Wipfli logo

The Lac du Flambeau Business Development Corporation


The intricacies of ESOP valuations

Jan 20, 2022

Did you know that, on average, more than 250 new employee stock ownership plans (ESOPs) are created each year? Right now, there are more than 6,500 ESOPs with 14 million participants — and that number is likely to increase as ESOPs become an attractive recruiting tool in today’s tight labor market.

That means the demand is increasing for ESOP business valuations, which are complex due to the need to consider the sometimes vague requirements of both the Department of Labor (DOL) and Internal Revenue Service.

You might have missed it as pandemic news took over the headlines, but the American Institute of Certified Public Accountants published new guidance to help clarify the procedures that should be followed for ESOP valuations.

It readdressed long-standing guidance on ESOP valuations and recapped some Department of Labor expectations that were made clear with two more recent enforcement actions involving process or settlement agreements for GreatBanc Trust and First Bankers Trust Services, Inc.

With this new guidance — and previous — it’s important to engage a valuation expert to prepare an ESOP valuation report:

1. Determining value for ESOP transactions

Both the IRS and DOL prefer to rely on fair market value (FMV) in ESOP valuations. The commonly accepted unofficial guide for the determination of value for ESOPs is the DOL’s Proposed Regulation Section 2510.3-18–Adequate Consideration, which includes:

  • FMV determined in good faith as the standard of value
  • Allowance of a control premium payment for the ESOP stock only if a two-part test (control in appearance and fact) is met
  • Consideration of whether the plan sponsor will be capable of covering the stock purchase obligation during the necessary time period

For many years, this was the best indication of the DOL’s expectations regarding ESOP valuations.

The more recent process agreements indicate that the trustee must document the independence of the valuation expert, which requires that:

  • The valuation expert be retained by and, during the development of the valuation, work for the ESOP trustee rather that the ESOP sponsor or any other party to the ESOP.
  • The valuation expert should not have prepared, for any parties besides the trustee, any previous valuations for the company that is the proposed ESOP sponsor.

It’s also considered a best practice that, when communicating with the ESOP sponsor, the valuator include the trustee when possible and, if not possible, share such information afterward.

In addition, valuation experts should confer with the trustee before releasing the report draft to any parties besides the trustee and before sharing any information with participants of the ESOP.

2. Requesting and reviewing the ESOP documents and financial information

The documents the valuation expert should review include the plan document and summary, the agreement covering the sale of stock to the ESOP, the ESOP trust document, any historical Form 5500s and possibly any available repurchase obligation studies and summary reports of the participants’ statements.

With regard to historical financial information, audited financial statements are preferred, but reviewed statements may also be acceptable.

If internally prepared financial statements are the best available, the valuator should consider testing the validity of those financial statements by reconciling them with filed tax returns, comparing cash flows using bank statements and/or reviewing with management changes in account balances from prior to current years.

In addition, valuation experts should document the measures taken to mitigate the risk associated with using financial statements that were not audited.

The financials relied upon should conform with the Financial Accounting Standards Board’s ASC Subtopic 718-40, which provides guidance regarding share-based payment transactions for ESOPs and relevant accounting and reporting standards. The key component is that the balance sheet must report the ESOP’s acquisition debt as a long-term liability with an off-setting contra-equity account titled similar to “Unearned ESOP Shares.” (It’s appropriate to ignore this contra-equity account, though, in the application of the asset approach.)

Other common adjustments to financials for ESOP valuation purposes include reducing expenses for the unusually high amount of retirement benefits that often exist in ESOPs and for any portion of officers’ compensation that may be considered unfair to ESOP participants.

With respect to prospective financial information (PFI), the DOL will have the advantage of hindsight when evaluating the reasonableness of the provided information.

Valuation analysts can take pre-emptive measures to support the reasonableness of the PFI by:

  • Obtaining (not preparing) the PFI from the ESOP sponsor or the trustee and documenting who prepared it. If the preparer has any potential for conflict of interest, documentation of how that situation was resolved must be included.
  • Documenting how the reasonableness of the PFI was analyzed with a comparison to suggested measures of historical operating results, among other analyses.
  • Demonstrating sensitivity analysis in the report to reflect the impact on the stock price if the PFI fell short of or exceeded reported expectations.
  • Comparing the sponsor company’s PFI cash flows to historical cash flows (considering payments for ESOP debt, the repurchase obligation, as well as expected needs for working capital and capital expenditures).
  • Asking the preparer of the original PFI to revise the information if the valuation expert determines that it is not reasonable.

3.  Particular considerations for valuations of ESOP shares

According to the referenced process agreements, there are certain components beyond what are addressed in a typical business valuation that should be included in a valuation engagement performed for ESOP purposes. It’s recommended that the valuation analyst provide the trustee with a comparison of key valuation variables in the current valuation versus any prior valuation completed in the past 24 months. Key valuation variables could include multiples utilized, discount factors, required rates of return on equity and financial statement adjustments.

The valuation analyst should also address the sponsor company’s ability to use its future cash flows to cover debt-service (for leveraged ESOPs) and the repurchase obligation.

As is the case with other privately held stock, discounts for lack of control or marketability may be appropriate in ESOP valuations, but ESOP shares include other considerations.

Currently, the best practice with respect to control/minority issues is to adjust cash flows to reflect the applicable level of control.

If the ESOP trust owns less than 50% of the outstanding shares, the valuation expert should consider whether the shares have been devalued. If the ESOP trust owns a controlling interest, how the prerogatives of control are being exercised by the ESOP — by the trustee or the participants — should be determined.

The discount for lack of marketability should recognize the time required for earned benefits to be paid to the participant, among other factors.

There are other elements of valuations for ESOP stock purchase transactions that should be included in an ESOP valuation report. For example, it may be necessary to address whether the transaction treats ESOP participants fairly from a financial perspective and with respect to other parties in the transaction, and whether financing terms are market-based and beneficial to ESOP participants.

How Wipfli can help

While the process agreements are neither law nor regulation, abiding by their terms will likely help the position of the trustee, the sponsor and the valuator if any ESOP transactions become subject to a Department of Labor enforcement action. It will benefit parties to the ESOP if a valuation expert who is knowledgeable and experienced in the field of ESOP valuations is engaged to perform their valuations. Check out our ESOP services web page or learn more in these educational resources:


Claren O’Bannon, CPA/ABV/CFF, CVA, ASA
View Profile