ESOP Valuation, Current Topics

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ESOP Valuation, Current Topics
2003 American Society of Appraisers International
Appraisal Conference Business Valuation Prepared
by E.W. (Sandy) Purcell Managing Director July
16, 2003
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Topics to be Covered Today
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ESOP BASICS
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ESOP General Overview - Introduction

• Two types of ESOP structures
• A C-Corporation ESOP Structure
• A S-Corporation ESOP Structure and
• A combination of a C-Corporation ESOP and an
  S-Corporation ESOP Strategy.

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C-Corporation ESOP Transaction

• The Company is a C-Corporation and establishes an
  ESOP.
• The Company borrows funds and re-lends the
  proceeds to the ESOP on terms and conditions that
  may or may not be equivalent to the original loan
  (the Inside ESOP Loan).
• The ESOP uses the funds to purchase shares of
  existing shareholders. The shares are held in a
  suspense account.

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C-Corporation ESOP Transaction

• The Company services the new debt by making
  tax-deductible contributions to the ESOP in an
  amount equal to the principal and interest due on
  the Inside ESOP Loan. The ESOP repays the Inside
  ESOP Loan to the Company and the Company makes
  the debt payment to the lender.
• As the Company makes the ESOP contributions,
  shares are released from the suspense account and
  allocated to the employees participating in the
  ESOP.
• The ESOP can be viewed as a prefunded benefit
  plan for employees and as an ownership/management
  succession plan.

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C-Corporation ESOP Transaction

• After an initial ESOP purchase, the Company (now
  controlled by the ESOP) elects S-Corporation tax
  status.
• S-Corporation earnings are taxed at the
  shareholder level.
• As a qualified benefit plan, ESOPs are not
  subject to taxation.
• The 100 S-Corporation ESOP Company is not
  subject to federal corporate income taxation but
  if the ESOP does not own 100, then the Company
  still must make cash distributions to non-ESOP
  shareholders for their individual-level tax
  liabilities.
• The following example summarizes company
  projected tax savings if the company is 100
  owned by an ESOP. Assume the Company has taxable
  earnings as indicated below and a tax rate of 40.

FYE December 31 (Figures in millions)
2003 2004 2005 2006 Taxable Earnings 2.197 2.
525 3.613 3.170 Projected Annual Tax Saving _at_
0.879 2.123 1.445 1.268 Cumulative Projected
Tax Savings 0.879 1.889 3.334 4.602
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BASIC ESOP VALUATION
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Revenue Ruling 59-60

• Factors to Consider in Estimating Fair Market
  Value
• The nature of the business and history of the
  business enterprise,
• The economic outlook in general, and the
  condition and outlook for the non-metallic
  materials manufacturing industry in particular,
• The book value of the stock and the financial
  condition of Company,
• The earning capacity of the Company,
• The dividend-paying capacity of Company,
• Whether or not the enterprise has goodwill or
  other intangible value,
• Sales of stock and the size of the block to be
  valued, and
• The market prices of common stocks of
  corporations engaged in the same or similar lines
  of business whose stocks are actively traded in a
  free and open market, either on an exchange or
  over the counter.

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DOL Adequate Consideration Guidelines

• The nature of the business and the history of the
  enterprise from its inception.
• The economic outlook in general, and the
  condition and outlook of the specific industry in
  particular.
• The book value of the securities and the final
  condition of the company.
• The dividend-paying capacity of the company.
• Whether or not the enterprise has goodwill or
  other intangible value.
• The market price of securities of corporations
  engaged in a similar line of business, which are
  actively traded in a free and open market either
  on an exchange or over-the-counter.
• The marketability, or lack there of, of the
  securities.
• Whether or not the seller would be able to obtain
  a control premium from an unrelated third-party
  with regard to the block of securities being
  valued.

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Overview of Valuation Techniques

• Market Approaches
• Guidelines Publicly Traded Company Method
• Guidelines Merged and Acquired Company Method
• Income Approach
• Discounted Cash Flow Method
• Asset Approach
• Adjusted Book Value Method

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Market Approach

• Guidelines Publicly Traded Company Method
• Selection of guidelines companies (or
  transactions)
• Calculation of market multiples (debt free basis)
  and fundamentals from guideline companies
• Computation of subject company earnings
  fundamentals
• Comparative risk analysis of subject company and
  publicly traded guideline companies
• Selection of the risk adjusted market multiples
  to apply to the subject company earnings
  fundamentals and
• The determination of value for the subject
  companys market value of invested capital
  (MVIC).

