ESOP Valuations: Same as Other Valuations or Different?

Business valuations performed for ownership interests held by Employee Stock Ownership Plans (ESOPs) are similar to business valuations of other ownership interests. Both types of valuations will consider the three approaches to value (the Market Approach, the Asset Approach, and the Income Approach), be performed by qualified valuators possessing the requisite training and experience for the type of valuation, and will consider appropriate economic factors and industry trends. For both valuations, the valuator must comply with the Standards and Regulations associated with any valuation-related professional designations held.

On the surface, both valuations have similarities, but there are considerations unique to ESOP valuations. The following discussion points are a few of the more important items which make ESOP valuations different from other business valuations. The specific facts and circumstances will vary for each ESOP, but the valuator should consider how the following impacts the ESOP valuation.

Regulatory Oversight

ESOP valuations, both transactional and the annual compliance valuations, are subject to oversite by the IRS and the Department of Labor (DOL). In 1988 the DOL published its Proposed Regulation Relating to the Definition of Adequate Consideration to provide guidance on the meaning of “adequate consideration” under the Employee Retirement Income Security Act of 1974 (ERISA), which requires ESOPs to pay no more than “adequate consideration” when investing in qualifying employer securities.

The proposed regulation was never finalized but has been referenced as guidance by the IRS, DOL, and valuators. The DOL issued new draft guidance in January 2025 under SECURE 2.0 Act mandate, but the guidance was withdrawn following a regulatory freeze. The impact of the Proposed Regulation should be determined and addressed in an ESOP valuation.

Taxation Status

A 100% ESOP owned S corporation can be a non-taxable entity if certain criteria are met. The ability to avoid federal taxation (and often state taxation) on the ESOP’s share of company earnings presents a powerful opportunity. The tax savings can be used to pay down debt, invest in capital items promoting growth, or other areas the company deems appropriate.

When valuing a 100% ESOP owned S corporation, the valuator must determine if it is appropriate to “tax affect” the earnings of the S corporation. Some of the arguments for tax affecting include the belief that discount rates, pricing multiples, and transaction databases are based upon tax paying C corporations.

An additional argument is that the most likely purchaser of the company would be a C corporation, so taxes need to be considered because they will not pay for tax savings that will not be realized. A counter argument for not “tax affecting” an ESOP’s S corporation’s earnings is that the company does not have a tax liability and recording a tax liability creates a phantom expense that decreases value.

DLOM & the Put Option

A factor that generally distinguishes ESOP shares in closely held companies is that a “put option” is required to be attached to the ESOP shares. Without this put option, employee participants could be forced to hold employer securities for extended periods of time. The put option requires the employer to provide the needed liquidity by repurchasing the distributed employer securities. This employer obligation is commonly referred to as the “repurchase liability.”

The DOL Proposed Regulations guide the valuation analyst to consider: (1) the extent to which the “put options” are enforceable, and (2) the company’s ability to meet its obligation. Most ESOP valuation practitioners interpret the ESOP put right as a substantial mitigating factor in the determination of the discount for lack of marketability (DLOM). The degree of mitigation is the responsibility of the valuator to determine. A counter argument for the reduction of the DLOM is that an outside purchaser (a non-ESOP investor) would not pay for the put option because they would not benefit.

Repurchase Liability

Under U.S. Generally Accepted Accounting Principles, the repurchase liability is not presented as a liability on the company’s balance sheet. The obligation to purchase shares from participants is a legitimate future outflow of cash from the ESOP trust to be funded by the company. The valuator must determine if the future outflow of cash from the ESOP trust should impact the valuation.

One argument for not accounting for the repurchase obligation is that a hypothetical outside buyer would not have the repurchase liability, and the value would be depressed if the repurchase liability (or present value of the estimated cash outflows) were included in the valuation. Another argument is that the repurchase obligation could be met by future tax savings of a 100% S corporation ESOP which does not pay taxes.

An additional complication stems from how the repurchase liability is determined. Is it estimated by management or was it prepared by an independent third party? A repurchase obligation study performed by an independent party can be cost prohibitive to the ESOP, but the estimated annual cash outflows are difficult to determine without a study.

ESOP valuations are subject to unique factors which make them different from valuations for other ownership interests. The valuator must look at the specific facts and circumstances of each ESOP valuation engagement and determine how to address the factors. At McKonly & Asbury, we have extensive experience with ESOP valuation procedures. If you have any questions regarding ESOPs, please contact T. Eric Blocher CPA, ASA, CVA.

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