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An employee stock ownership plan (ESOP) is a qualified defined contribution plan with the primary investment goal of purchasing and owning equity securities issued by the sponsoring corporation. It is a mechanism by which the employees become the beneficial owners of company equity.
From the perspective of an ESOP company, various income tax benefits enable ESOPs to be corporate finance tools, thereby accomplishing both corporate finance objectives while at the same time accomplishing employee stock ownership and compensation objectives.
ESOP transactions can be complex because by their nature they can require knowledge from most or all of the following disciplines:
Valuation
Law
Corporate Finance
Income Taxation
Qualified Plan
Administration
ERISA
Fiduciary
Relationships
Since an ESOP is a qualified benefit plan under the Employee Retirement Income Security Act of 1974 (ERISA), it is subject to many of the ERISA rules (nondiscrimination, vesting, etc.). ESOPs are also unique in that they are subject to certain additional ERISA requirements specific to ESOPs, as well as being exempt from certain ERISA qualified plan requirements that are not applicable to ESOPS.
ESOPs can be non-leveraged, in which case the contributions to the plan are either in stock or in cash used to purchase stock, or in leveraged form, when a loan is used to finance a purchase of stock, often from a control shareholder. The loan can be provided either from a third-party lender or from the selling shareholder in the form of seller financing.
Selected ESOP Valuation Considerations
In addition to general valuation principles, approaches, and methods, ESOP valuations are subject to an evolving body of laws, regulations, and court decisions.
Control/Minority and Lack of Marketability
The relevant Department of Labor (DOL) ESOP regulations require that ESOPs pay no more than adequate consideration when investing in employer securities. The provisions found in Revenue Ruling USPAP are generally required for determining adequate consideration for ESOP transactions, as well as specific additional provisions regarding the marketability or lack thereof, and the presence or absence of control. The impact of the ERISA-required put right, which requires that the ESOP company offer a put right to the employee-participant, is one specific factor that must be considered in determining the magnitude of any necessary discount for lack of marketability. The existence of a put right provides a potential source of liquidity; however, that same put right also results in a growing repurchase liability that must also be taken into consideration in determining the ability of the ESOP company to honor the put obligations as they arise.
The presence or absence of a control premium is specifically addressed in the DOL ESOP proposed regulations. Under those regulations, a control premium might be applied even if the current acquisition of shares by the ESOP is a minority block, if it is anticipated that within a reasonable time that control will pass to the ESOP. Likewise, a control premium might not be applied even in the event of an acquisition of a control block of shares if it is reasonable to assume that control might pass from the ESOP within a short time period after the acquisition.
ESOP Specific Adjustments
Special consideration must be given to adjustments for certain expenses including ESOP-related expenses and management compensation. Employer ESOP contribution expenses are typically added back to earnings, to the extent that the contributions are in excess of normal retirement plan benefits. This might be the case where the ESOP-company is making additional contributions to the ESOP to enable the ESOP to prepay ESOP stock acquisition indebtedness. However, this might not be the case if the ESOP contributions are in lieu of market levels of wages and benefits, or if the current level of ESOP contributions is expected to remain in place indefinitely.
Audited financial statements for an ESOP company typically reflect a non-cash adjustment to cash compensation expense related to the fair market value of shares released or deemed to be released to ESOP participants during that year. However, the underlying economic assumption used by most valuation analysts is that any increase in fair market value of the company shares within the ESOP reflects earnings within the ESOP plan. As such, most valuation analysts add back the auditor’s non-cash compensation expense adjustment in determining normalized earnings.
Concerning officer’s compensation expense, many valuation analysts make excess compensation adjustments if members of management are earning amounts in excess of market levels of compensation if either the subject interest is a controlling interest or if compensation policies are expected to change to lower levels if the subject interest is a minority interest. In an ESOP valuation, many valuation analysts make such adjustments only if compensation policies will be changed to reflect the reduced level of compensation, regardless of whether the interest owned by the ESOP is a controlling or minority interest.
Leveraged ESOPS
After an ESOP purchases employer securities with loan proceeds, the ESOP-company has significant demands on cash flow to make debt payments. As such, the ESOP shares immediately after a leveraged ESOP transaction are typically worth less than the per share value used in the original transaction due to the reduction in available cash flow after debt service.
However, the income tax benefits available as a result of using the ESOP as a corporate finance vehicle help to offset part of the reduction in value from the required debt service. The ESOP company makes deductible contributions to the ESOP in amounts sufficient to pay principal and interest on the debt. As such, the ESOP-company is able to deduct principal payments and interest payments. In addition, in certain circumstances, dividends paid on shares held by the ESOP are also tax deductible. Valuation analysts typically determine the present value of the ESOP tax shield and add this amount back to the equity value of the company.
S-Corp ESOPS
The Small Business Job Protection Act of 1996 allowed ESOPs to own shares of an S corporation, and the Taxpayer Relief Act of 1997 added an exemption for S corporation ESOPs to the unrelated business income tax (UBIT). As such, in certain situations, no Federal income taxes were owed beginning in 1998 on the ESOP’s share of S corporation earnings. The greater the percentage of S corporation stock owned by the ESOP, the greater the proportion of profits that are not subject to income taxes (until distributed to ESOP participants in a taxable transaction). Controversy over this potentially substantial tax benefit arose, as the Treasury department and some lawmakers learned of ESOPs created at small family-owned companies solely for the purpose of avoiding federal income taxes. Congress took action to close what it perceived as taxpayer abuse of this income tax provision in the Tax Relief Reconciliation Act of 2001 with new IRC Section 409(p). This new section, described as the Anti-Abuse S corporation ESOP law, is a complex set of regulations designed to preserve the income tax benefits only for ESOPs that provide broad-based employee ownership. The new rules were effective March 14, 2001 for ESOPs adopted by S corporations or for C corporations with existing ESOPs that subsequently elected to be an S corporation. Existing S corporation ESOPs were grandfathered until the plan year beginning after December 31, 2004. The potential absence of federal, and possibly state, income taxes on the ESOP’ s share of an S corporation’s earnings presents a unique valuation issue requiring special consideration.
Timing of Valuations
An ESOP appraisal is typically required at each of the following events:
A valuation is required whenever the ESOP makes an acquisition of employer securities.
A valuation is required at least annually thereafter, although some companies do more frequent valuation updates.
A valuation is required whenever there is a transaction between the ESOP and a party in interest (as defined by ERISA as a fiduciary; service provider; employer whose employees are covered by a plan; employee organization whose members are covered by the plan; 50 percent or more owner of such employer or employee organization; spouse, ancestor, lineal descendent, or spouse of a lineal descendant of any of the persons above except an employee organization; corporation, partnership, trust or estate of which 50 percent is owned directly or indirectly by persons above (other than relatives); employee, officer, director, or 10 percent or more shareholder of any of the persons mentioned above except a fiduciary or a relative; and, 10 percent or more partner or joint venture of any person above except a fiduciary or relative).
A valuation is required whenevere the ESOP sells some or all of its stock in the company.