ESOPs: Trends in the Market

June 29, 2012

Employee stock ownership plans – ESOPs – are tax-advantaged employee benefit plans designed by Congress to allow the purchase of private company shares to encourage employee ownership.

ESOPs work well for companies to encourage employee ownership and for companies that might otherwise have a hard time attracting outside buyers.

How Employee Stock Ownership Plans Work

An ESOP acquires a private company’s shares, often from founders, and holds them in trust for the benefit of employees who qualify to be beneficiaries. The ESOP vests ownership in the shares over time, becoming another retirement account similar to a 401(k).

The plan typically borrows the funds needed to complete the acquisition, and then the company makes deductible contributions and pays dividends to the ESOP to fund the repayment of the loans.

ESOPs are excellent vehicles for structuring deals to fine tune the needs and preferences of owners. They move ownership of the company into the hands of the employees and give selling owners tax-advantaged liquidity.

Owners are more likely to sell their companies when they are ready to change their lives than when market conditions would indicate the optimal time to sell. The driver is psychological: When the economy is growing and profits are rising, even more seasoned owners feel invigorated and involved. Buyers become more active as the credit cycle loosens.

While the Great Recession officially ended in 2009 (though unofficially it is entering its fourth year of casting a shadow over the economy), conditions today are far from optimal.

Many owners who would be sellers are finding that “going to market” has been a tough prospect these past few years. But in the right circumstances, ESOPs represent ready and willing buyers for many companies that would otherwise not gain much attention today.

Valuation Multiples and Capital Markets

Transaction multiples have stabilized, and volume has improved significantly since the bottom of the recession. Comparing results from 2010 and 2011 to multiples and number of transactions from 2008-2009, transaction markets have certainly up ticked overall, even if only in relative terms.

Public markets have been more mixed. Though the broad markets have rallied from their 2009 lows, a number of public companies have shown significant earnings growth without a similar increase in value. So their multiples have moved down toward longer-run levels.

Meanwhile, reports of lending continue to focus on tightened credit, though ESOP lending has improved from the nearly-no-lending environment at the bottom of the recession.

Upside-down ESOPs

ESOP companies have been climbing out of their own earnings hole. ESOPs of a certain vintage, particularly from the mid-2000s, were formed during peak market multiples and peak valuations. At the time of formation, those valuations were in line with the market. Unfortunately, those ESOPs that were fully leveraged have seen their enterprise value fall significantly below their debt levels, and the improving conditions haven’t quite reached equity break-even – yet.

Still, for companies with positive earnings and a sustainable outlook, the equity did not go to zero. Instead, it has behaved as a long-term option play: So long as the company can service the debt or work with the lenders to operate and grow the business, the equity has the value inherent in capturing the upside of future performance. Their expectation is that one day the growth will be sufficient to fully repay the debt and create positive value for shareholders.

The Evolution of ESOP Valuation Practice

Valuation theory and practice continue to evolve for ESOPs. A number of issues continue to be debated in ESOP appraisal. Shares owned by an ESOP carry a mandatory put option by law, so that employees can convert them to cash upon retirement or leaving the company.

Whether that put option is truly the reason the discount for lack of marketability (a reduction in value if the initial valuation is deemed to be based on readily marketable shares) is small or zero for ESOP shares is a hot topic. The other side of the same coin is whether the repurchase liability should have an impact on valuation of ESOP shares. (The repurchase liability is the quantification of the impact on the ESOP or company of the obligation to cash out shares from retiring employees.)

For more complicated leveraged ESOPs, an area of current focus is whether formulaic options valuation models properly capture the nuances of complex financing instruments. This is an area of ongoing development, particularly when audit firms examine the expenses and value related to financial derivatives.

Legislation to Hold Appraisers as Fiduciaries of ESOPs

Everyone is getting in on this game. The Department of Labor is working on new rules and regulations to hold appraisers as fiduciaries. Meanwhile in the Senate, legislation is in the works opposing the DOL/ESOP fiduciary proposal.

Proponents suggest the increased responsibility is necessary to hold appraisers accountable, to provide strong enforcement tools for protecting ESOP beneficiaries and to protect the public from improper appraisals.

Opponents worry the added regulation is excessive, and the increased costs and liability exposure will drive appraisers from the ESOP market, causing disruptions and hardships. This is a very hot topic, particularly in an election year, and one worth keeping track of for ESOP companies.

Overall, the market continues to improve, albeit slowly. ESOP appraisals continue to evolve, but changes brought about by the evolution should not cause disruption for ESOP companies. What happens in Congress, on the other hand, is something worth paying attention to – as if folks really needed one more reason to pay attention in an election year!