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ESOP VALUATION QUESTION


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I have a question with regards to the application of an ESOP Valuation as is affects the share price paid to outgoing direct shareholders.

My employer is roughly 70% ESOP owned and 30% owned by direct shareholders.  When a valuation takes place a new enterprise value is reached by the weighted average of 3 different methods (DCF, CCF, & Guideline).  A discount for lack of marketability is then applied for a final enterprise value.  The final enterprise value is then divided by the number of outstanding shares to get the new share price.

Assuming the new valuation is higher than the previous valuation (as is usually the case), the new share price is higher for two reasons:

1) the company is worth more, and

2) there are fewer outstanding shares than the previous year because there are always many more shares sold by departing employees than bought by existing employees. 

For example, in a recent year the share price went up 14%; 8% was due to an increase in the value of the company while 6% was due to fewer outstanding shares.  Since all ESOP transactions take place on the last day of the year the new valuation is as of 12/31 as is the sale of the stock by outgoing employees.

My question – if outgoing direct shareholders are paid using the new 14% higher valuation then they are getting the 6% benefit of fewer outstanding shares.  This seems like faulty, circular logic to me – there aren’t fewer shares until AFTER they sell so in my opinion they should only be paid at an 8% premium not a 14% premium.  But since it all happened on 12/31 the company paid them out at the full 14% premium. 

Am I correct in thinking this is a problem or am I not understanding something?

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2 hours ago, JimboPColtrane said:

I have a question with regards to the application of an ESOP Valuation as is affects the share price paid to outgoing direct shareholders.

 

My employer is roughly 70% ESOP owned and 30% owned by direct shareholders.  When a valuation takes place a new enterprise value is reached by the weighted average of 3 different methods (DCF, CCF, & Guideline).  A discount for lack of marketability is then applied for a final enterprise value.  The final enterprise value is then divided by the number of outstanding shares to get the new share price.

 

Assuming the new valuation is higher than the previous valuation (as is usually the case), the new share price is higher for two reasons:

1) the company is worth more, and

2) there are fewer outstanding shares than the previous year because there are always many more shares sold by departing employees than bought by existing employees. 

For example, in a recent year the share price went up 14%; 8% was due to an increase in the value of the company while 6% was due to fewer outstanding shares.  Since all ESOP transactions take place on the last day of the year the new valuation is as of 12/31 as is the sale of the stock by outgoing employees.

 

My question – if outgoing direct shareholders are paid using the new 14% higher valuation then they are getting the 6% benefit of fewer outstanding shares.  This seems like faulty, circular logic to me – there aren’t fewer shares until AFTER they sell so in my opinion they should only be paid at an 8% premium not a 14% premium.  But since it all happened on 12/31 the company paid them out at the full 14% premium. 

 

Am I correct in thinking this is a problem or am I not understanding something?

 

The first line in bold:  Do you know that is true?  

The second line in bold:  Are you sure that is true?

To know those are true would require you to know the inner workings of the ESOP and see the appraisal.   If you have access to that data fine but the average participant wouldn't know this for sure. 

I am not an appraiser but I don't know of any appraiser that would do what you are saying if I am understanding your correctly.    If you have the kind of access to know what you know do you have access to ask the appraiser questions?  They tend to care very deeply about the denominator for the reasons you spell out.   I have seen them do so pretty good math to account for the changes in outstanding shares for 12/31 transactions over the years.

 

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Yes I have the data.  I am a new member to the Board of Directors and ESOP Plan Committee, and as such I am involved in the review of the valuation.  Let me be clear – I don’t believe the valuators have done anything wrong – the enterprise value they derived seems appropriate and the new share price is accurate for the new year.  Also, I don‘t believe anything willful or fraudulent has taken place; the Board and ESOP Committee are comprised of honest, hardworking, intelligent people.  However, I think it is possible a mistake has been made.  I have no accounting/finance background so the most likely scenario is that I am not understanding something but I’d like to get some feedback from seasoned ESOP professionals before I pose the question to the Board. 

