ESOP Valuation - Part 4

Preparing for the Annual ESOP Valuation

As a member of the management team of a company that sponsors an ESOP, you may be involved with the annual (if not more frequent) ritual of the administrative ESOP valuation, commonly known as the annual ESOP update.  This is not to be confused with a transaction valuation, in which the fair market value is established to set the bar for the parties involved in an ESOP transaction.  In this context, the fair market value "bar" establishes the maximum value, by law, at which a selling stockholder(s) can sell his/her stock to either a newly formed ESOP or an existing one.  In this article, however, we will focus on the annual ESOP update valuation (the "annual valuation").

The annual valuation process spans anywhere from a two- to four-month time period (perhaps longer) that culminates in an independent ESOP appraiser rendering an opinion of value of the stock of your closely held company.  This new stock price is then communicated to your ESOP administrator and forms the key component of the ESOP participant statement, which all ESOP participants must receive each year.

Let's take a look at the usual process followed to perform the annual valuation.  Your ESOP appraiser (let's call him Bill) will most likely contact you 15 to 30 days after the end of your "Plan Year" to ask for a number of documents that will enable him to get started.  By requesting various company documents and information, Bill has effectively begun what is commonly referred to as the due diligence phase of the valuation assignment.

Bill will request various documents to review and ultimately store in his work paper file.  Key among these documents are your company's audited/reviewed/compiled financial statements for the most recent fiscal year; amendments to your company's articles of incorporation, by-laws, shareholder agreement, or ESOP plan documents, if any, during the past year; lists showing a breakdown of your company's largest customers/clients and suppliers in the most recent year; a summary of your company's stock ownership as of the valuation date; updated forecasted financial statements, if any; details of any changes in key personnel or significant changes in key personnel's qualifications; a fixed assets register or depreciation schedule; a description of any significant business events that occurred in the past year (e.g., acquisitions or sales of lines of business or major assets, an introduction of a new product or service line); a list of officers' and directors' compensation by type of compensation (e.g., base, bonus, benefits); and details of any litigation including pending or threatened lawsuits.

Why are the preceding documents needed for Bill to perform a stock valuation?  After all, doesn't valuation essentially boil down to applying a multiple to a company's typical or future earnings stream?  As you might already know, there is a lot more involved.  An appraiser must understand your company's business very well (not to mention the industry in which you operate).  In order to reach that level of understanding, Bill needs a fairly detailed synopsis of the company's activities during the past year.  Bill will also keep abreast of developments in your industry and, if applicable, economic forces that impact your company.  In addition to understanding your company very well, the appraiser needs to thoroughly understand your company's financial condition and recent operating performance.  Hence Bill's need for a complete set of financial statements, sales and expense schedules, a breakdown of officers' compensation, etc.

The due diligence phase of the appraiser's assignment culminates in a management interview, at which time Bill will typically convene the management team for an in-depth discussion of all aspects of your company which he believes will have an impact on his conclusion of value.  Bill will leave that meeting with about 90% of the information he needs to complete the valuation and write his valuation report.  As for the remaining 10%, Bill will most likely follow up with your team within a week or so to get the answers to his remaining questions.

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