ESOP Valuations: How Much is Too Much?

The U.S. Department of Labor (DOL) recently suffered a resounding defeat in Walsh v. Bowers. In that case, a federal district court rejected the DOL’s claim that an employee stock ownership plan (ESOP) overpaid for the sponsoring company’s stock.

Background

The owners of an engineering firm formed an ESOP, then they sold the ESOP all of their shares of the firm’s stock for $40 million. The DOL sued them, alleging that they violated the Employee Retirement Income Security Act (ERISA) by making the ESOP pay more than the company’s fair market value (FMV).

FMV is determined in good faith by the ESOP trustee. Under ERISA, this is the appropriate standard for determining whether an ESOP has paid adequate consideration for a company’s stock.

DOL Errors

The ESOP trustee relied on an independent appraisal of the company’s value as of the transaction date. The $40 million price tag was derived from the guideline public company method, the guideline transactions method (described by the court as the “industry acquisition method”) and the discounted cash flow method. Each method resulted in a value exceeding $40 million, supporting the conclusion that the purchase price didn’t exceed FMV. At trial, several defense valuation experts agreed with this conclusion.

The court found several errors in the DOL’s valuation, including:

• The DOL’s expert, who valued the company at $26.9 million, ignored Uniform Standards of Professional Appraisal Practice (USPAP) by failing to interview management or gather information via deposition and other discovery tools. As a result, he erroneously deducted certain consulting fees that had been passed through to clients as company expenses. The expert also violated USPAP by applying certain valuation discounts based on events occurring after the valuation date. As a result of these errors, the expert undervalued the company by more than $13.5 million.
• The DOL relied on a third party’s “nonbinding preliminary indication of interest” in buying the company for $15 million. The court found this informal offer to be irrelevant, likening it to someone who offers $15,000 for a used luxury car with a Blue Book value of $40,000.
• The DOL also relied on a post-sale appraisal from the firm that valued the company at only $6.53 million as of the transaction date. But the post-sale valuation included debt incurred to buy the stock.

Part of the DOL’s argument was that the ESOP trustee spent relatively little time on the valuation and quickly accepted a price near what the owners were seeking. The court pointed out, however, that the trustee negotiated favorable terms on the seller notes used to finance the purchase, saving the ESOP millions of dollars.

ABCs of Business Valuation

The ESOP prevailed in large part because the judge understood basic valuation principles and how they apply in the context of ESOP transactions. Not all judges are this informed about these issues, however. That’s why it’s critical to engage experts who can help educate judges on often complex and nuanced valuation concepts.