Comprehensive ESOP Valuation Case Study

By Pavan Srikar

By Vivek Shah

By Dhara Shah

Introduction:

An employee stock ownership plan (“ESOP”) is an employee benefit plan that gives the employees ownership interest in the Company in the form of stock. ESOPs offer various tax benefits to participants, selling shareholders, and the sponsor company. ESOPs are used by several employers as a strategy to align the interests of their employees with those of their shareholders.1

Preparation of a valuation report for the stock held by or to be sold to an ESOP requires rigorous analysis and must satisfy the requirements of the Department of Labor (“DOL”).2

From the DOL and Internal Revenue Services (“IRS”) perspective, an ESOP cannot pay more than adequate consideration for the shares acquired. Adequate consideration means the fair market value (“FMV”) of the asset as determined in good faith by the trustee or fiduciary pursuant to the terms of the ESOP plan and in accordance with the regulations of the Secretary of Labor.3

In addition to opining on whether the amount paid for or received in an ESOP transaction qualifies as “adequate consideration,” a fairness opinion will also include the valuation analyst’s opinion regarding whether the proposed transaction is fair to the ESOP participants and trustee from a financial point of view. Further, the acquisition financing is examined to determine if the interest rate and financing terms are reasonable in the given economic environment. 4

The Scenario and Transaction Details:

The owners of the company (the “Company”) were looking to exit by transferring the ownership to the current employees (the “Transaction”). In accordance with the Transaction, the ESOP Trust was created. The ESOP Trustee (the “Client”) required a report that estimated the FMV of the Company’s stock and a fairness opinion on the Transaction.

The Transaction was externally financed through a five-year senior loan with a floating interest rate and a seller loan with a fixed interest rate. Given the subordinated nature of the seller loan and a relatively low interest rate, seller warrants were also issued.

Further, the internal ESOP loan between the Company (Sponsor) and the ESOP Trust was structured for a much longer period.

Also, to ensure the retention of key management personnel and that the Company achieves the performance targets after the Transaction, retention and performance-based stock appreciation rights (“SARs”) were also issued.

The Ask:

The scope of the valuation project was to express an opinion on the FMV of the Company’s equity value (“Subject Interest”) in connection with its possible purchase by a newly created ESOP as of the Transaction closing date (“Transaction Date” or “Closing Date”) as requested by the Client. Further, a fairness opinion on the Transaction was also required.

The level of value was controlling and non-marketable, and the premise of value was becoming a concern.

Our Solution:

Deliverable:

We performed a robust valuation analysis and compiled our findings into a valuation report, including the fairness opinion, which included the following:

The Company overview covers essential aspects such as business, customers, offerings, competition, management, and key employees;

Analysis of economic, industry, and regulatory factors influencing the Company’s operations.;

In-depth financial analysis (balance sheet, income statement, working capital, leverage, revenue, and profitability analysis);

Discussion of the proposed Transaction;

A valuation range for the Subject Interest to assess the reasonableness of the Transaction value;

Forecast reasonableness assessment;

Transaction analysis; and
Valuation methodology, valuation discounts, and concluded value of the Subject Interest.

Procedure:

As a part of this engagement, the following steps were performed for the valuation:

Performed a valuation utilizing generally accepted valuation methodologies.

Applied normalizing adjustments (such as cash surrender value of life insurance, expenses related to the ESOP Transaction, and employee retention tax credit under the CARES act5) to EBITDA for historical and projected financial statements.

Calculated a range of equity values for the Company and applied a discount for lack of marketability.

Concluded value of the Subject Interest on a controlling, non-marketable basis.

As a part of this engagement, for the transaction summary, we shared the following analysis along with a fairness opinion on the Company:

Summary of the Transaction.

Created a debt amortization schedule for the loans as mentioned above.

Performed a credit analysis to test the debt covenants as laid out in the Transaction term sheet (“Term Sheet”).

Projected the future value per share based on valuation parameters considered.

Calculated internal rate of return (“IRR”) for the issued synthetic equity (Warrants and SARs)
Created a fully diluted capitalization table.

Valuation Methodology:

Capitalization Of Cash Flow Method (“CCF”):

We analyzed the Company’s historical EBITDA and cash flow trends to estimate adjusted cash flow, which was then capitalized to determine an enterprise value.

The capitalization rate was estimated as the weighted average cost of capital (“WACC”) less the long-term growth rate.
For WACC calculation, the cost of equity was determined using the build-up method, and the after-tax cost of debt was based on the Company’s borrowing rate.

Discounted Cash Flow Method (“DCF”):

To determine an enterprise value using the DCF approach, we calculated the Company’s cash flows over a forecast period based on projections provided by Management. We also evaluated the reasonableness of the management-provided forecast by comparing it with the historical trend and industry benchmarks.

Beyond the discrete forecast period, we assumed that the Company’s business operations would continue for an infinite period and estimated the terminal value by applying a long-term growth rate.

We then discounted the projected cash flows for the discrete period and terminal value to the present value using the WACC.

Guideline Transaction Method (“GTM”):

We conducted extensive market research on various databases to identify relevant transaction deals involving similar target companies in terms of industry, size, and other key characteristics involved in recent M&A transactions.

We then applied the selected range of EV/EBITDA multiples to the Company’s EBITDA metric to arrive at the enterprise value.

Concluded Enterprise Value:

Upon completing our valuation analysis, we assigned equal weight to all three methods described above to conclude the overall enterprise value.

Bridge from Enterprise Value to Equity Value:

We made the following adjustments to enterprise value to derive equity value:

Concluded Enterprise Value

Plus: Cash, Debt, Working Capital, the Cash Surrender Value of insurance policies that will be terminated upon closing of the transaction, and the customer deposits that were eliminated from working capital.

Plus: Transaction Adjustments as per the targets defined in the term sheet.
In connection with the transaction, retention SARs will be available for issuance immediately after closing. An estimate of the dilutive impacts of the retention SARs has been factored into the equity value.

Equals Equity Value

Refer to the table at the bottom of the case study for the calculations.

Discounts, Common Stock Value, and Subject Interest Value:

Discount for Lack of Control & Lack of Marketability (“DLOC & DLOM”):

Since we valued 100.0% of the stock in the private company, we did not apply DLOC to the calculated fair market value of the subject interest.

Further, since the Company was a closely held private company and there was no active market to sell or transfer ownership interest, a DLOM was applied.

The ESOP agreements have put provisions attached to them. This provision, coupled with the Company’s commitment and ability to honor its future put obligations for repurchase from plan participants, affects the degree of DLOM.

In our case, we selected lower DLOM due to the put provision in the ESOP agreement.

FMV of the Subject Interest:

We estimated a range of fair market value of the Company’s equity value on a controlling, marketable basis.

Thereafter, we applied a DLOM to derive the value of the Subject interest on a controlling, non-marketable basis.

We also evaluated the Company’s value under the terms of the Term Sheet and compared it to the range of FMV of the Subject Interest estimated above to assess the fairness of the Transaction.