Valuation is key to avoiding problems when creating an ESOP

With the baby boomer generation nearing retirement age, many business owners are researching different options of what to do when they do step down.

One option that has become more popular recently is the employee stock ownership plan (ESOP). Especially in today’s market, where sellers are pickier and mergers and acquisitions are tougher, ESOPs have become unique alternatives.

Not all companies are suitable for ESOPs, so you need to do some assessment and planning ahead of time to determine if this is the best option for you. You also need to make sure you receive an appropriate valuation.

“An ESOP is not allowed to pay more than fair market value for the shares it buys,” says Brian Bornino, CPA/ABV, CFA, CBA, the director of valuation services at GBQ Consulting LLC. “Overvaluation is the biggest risk. If the ESOP pays too much, it is considered a ‘prohibited transaction’ under ERISA and the ESOP could get unwound and incur penalties and fines.”

Smart Business spoke with Bornino about how to make sure an ESOP is valued properly and the business and tax advantages of forming an ESOP.

What are some major problems or risks that companies can run into when creating ESOPs?

You need to do planning ahead of time to determine if an ESOP meets your business objectives and is a good fit. You don’t want to put an ESOP in a company where it’s not a good fit. The planning upfront will help you determine if it makes sense or not. Oftentimes hiring an ESOP advisor to perform a ‘feasibility analysis’ is the first step.

You also need to avoid overvaluation of the company, which can be hard since you want to maximize the value. The important thing is to have the company valued at fair market value, because the ESOP can’t overpay. The ESOP won’t work if you’re not willing to accept that number or lower.

How can you make sure you are getting a correct ESOP valuation?

It’s important to work with a valuation firm that specializes in ESOPs. There are a number of factors that valuation people will look at, including forward-looking financial analyses that model out what the company will look like with an ESOP.

The buyer is the trustee, who typically hires the valuation firm. The trustee is appointed as a fiduciary to represent the ESOP in the transaction, although it will rely upon the valuation firm’s opinion and expertise. The trustee will feel comfortable if the valuation firm has significant valuation and ESOP experience and a strong reputation in the ESOP community. The trustee and the valuation firm must gain a good handle on fair market value since it is the maximum that an ESOP will pay. If that price doesn’t jive with what the seller is looking for, you move onto another option.

On the other hand, there are a lot of tax advantages that an ESOP transaction can offer that increases the business owner’s net proceeds and often bridges the gap between seller expectations and fair market value.