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Market Approach
x


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Income Approach

• Discounted Cash Flow Method
• The determination of the appropriate cash flows
  to discount, based upon projected income
  statements and balance sheets for the subject
  company
• The selection o an appropriate discount rate for
  the subject company projections, based upon an
  analysis of alternative investments, including
  the cost of capital for guideline public
  companies
• The determination of a terminal value for the
  subject company, as of the end of the last period
  for which projections are available and
• The determination of value for the subject
  companys market value of invested capital
  (MVIC)

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Overview of Valuation Techniques
Discounted Cash Flow Approach






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Asset Approach

• Adjusted Book Value Method
• The adjusted Book Value Method focuses on
  individual asset and liability values, which are
  adjusted to fair market values.
• The Adjusted Book Value Method is typically
  applied in instances involving a liquidation
  analysis, or in cases where the subject company
  has a heavy investment in tangible assets, such
  as real estate holding companies.
• Other Considerations
• Non-operating Assets
• Prior Sales
• Premium for Controlling Interest/Discount for
  Minority Interest
• ESOP Tax Shield and
• Discount for Lack of Marketability.

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S-CORPORATION VALUATION ISSUES
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Tax Court Decisions

• Three Tax Court Cases
• Gross
• Adams
• Heck

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Gross Case

• Tax effecting S-Corporation earnings rejected
• Facts
• G J Bottling Company (Pepsi-Cola bottler with
  stable and profitable operations)
• S-Corporation
• Distributed 100 of net income annually
• Restrictive Stock agreement prohibiting transfers
  outside two families or transfers that would hurt
  S-Corporation election

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Gross Case
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Adams Case

• Uses Gross Case to justify a zero corporate tax
  rate to estimate net cash flow when the stock
  being valued is stock of an S-Corporation
• Facts
• Waddell Sluder Adams Co., Inc. (Insurance
  Agency)
• S-Corporation
• Controlling interest at issue

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Adams Case

• Court rejected petitioners expect increase to the
  built-up discount rate to account for corporate
  tax

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Heck Case

• Facts
• Korbel Bros, Inc. (producer of economically
  priced champagne)
• S-Corporation
• Facilities located on 1800 acres in Sonoma
  County, CA
• Exclusively distributed by Brown Forman
  Corporation who had a Right of First Refusal
  with respect to any offers
• History of stable operation and earnings

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Heck Case

• Court rejected market approach conclusions
• Neither expert deducted Federal income taxes in
  arriving at the S-Corporation cash flow

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S-Corporation Valuation Issues

• S-Corporation pays no taxes
• In theory, applying same multiples as
  C-Corporation valuation would inflate the value
  of the S-Corporation

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Issues

• Who are the willing buyers?
• Would a third party buyer incrementally pay for
  seller-specific tax benefits?
• M A Transactions
• Equity Sponsors
• How do you account for risk of lost benefit of
  S-Corporation status?
• How does tax distributions affect value?
• In the ESOP context, is fair market value the
  value in-place or in-exchange?

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ESOP REAL WORLD DEPARTURES
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Control Premiums / Minority Discounts

• DOL Proposed Regulations
• Control in-fact
• Market evidence of control premiums
• Inconsistent treatment when ESOP
• Acquires control through a series of minority
  interest acquisitions
• Acquires a minority interest in a multi-investor
  transaction, paying its pro-rata share of control
• Acquires a minority interest with an option to
  purchase control within a reasonable time frame

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Control Premiums / Minority Discounts

• Can a control ESOP pay a premium to acquire a
  minority interest
• HLHZ Acquisition of Minority Interest Study
  suggests strong market evidence for a premium

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Control Premiums / Minority Discounts
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Second Stage Transactions

• Price protection for First Stage ESOP
  participants
• Floor Price
• Value excluding Second Stage ESOP debt
• Does the existence of price protection create a
  second class stock in
• S-Corporation context?
• Two distinct values
• PLR 127372

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Second Stage Transactions
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Conversion Premiums

• Transactions still being implemented with Super
  Common or Convertible Preferred Stock with
  dividends
• Can overcome 415 limitations
• Reduces dilution to residual shareholders
• Gives company a tax deduction for dividends paid
  to ESOP
• What is the appropriate dividend rate
• How should a conversion premium be calculated
• IRS position on conversion premiums in the 20
  30 range

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LLC Structure

• The following diagram outlines a potential LLC
  structure

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LLC Valuation Issues

• Timing Particularly, the reinvestment of
  proceeds into a leveraged entity post-ESOP
  transaction.
• Preference of Various Securities in the LLC
• Services Agreement Required in the LLC Structure
• Potential Maintenance of Control

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Return Considerations

• When completing this type of transaction two
  specific returns need to
• be analyzed
• Investors The equity investors will require a
  market rate of return depending on the type of
  security that they purchase upon the
  reinvestment.
• ESOP The ESOP transaction is a 100 leveraged
  transaction requiring no equity from the ESOP
  (which results in a theoretically infinite
  return). One manner of calculating the returns
  may be to analyze the value of the shares as they
  are released in the plan.