ESOP Feasibility and Valuation Basics

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ESOP Feasibility andValuation Basics

• Ohio Employee Ownership Center
• Akron/Fairlawn Hilton
• Fairlawn, Ohio
• April 21, 2006
• Richard A. Schlueter
• rschlueter_at_comstockvaluation.com

COMSTOCK VALUATION ADVISORS ? 1 Levee Way, Suite
3109 ? Newport, Kentucky 41071 ? 859-957-2300
? Fax [phone] ?
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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.

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ESOP Tax Benefits

• Deductibility of Principal and Interest
• Deferred Gain on Sale to ESOP
• S Corporation Tax Exemption

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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.

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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

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Valuation Principles

• Fair Market Value
• Adequacy of Consideration
• Financial Fairness

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Fair Market Value

• The price at which the companys 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.

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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.

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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.

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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

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Levels of Value

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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.

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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
• Owners compensation perks
• Bonus and employee benefit plans

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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

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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.

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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

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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

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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

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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.

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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.

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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.

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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 firms
  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.
• Ricks 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.