The Employee Retirement Income Security Act ("ERISA") of 1974 created Employee Stock Ownership Plans ("ESOPs") as a means to give employees a share of company ownership. The authors of ERISA hoped that employee empowerment would increase the US workforce's overall efficiency. ESOPs are commonly structured as separate, legal trusts. The trust borrows money at a favorable rate to repurchase owners' shares. Employees may then buy shares in the trust. The company makes contributions to the trust to repay the loan.

Incentives & Benefits

To provide an incentive to company owners to create an ESOP, Congress included significant tax and estate planning benefits for ESOPs, such as:  

•Business owners are allowed to sell their shares to the ESOP and reinvest the proceeds tax-free;  

•Shareholders of the ESOP benefit from tax deferral and savings; and  

•Interest and principal loan repayment contributions made by the company to the ESOP are tax deductible.   

When the ESOP is originally formed, the initial purchase from the owner must be fairly priced. The shares owned must be re-valued annually to determine the repurchase price in the event of employee retirement, death, or departure. Both of these circumstances require independent valuation. In addition, ERISA requires an ESOP to pay no more than "adequate consideration," or fair market value, when investing in a business' stock. Consequently, plan fiduciaries must determine the fair market value. The IRS, the ESOP trustees, and the Department of Labor often scrutinize these ESOP valuation assertions. As a result of all these, an appropriate ESOP valuation must be well documented, unbiased, and supportable.

ESOP Valuation Process

Valuation Process  ESOP transactions in closely held companies must be based on a current appraisal by an independent, outside valuation expert. The valuation process assesses how much a willing buyer would pay a willing seller for the business. 

Various factors are considered in valuing ESOPs such as:  


•discounted future cash flows    

•asset value    

•comparable companies    

A true valuation of an ESOP will reduce the value of the company for a lack of control, a lack of marketability, and repurchase liability. The reduction for a lack of control is taken due to the fact that owning a controlling interest in the business is worth more than owning a minority interest, even on a per share basis. The value is reduced from marketability because shares of publicly held companies are worth more than closely held firms because they are easier to buy and sell. Although ESOP company shares have better marketability than non-ESOP firms, they are still not as active or marketable as stock trades on a stock exchange.    ESOP valuations are generally more complex than regular valuations of businesses. ESOP valuations include adjustments relating to fair market value, liquidity discounts, tax pass-through status, and other factors.

Two Areas of ESOP Valuation Services:

ESOP valuation services generally fall into one of two areas: initial ESOP transaction valuation/consulting services and annual (or updated) valuation services.  

Initial ESOP Transaction Valuation/Consulting Services: 

Valuation consulting for an initial ESOP transaction is often a two phased project. In the first phase, appraisers are typically retained by the Company’s exploratory ESOP committee during the initial planning stages when the feasibility of the ESOP is still being determined. Our work in this first phase involves performing a valuation analysis to determine a rough range of value for the Company to help assess the feasibility of the ESOP. Reporting of the Company’s range of value in this phase is flexible, helping to contain fees during the preliminary feasibility determination stage. If after phase one, it is determined that the ESOP is not feasible, then our work is typically complete and project fees have been minimized for our client. However, if it is determined that the ESOP is feasible, then we will proceed with phase two. In the second phase, appraisers increase the scope of the valuation services being provided and prepare a comprehensive valuation report of the equity interest in the Company being sold to the ESOP. This report provides support for the transaction and ensures that no more than “adequate consideration” is being paid by the ESOP for the equity interest. Our comprehensive valuation reports are considered an “Appraisal Report” as defined by the Uniform Standards of Professional Appraisal Practice (USPAP).  

Annual Valuation Advisory Services: 

We regularly provides annual valuation services (aka valuation updates) to our clients. Valuation updates can be performed quarterly, semi-annually, or annually, but are most commonly performed on an annual basis. In a valuation update, we determine the fair market value of the equity interest in the Company owned by the ESOP using the same careful attention to detail that was provided in our appraisal for initial ESOP transactions. A comprehensive valuation report is also prepared for each valuation update. The valuation update is utilized by our clients to determine the fair market value of the common stock in the Company owned by the ESOP for regulatory reporting purposes. The fees associated with providing an annual valuation update are generally less than the fees paid for our original appraisal of the Company since we can take advantage of efficiencies created from having previously appraised most companies.

ESOP as an Acquisition or Exit Strategy for Sellers

An employee stock ownership plan (ESOP) is an alternative available to sellers for disposing of their businesses. This option comes with certain tax advantages for both seller and buyer. There are a wide range of small and middle-market companies that cannot find suitable buyers (or that choose to "sell" their companies to their employees). These sellers often create an ESOP to buy all or substantially all of the company, using deferred compensation.     

Two general categories of ESOPs are:    

1. Leveraged ESOP. Uses borrowed funds (either directly from the company or from a third-party lender based on the guaranty of the company, with the securities of the employer as collateral) to acquire the employer's securities The loan will be repaid by the ESOP from employer and employee contributions as well as from an dividends that may be paid on the employer's securites.    

2. Non-leveraged ESOP. A stock bonus plan (or contribution stock bonus plan with a company with a money purchase pension plan) that purchases the employer's securities with funds from the employer that would have been paid as some other form of compensation (that were not provided by a third-party lender).