Expert reviews role of valuation in ESOP cases


Valuation is complex and requires retaining an independent valuation advisor, according to Theodore M. Becker, of the law firm Drinker, Biddle, Chicago. And the process is unique to employee stock ownership plans (ESOPs) sponsored by privately held companies whose stock is not publicly traded, Becker said during an American Bar Association (ABA) webinar on October 28, 2014.

To determine a stock’s fair market value, the advisor must perform a valuation as of the transaction date, said Becker. Because valuation is complex, however, it requires retaining an independent valuation advisor. Valuation typically involves two methods; projecting future financial performance and looking to values of comparable public companies.

The fiduciary’s role in valuation takes into account Code Sec. 408(e)(2) where “adequate consideration” is “the fair market value of the asset as determined in good faith by the trustee or named fiduciary,” according to Becker. There remains debate over contours of this test, but a few things are clear, Baked noted. The valuation advisor must be independent, and reliance by the trustee on valuation advisor is not a “complete whitewash” that satisfies Code Sec. 408(e)(2). “The trustee must ensure that valuation advisor has complete and accurate information,” he explained. “Reliance on valuation must be reasonable; it cannot ignore flaws or errors that are reasonably detectable.”

Becker said the procedural problems in ESOP cases arise due to relying on unreasonable management and incomplete projections of future performance. As an example, he noted projections that far outstrip recent performance or are based on an unfounded business plan. In addition, there are revenue projections that do not account for costs associated with expected growth. The problem may stem from using comparable companies that are not really comparable, according to Becker. Problems arise when using discount rates that do not account for the risks facing the company, such as improper premiums for “control,” applying control premium or reducing minority discount for unfounded reasons, paying for control but not getting it. “In other words; allowing sellers to still control the Board of Directors,” said Becker. Moreover, relying on unreliable financial statements, cursory review of valuation and failing to question key assumptions invariably lead to problematic valuations.

While there are still many “problematic areas,” Becker stressed the importance of documentation by the trustee. Foremost, the trustee will determine the prudence of accepting and relying on the valuation analysis. The trustee must then identify and question assumptions in the valuation report, and make reasonable inquiry as to the consistency of the valuation report with due diligence information. The trustee must also determine that the conclusion is consistent with the data and that the valuation report is internally consistent, said Becker.

Source: Theodore M. Becker’s ABA webinar, 10/28/14.

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