I am questioning if the company has correctly applied the valuation to the outgoing shares.  It doesn’t seem right to me that someone selling should get the benefit of the decreased outstanding share count.  That just doesn't make sense to me.  

Any feedback by those familiar with with ESOP valuations and the setting of the share price is much appreciated.

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My advice to you is to get a conversation with the appraiser and trustee (especially if it is an outside trustee - bank or trust company). 

If there is an outside trustee they will have most likely have thought through this but mistakes happen.

However, the idea they (both the trustee who is supposed to be reviewing the appraiser's work) have to defend their work is reasonable.

Based on your description I agree the denominator sounds wrong.   Those two should be able to defend their denominator.

To be clear if I implied I thought someone did something wrong I did not intend to do so.   

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Because you appear to be a fiduciary in some capacity (maybe not the one with direct responsibility, but one with monitoring responsibility) you have a duty to follow ESOP Guy's advice.  You have taken the first steps in discharging that duty -- informing yourself about what is going on as you step into your role, and then asking questions about what you do not understand or appears odd to you.  The appraiser may not know or may misunderstand how the company is using the appraisal for non-ESOP transactions, e.g. believing that the valuation number is post-sale to to the company by departing employees.  The questions of who "owns" the appraisal and permitted use of the appraisal is important to everyone, including the appraiser. 

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  • 2 weeks later...

Thank you both for your feedback, I appreciate it.  I do understand my fiduciary responsibility and will see this through.  Just wanted to do as much research on my own as I could before taking the next step. 

I'm wondering if maybe this is a common issue since all ESOP transactions occur on 12/31 (I assume that's the same for all ESOPs that follow a calendar year?).  Was hoping someone would say that since the share sale and the new valuation both take place on the same day, the "denominator" would reflect the reduced share count even though it pushes up the sale price for those same shares?  Or do companies use the new enterprise value to determine two different share prices:

1. the sale price for the existing shares using a denominator that includes the count of those shares being sold

2. the new share price for future transactions for the new year using a denominator that reflects those sold shares removed? 

Meaning shares sold on 12/31 would be valued at a different share price than shares bought in the new year (even though the company enterprise value is the same).  Does that make sense?    

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  • 4 weeks later...

From my understanding in a situation like this the departing shareholder should be paid at a value that's inclusive of the shares they will be selling.  

But in general if shares are redeemed and the total issued and outstanding shares decrease so will the value of the company in proportion, so no change of value should necessarily occur, e.g., company valued at $1,000,000 with 100,000 shares has value per share of $10/share.  If the company redeems 50,000 shares at $500,000 there will remain 50,000 outstanding shares and the company will reduce in value by $500,000 so, $500,000/50,000= $10/share

Now if the appraisers are reducing the firm's value by the future repurchase of shares and then using the weighted average you described then you'll get different math since cash & equivalents gets different weighting in each valuation method.  But that's not necessarily how I'd do it (unless the situation is more complicated than I read) because the value of cash in the various valuation methods is taking in all sorts of assumptions whereas the book value method described above supports these types of transactions by keeping the relationship between the company's cash to it's value pretty straightforward. 

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JHawk, this is very helpful.  Definitely helps me think it through from another angle.

 

QDROphile & ESOP Guy, thank you also so much for your thought-provoking responses.  I appreciate everyone’s input.

 

I realize that there is a side of this that I have not thought through. Although I have access to all the valuation documents I do not know the exact makeup of the share counts used pre-and post valuation. There is an element of information missing here which probably explains my confusion.

 

I am waiting for various Board member summer vacations to pass and then intend to take this up with the group.  At this point I think it is very likely there is a simple explanation for my confusion and I will posit my query as a simple point of clarification rather than an accusation or the like. 
 

Many thanks for your insight.  

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  • 3 weeks later...

You might also want to ask about whether a discount for lack of control should be applied to the non-ESOP shareholder transactions.  The ESOP trust owns a control position, and presumably the shares being sold by the non-ESOP shareholders might be worth less.

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