The S Corp ESOP Valuation Paradox
A 100% ESOP-owned S corporation naturally becomes more acquisitive as the years pass and it pivots from retiring its substantial ESOP buyout debt to accumulating cash. When evaluating acquisitions, board members need to be aware of certain valuation nuances that may negatively bias their view of an acquisition target.
Traditional M&A analysis focuses largely on identifying revenue and cost synergies needed so that the buyer's stock price is positively impacted. Acquiring a business to expand a customer base via products or geography is a typical revenue synergy while cost synergies often include the elimination of redundant overhead.
Since the ESOP valuation convention is that S corporation ESOP are taxed as regular corporations, the analyst may conclude the synergies are a bridge too far and forego the opportunity. However, unlike tax paying companies making acquisitions, a 100% ESOP-owned S corporation acquiring a tax-paying target has a unique cost synergy of not paying taxes on the target's earnings post transaction.
This paradox, that the buyer will enjoy tax benefits on the target's income but won't be immediately recognized in the ESOP appraiser's equity valuation, presents a quandary for the parent's board and management. While the ESOP trustee and appraiser are bound to value their 100% ESOP client as if it is paying taxes, the company's board of directors can take a different view and consider the long-term value of these savings even though such future benefits will not immediately be reflected in the appraised share price.
Assume, for example, the company analysts determine (using its standard ESOP valuation methods) that the company should pay no more than $15 per share to avoid dilution to the sponsor's share price. But by including consideration of the future tax flow savings, they determine a value of $20 per share is not dilutive. If the "winning price" for the target is $18 a share, the ESOP company's board may be mistaken not to bid at the market since a more realistic economic valuation approach suggests $20 per share is non-dilutive. By overlooking this additional value, the board may have passed up an accretive purchase price at $18 per share.
In this example, it should be noted the buyer's initial, post-transaction ESOP appraisal may be negatively impacted because the ESOP appraiser does not consider the tax benefits. However, over the longer term the ESOP appraisal will reflect the tax savings by increased cash or lower debt on the balance sheet and therefore support the higher initial purchase price.
The bottom line is that 100% ESOP-owned S corporations need to carefully understand the subtleties of valuing acquisitions and how some inherent contradictions in mainstream ESOP valuation methods may negatively bias the evaluation and decision making process of making acquisitions of non-ESOP targets.
* It is the accepted practice of the ESOP appraisal community that pursuant to the definition of "Fair Market Value" under IRS revenue ruling 59-60, the concept of a "willing buyer" implies that such a buyer is a C corporation and that the ESOP valuation must treat the company as if it were paying taxes, even if the company is an S corporation 100% owned by an ESOP without the actual obligation to pay corporate income taxes.
AUTHOR: James F. Higgins Jr.