Heads I Lose Tails You Win

Can shopping your company torpedo an ESOP?

By Ronald J. Gilbert, President ESOP Services, Inc.

4/17/2018

“Every way you look at this you lose,” from Mrs. Robinson, Simon and Garfunkel.

Those words, from the iconic song, pretty much sum up an emerging theory from some ESOP valuation firms that goes something like, “If you shopped your company and received written offers, then the ESOP can never pay more than these offers, even if you turned down the offers because they were too low, and all the other valuation evidence supports a higher value.”

Background

Since the days I worked with Louis Kelso 40 years ago, some companies considering an ESOP have gone down a “dual track”.  They retained an investment banking firm to shop the company and get the best offer possible.  At the same time they conducted an ESOP feasibility study which would include a preliminary valuation solely for the purpose of the ESOP transaction.  If a very attractive offer emerged, the independent valuation firm and trustee would normally not factor the premium price into the other valuation methods being considered.  Those other valuation methods typically are public company comparables, discounted future cash flow, and transaction evidence.  The valuation firm and trustee reasoned that the buyer was willing to pay a big premium for strategic reasons and/or cost savings that the ESOP could not realize as a stand-alone business.  The premium price was ignored.

The Bargain Hunters

If a strategic buyer did not emerge, then the offers frequently would be labeled “bargain hunting” from so called financial buyers.  These are typically Private Equity Groups (“PEGs”) shopping for a good deal.  While PEGs can pay very attractive prices for companies they fall in love with, they frequently buy at bargain prices because they know there will always be bargains out there.

Flip This Company

PEGs require rates of return on their investment in the mid-teens to mid-twenties, realized in approximately five years.  That frequently means selling the company within approximately five years, or having their investment cashed out with bank financing.  That’s what they tell their investors they will do, and investors look intently at their performance.  The lower the price the PEG pays, the better chance they have of realizing their rate of return target.

PEGs know that if they are patient enough they will find a bargain.  Good companies go to market for many reasons including the death of a major shareholder and/or key executive, or a serious illness of that same person, life style choices by the owner or owners, seismic industry shifts, and a host of other reasons.  These individuals or their estates frequently need or want significant amounts of cash and they want it soon.

House Hunting

Think of a mid-size city where a major employer has announced that in the next six months they will be laying off thousands of employees.  If you are about to shop for a home in that city, why would you pay fair market value (emotional considerations aside) when, if you were patient,  you will find a really great home where the owners are forced to accept a bargain price?

ESOPs and Rodney Dangerfield

ESOPs are a bit like Rodney Dangerfield “I don’t get no respect”.  If you are not old enough to remember him, go to www.rodney.com or ask Siri or Alexa.

ESOPs get no respect from independent valuation firms and trustees in two areas.

1. The discounted flow is “tax affected”. Translation, “even though we know you are going to operate as a partially or 100% ESOP owned S corporation and pay reduced or no federal income tax and little if any state tax, we will value you as if you are a C corporation tax payer”.  The vast majority of ESOP valuation firms take that approach, and it is not going to change.
2. Even though decades of research from The ESOP Association and the National Center for Employee Ownership show that ESOP companies are more productive and profitable than their peer group, and have a four times better survival rate in recessions, there is no credit given in the valuation for these facts. No respect.

The Concrete Ceiling

The background above provides the context.  Some ESOP valuation firms are taking the position that if a robust auction of the company has occurred, then the highest possible price that the ESOP can pay is either the highest of the offers or an average of the offers.  It is a concrete ceiling.

They are taking this position despite the fact that the sellers of the company turned down all of the offers because they were too low and/or the terms were not acceptable.

The proper approach is to look at ALL appropriate indications of value.  This would normally include discounted future cash flow, public company comparables, transaction evidence (often the most difficult to obtain), and the auction that has occurred.

The appraisers must use their judgement as to weighting the different value indications.  It would certainly be logical, if the company had been extensively shopped, to give equal weight to the offers as well as the other three methods.

Not so says the Concrete Ceiling Theory.  “We won’t give you credit for your tax-free status, your strong probability that you will perform better as an ESOP company or an offer from a strategic buyer (if you had one), or any other indication of value.  We WILL use the bargain price offers as the absolute measure of your value.”

One Edged Sword

The Concrete Ceiling Theory seems to come unraveled if there is an attempt to apply it to a distressed sale of an ESOP company.  Think back to 2009 when many companies, including some ESOP companies, were on the verge of going out of business and desperately seeking an outside buyer.  Knowing this, buyers were making offers that were clearly below the fair market value of the company.  How would the ESOP trustee and financial advisor conclude that the offer was below fair market value?  By looking at the other valuation methods referred to above, public company comparables, discounted cash flow, and transaction evidence.

If one attempts to apply the Concrete Ceiling Theory, then those offers defined the market.  We don’t think that the Department of Labor would agree.  An ESOP trustee, cognizant of the company’s distressed situation, should still attempt to negotiate a better deal.  A claw back would be at the top of the list, and an earn out also be appropriate to seek, and maybe better terms for the ESOP then non-ESOP shareholders.

Take Aways

If you are thinking of going down the parallel track process and having an investment banker firm shop your company, we would recommend;

1. Do it on a preliminary basis and receive only verbal indications of interest regarding proposed price and terms.
2. Immediately initiate a “Phase I” ESOP feasibility study to determine under the umbrella of an independent trustee, a preliminary value for ESOP purposes, as well as examining all the myriad of details that will provide a “decision package” as to whether the ESOP is feasible to accomplish the objective of the company and the selling shareholders.

“Tax-free” Rollover

Keep in mind that the ESOP may be a better deal for the selling shareholders even if the price the ESOP pays is lower than an outside buyer offers.  That is due to the IRC 1042 “tax-free” rollover which allows selling shareholders to defer and potentiality eliminate capital gains tax on the sale of stock to an ESOP.  There are a number of criteria that must be met to determine if the sellers are eligible to elect the “tax-free” rollover.  If they are eligible and their basis in the stock they own is low, the savings can be up to 23% to 33% of the transaction price depending on the state of residence.  If we assume an average of 25%, that means that the ESOP could pay 15% less than the outside buyer and the seller would net 10% more from the sale to the ESOP.

Detailed Analysis

ESOPs are complex, and a detailed analysis is required to provide sellers, boards of directors, management, and advisors information in order to make an informed decision.  In the meantime, don’t bump your head on the concrete ceiling.  It can be low.

You do not want to find out until it is too late that the independent trustee and independent valuation firm have bought into the Concrete Ceiling Theory, and find yourself humming “Mrs. Robinson”.