Control Premiums

[Guest CitationSquirrel]

I am doing some research into the gray area of the use (or non-use) of control premiums in valuing ESOPs that hold a majority of the stock in the company.

The argument for not using a control premium seems to come down to the fact that the ESOP is made up of individual participants and each participant holds a minority interest in the company, therefore the stock is valued on a minority interest. But, on the other hand, if an ESOP owns a controlling interest in a company, especially cases of 90% or 100% ownership, then the ESOP has control and it makes sense that the stock should be valued on a control basis.

I’m looking to see how other professionals deal with this situation. If an ESOP owns 100% do you require that it be valued on a control basis? I know there are a variety of case specific facts that play into the outcome. But, generally, what is your view of this situation?

TIA

[Guest Harry O]

I have seen deals where the ESOP is a minority shareholder and the majority shareholders claimed entitlement to a control premium. In these cases the ESOP is usually not giving reps and warranties and additional consideration to the majority individual shareholders was largely justified on this basis. I'm not sure there is any clear answer to the issue of control premiums when ESOPs are participating in a sale of the company. I'm interested in the thoughts of others.

P.S. Why would there be any control premium if the ESOP owns 100% of the company? Who does the ESOP have control over where there are no minority shareholders?

[RLL]

Hi CitationSquirrel ---

If an ESOP is purchasing a controlling interest in a closely-held company, it would be OK for the ESOP to pay a controlling interest price for the stock....although the ESOP fiduciaries have the obligation to bargain for the lowest purchase possible price. When an ESOP already owns a controlling interest and is purchasing minority interests, it is not clear that the ESOP can pay a controlling interest price.

For valuation of participants' interests in an ESOP on an ongoing basis, it is appropriate to use a minority interest valuation only if the ESOP has acquired its stock at minority interest prices. If the ESOP has paid a controlling interest price to acquire the stock, that stock should continue to be valued on a controlling interest basis....to do otherwise would deny participants the benefit of the ESOP's having purchased (and paid for) control, and ERISA allows the payment of a controlling interest price only to the extent that the purchase benefits participants. See ERISA section 404(a)(1). If the ESOP acquires control over time through purchases at minority interest prices, continuing use of minority interest valuation on an ongoing basis is appropriate if the ESOP fiduciaries decide that such approach is in the best interest of the participants.

When an ESOP company is sold, all shareholders (holding the same class of stock) will receive the same sale consideration...which presumably represents a controlling interest price. When an ESOP sells its stock in a transaction where the entire company is not sold, the ESOP should receive a controlling interest price if it's selling control; if the ESOP is not selling control, the fiduciaries should bargain for the highest possible selling price...which under certain circumstances should be a controlling interest price.

[Kirk Maldonado]

RLL:

What is your opinion about situations where the ESOP does not gain control, but the selling shareholder wants to get a control premium because it is anticipated that the ESOP will gain control in some future transactions? Typically, the parties would commit to entering into those transactions in the future, as justification for the "surcharge."

My view is that this is a pretty aggressive technique, because there is no ironclad guarantee that the future transactions will actually be consummated. Furthermore, I feel uncomfortable with the ESOP paying a premium for the right to effect a transaction in the future.

[Guest Harry O]

Or what about situations where the non-ESOP shareholders give reps and warranties that the ESOP trustee cannot give? Shouldn't the non-ESOP shareholders get more consideration than the ESOP since they must stand behind the reps if breached?

[RLL]

Hi Kirk ---

The 1988 proposed DOL reg defining "adequate consideration" [under ERISA section 3(18)] sanctions the use of controlling interest price in limited situations in which the ESOP acquires a minority interest together with an option to acquire control within a reasonable period of time. Without further guidance, it may be difficult for an ESOP fiduciary to get comfortable with utilizing this approach....and the fiduciary can easily be second-guessed if the ESOP does not actually exercise its option and acquire control.

Hi Harry O ---

The circumstances that you describe cause me concern....there may be a serious problem if the ESOP receives less consideration (on a per share basis) for its stock than non-ESOP shareholders. It is possible to structure an arrangement where all shareholders, including the ESOP, have a portion of the sale consideration placed in escrow to "stand behind" the reps and warranties.

[Guest Harry O]

RLL -

I agree with your concern. But most ESOP trustees are simply not in a position to make reps and warranties about the active conduct of the business. These matters are usually the day-to-day responsibility of the other seling employee-shareholders. My experience is that ESOP trustees won't give these reps so it ends up falling on the non-ESOP shareholders (which are usually the majority owners in my experience) to give them and stand behind them with indemnification responsibilities. This, of course, leads these shareholders to ask for additional consideration. I've never seen a satisfactory resolution of this issue. But I suspect this is a common fact pattern (I've been involved in two such transactions) and wonder what others do . . .

[RLL]

Harry O ---

A portion of the sale consideration for all shareholders can be "held back" in escrow for a period of time to stand behind the reps and warranties that the buyer requests. If there is no liability to the ESOP trustee beyond the escrowed amounts, the ESOP trustee should be in a position to make the reps and warranties subject to it's own knowledge of such matters.