March 6, 2017
What Every Business Leader Should Know About ESOP Valuations
What Are ESOPs?
Business owners can use Employee Stock Ownership Plans (ESOPs) as a way to sell ownership of their company to their employees. While instituting an ESOP, the company sets up a trust as a medium where company contributions, cash, and stock can be transferred to employees. The trust is set up so it may allocate equity to individual employee accounts, often dependent upon pay or seniority in the company. There are two distinct types of ESOPs — nonleveraged and leveraged.
In a nonleveraged ESOP, the trust is maintained through annual contributions of stock or cash given by the company (so that the ESOP may then repurchase existing stock). A leveraged ESOP is similar, except that it is funded by debt that the company borrows from banks or other lenders. The company will then either loan the proceeds directly to the ESOP trust or make annual contributions. With this cash, the ESOP may buy additional stock from the company or from other shareholders, which could then be allocated to employees.
Why Create an ESOP?
A primary reason to pursue an ESOP as opposed to other means of transferring company equity to employees is that contributions made to an ESOP trust are tax-deductible. Additionally, for a leveraged ESOP, the company has the ability to deduct certain debt payments from its tax liability when paying off the loan used to fund the ESOP.
For both types of ESOPs, when employees retire or leave the company they are given their stock or cash (the company often has the option of buying the stock owed to the employee at Fair Market Value).
Why Do I Need an ESOP Valuation?
According to the Employee Retirement Income Security Act (ERISA), an ESOP must pay no more than “adequate consideration” when it buys the securities from the business owner. Adequate consideration is calculated through a third-party fair market valuation. Fair market value represents a price that willing buyers and sellers would perform the transaction in the market.
When Do I Need an ESOP Valuation?
If a company wishes to set up an ESOP, they first must undergo a company valuation to determine the feasibility of setting up the trust. Additionally, valuations need to be performed periodically to establish fair market value for equity contributed to or purchased from the trust. All ESOP valuations must be done by a third-party as required by the Internal Revenue Service (IRS) and the Department of Labor (DOL).