.M 3512-03 U.S. App (11th Cir. 2007). The question of the
proper way to reflect this deduction was not determined. There are two
possibilities, (1) show marketability discount in value, or
(2) reflect a contingent liability in the amount of the allowance for Built
in Gains tax on the balance sheet.
CONCLUSIONS REGARDING
DISCOUNTS
The
courts have indicated that a complete and defensible analysis of the applicable
issues must be made from which an appraiser bases his decision.
Because transfers of minority interests in closely held companies are very
rare, and there are no historical data sources available for these
discounts, the appraiser must rely upon his experience and judgment in determining
the appropriate discounts based upon a hypothetical analysis.
The IRS
states that valuation is a question of fact and the trier of fact must weigh
all relevant evidence to draw the appropriate inferences. This
begs the question of how can
an appraiser draw inferences if there is no
published data.
Conventional statistical analysis
will neither be appropriate nor possible in this situation. There is,
however, an available methodology called “heuristics” or the “heuristic paradigm”.
The vast
majority of people are not familiar with the term “heuristics,” though we all
use heuristics, probably
without being conscious of it. The word is derived from the Greek word “Eureka” meaning “I have found it.” In the past twenty years
it has been refined into a modern problem solving and analysis methodology, usually
associated with “systems science.” It has been developed to deal with
decision-making and judgment- making
involving complex systems where specific reliable data is not available, and
the time and
cost of obtaining such data necessary for a conventional statistical analysis
is simply not feasible.
Basically
heuristics is the art of drawing inferences when faced with limited, incomplete or
fuzzy data. It is based upon the innate human ability to recognize
patterns. We do this spontaneously. Even reading the words on
this page is a heuristic endeavor. The reader is
not interpreting literally the meaning of each word (which itself is a heuristic endeavor), but is
recognizing the pattern of ideas which the words convey. To employ the
heuristic approach requires two things:
A human mind, which is
genetically disposed to recognize patterns;
and
it must be a mind
with, Significant experience in the general subject matter from which to
recognize patterns.
Employing these attributes will allow an
appraiser to collect heuristic data points, none of which in itself will permit
a specific and defensible inference, but all of which serve to frame an
array which can be judged for their apparent relevance, weighting them
and ranking them to provide insights into the probable effect of specific
issues that, in the case of discounts, would foster a reduction of value.
It takes expert experience to do this well. This is likely the reason for the minimum
two-years experience in valuing the type of asset being appraised as set
forth in the Pension Protection Act of 2006 – which now governs appraisals
of this type.
A
complete discussion of heuristics is beyond the scope of this article. The
purpose here is to introduce the concept so that the reader may understand that
such a methodology is not only available, but scientifically defensible,
and to look deeper into it. Googling the word “heuristics” will lead
to a number of sites, including Wikipedia, which can shed some light on
this. But the important point to
remember is that as a result of the recent court cases, the analysis of
discounts must be as complete and defensible as the analysis of the
basic (majority interest) of the security. Rules of thumb won’t work.
CONCLUSIONS
Under
ERISA and IRS regulations there are severe potential penalties for
improperly determining “adequate
consideration” and damages from litigation can be significant (see Reich v. Valley National
Bank of Arizona (the “Kroy case”) where damages were $17,500,000 resulting
from the ESOP paying more than “adequate consideration” for shares to the
detriment of employees. There are likewise serious potential administrative penalties if
tax deductibility is denied resulting from improper valuation. This can arise when the
transaction becomes a “prohibited transaction”
under ERISA and IRS regulations, and the tax benefits could be disallowed
– resulting in penalties and interest, not to mention the payment of taxes. Therefore
it is of the utmost importance that all of the parties involved with the administration of an ESOP
(the trustee, the company owner, the lender, if there is one, the
appraiser, the tax accountant, and the ERISA compliance attorney) be in
coordination, and be aware of how the valuation issues affect the situation. And,
most importantly, to avoid serious financial risks and penalties, the valuation
report itself must address all the nuances engendered by the ESOP, and
the enabling legislation, so that the valuation is relevant, defensible,
and complete.
by Gerald W. Barney
Melisa Silverman
