ESOP Valuations are Monitored and Reviewed by Department of Labor and ERISA

Key Takeaways:
  • ESOPs require annual independent valuations to comply with DOL and ERISA regulations, ensuring fair share value for employees.
  • The annual valuation impacts financial reporting, tax benefits, employee motivation and succession planning within ESOP-owned companies.
  • ESOPs drive higher employee engagement and retention, often resulting in increased profitability and substantial retirement savings for employees.

 

Most companies obtain a business valuation when they are facing an impending event such as a merger. However, one type of business is required by federal regulations to have an independent valuation every year – companies that are fully or partially owned by their employees through an Employee Stock Ownership Plan (ESOP). 

An ESOP is an employee benefit plan that enables workers to gain an ownership interest in the companies they work for by buying shares of stock. Since ESOPs are employee benefit plans, they are governed by U.S. Department of Labor (DOL) regulations, as well as the Employee Retirement Income Security Act (ERISA). 

Nationwide, approximately 6,500 companies are either fully or partially owned by their employees through ESOPs, including some publicly traded companies. The largest public company with an ESOP is Florida-based Publix Super Markets with 250,000 employees. In Kansas, three companies are 100% employee-owned through ESOPs – Performance Contracting, Inc. (construction) of Lenexa with 10,300 employees; Terracon (engineering/consulting) of Olathe with 6,000 employees; and Medicalodges (long-term health care) of Coffeyville with 1,595 employees. 

Each year, participating employees receive shares of the company stock in their employee benefit accounts, which function like a 401(k) plan. Instead of investing in mutual funds or other equities like a 401(k) does, the ESOP invests in the company the employees work for.  

Annual ESOP Valuation 

Besides regulatory compliance, the annual valuation is crucial for an ESOP for several reasons: 

  • Fair market value (FMV) determination: The valuation determines the fair market value of the company’s shares, ensuring that employees receive a fair price for their shares when they leave or retire. 
  • Financial reporting: Companies need to report the value of their ESOP shares in their financial statements. This affects the company’s balance sheet and overall financial health. 
  • Tax benefits: Proper valuation helps in determining the tax benefits for both the company and the employees. It ensures that the ESOP is structured in a tax-efficient manner. 
  • Employee trust and motivation: Knowing the value of their shares can motivate employees and build trust in the ESOP. It shows transparency and fairness in how the company values their contributions. 
  • Succession planning: For companies using ESOPs as a succession planning tool, valuation helps in planning the transition of ownership smoothly and fairly. 

The annual valuation is reported on the company’s Form 5500, which is a public document filed annually with DOL.  

The valuation professional will look at several factors to reach a conclusion of value, including: 

  • What has happened to share prices in the past year? If the price went up or down, what are the reasons? If there is a large fluctuation, the valuation professional must explain the reasons in the valuation report. Did the company experience unusual growth or higher profitability? Did it enter a new market? 
  • The valuation professional will also look at what has happened in recent transactions in the region with similar companies. 

‘Put Provision’ Impact 

A significant difference with an ESOP valuation occurs when there is a “put provision” in the ESOP plan documents, which is common. This allows share owners to put shares back into the company if they retire or leave the company. This creates more liquidity for the shares held by the company’s ESOP.  

When a put provision exists and the ESOP owns a majority interest in the company, the valuation professional may or may not apply a discount for lack of marketability of the shares, depending on the unique characteristics of the plan. If the ESOP owns a minority interest in the total shares of the company, there is a discount for lack of control and generally a discount for lack of marketability that is applied to determine the price per share. 

ESOPs Motivate Employees 

Generally, ESOP participants are more invested in driving the value of their companies, and those companies have higher employee retention and a good corporate culture. 

A recent nationwide survey compared 14 million participants in ESOPs with 25 million workers who purchased other types of profit-sharing plan shares. The survey found the average value of the stock held by ESOP participants was $134,000, and for profit-sharing participants, $75,000. 

ESOP-owned companies are generally more profitable and have higher return on investment, and their employee shareholders often retire with more than $1 million in their retirement accounts when they have contributed to the long-term success of the business. 

If you would like to learn more about ESOPs and valuations, contact an Adams Brown valuation advisor.