ESOP Valuation Considerations During Times of Uncertainty
Crises like the coronavirus pandemic can cause significant challenges for administrators and trustees when valuing employee stock ownership plans (ESOPs). Plan administrators must consider whether their current valuations—most of which were finalized as of December 31, 2019—accurately reflect company values now that COVID-19 has introduced unprecedented levels of market volatility and economic uncertainty.
Independent appraisers who lead ESOP valuations use the Internal Revenue Service’s standard definition of fair market value—which is the price that would be paid if the organization were sold—to value the company stock. That valuation is used for all distributions in the following year. Because valuations that were finalized at the end of last year may not reflect the value of the company today, companies may be using inaccurate estimates when making distributions. These valuation challenges also affect acquisitions that are in-process, as third-party acquirers seek reassurance that deal terms accurately reflect the current value of a company.
There are two primary options ESOP administrators can consider to help address the risk of using a year-end valuation that doesn’t accurately reflect the current value of the company: conducting an interim valuation or making distributions over a multi-year pay schedule.
Interim Valuations
When considering the use of interim valuations, organizations should first assess whether the business has been materially affected by market volatility.
Next, organizations should review plan documents to determine whether interim valuations are permissible – or if administrators may amend documents to make them such. This needs to be done carefully, as amendments should be in the best interest of the participants—not the organization. Because amendments shouldn’t be reflective of a singular event, organizations should also consider the impacts such amendments will have on the ESOP when company value goes up as well as down.
But even if an interim valuation is allowed by the plan documents, organizations should only do one if they feel that they have appropriate visibility into the business to provide a better estimate of value relative to the most recent year-end valuation. If there is continued uncertainty regarding how the market will affect organizations going forward, it may be very difficult to accurately value. The interim valuation will have an impact on existing ESOP participants as well as those taking a 2020 distribution, and ESOP administrators need to ensure the valuation is fair to both groups.
Finally, the costs of interim valuations should be considered, plus additional administrative costs, such as recreating participant statements.
It is important for organizations to work closely with consultants and advisors throughout this process and thoroughly document the steps taken to provide backup to the decisions made.
Pay Schedules
ESOP administrators who aren’t confident that an interim valuation will resolve uncertainty in their most recent valuation may consider using a multi-year distribution schedule to help mitigate risk.
By law, ESOPs are allowed to distribute assets through a lump sum or a schedule of substantially equal annual payments over a multi-year term. Payouts on this schedule will be adjusted as year-end valuations are conducted over the term. This may better protect plan administrators from paying under- or overvalued lump sums in a volatile environment. If the plan document doesn’t currently allow for scheduled payments, the document may need to be amended.
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