Once an ESOP acquires company stock there is a requirement that the stock’s value be appraised by the independent appraiser at least annually. Many companies view this process as a perfunctory exercise whereby management supplies the appraiser with updated financial and other information and several weeks later the appraiser kicks out a stock value with little fanfare and almost no debate and review. A major portion of our advisory service involves assisting long-standing ESOP companies with various matters including debt refinancing, follow-on ESOP stock purchases and other ongoing ESOP advisory services. In these engagements, we almost always review the annual ESOP appraisals as part of our initial due diligence. In our review it is amazing how many times we encounter appraisals that have one or more errors. Less often, but even more remarkable, are the appraisals we encounter where there is a disconnect between the value analysis and the true prospects of the business (i.e. the appraisal is dramatically missing what we subjectively view is the appropriate value of the business).
On both of these points I acknowledge that no one (including a seasoned appraiser) is perfect, but there seems to be a lack of oversight and scrutiny by some (not all) trustees as well as the company’s board and management in making sure that the facts and calculations in the appraisal are accurate. The annual appraisal report should clearly be reviewed by the trustee since it is the trustee’s responsibility that company’s stock is being accurately appraised. However the trustee can sometimes lack the context and knowledge of the business to make sure that the analytical process is reasonable and accurate.
The company is ultimately the administrator of the ESOP plan and it is important for the company’s board of directors and management to ensure that the appraisal is accurate as it may very well impact future economic events including share repurchase as well is the ultimate buyout of the company. All too often the company’s board and management take for granted the findings of the appraiser and there is no dialogue or questioning the appraiser’s findings. This is a mistake that, if not checked, can result in problems that can snow-ball over time and cause unneeded financial duress over the longer term.
Checking facts and calculations in an ESOP appraisal should not be all that controversial (shouldn’t everyone want to arrive at the correct answer?) and one would expect that feedback should be graciously received by both the appraiser and the trustee. The issue of more subjective issues is often times a more difficult dialogue. No matter how objective and formulaic many ESOP appraisals may seem, there are always areas where subjective “gut” calls are being made by the appraiser. This is not to suggest that the appraiser is being arbitrary in their use of particular information and assumptions. However there is a wide range of outcomes that can result from these subjective elements. An example is when an appraiser utilizes a company-specific risk premium in estimating the company’s cost of equity. Although all other aspects of determining the cost of equity are based on empirical data, the company-specific risk premium is based largely (if not entirely) on the sole judgment of the appraiser. One appraiser might use a 2% company-specific risk premium whereas another appraiser analyzing the same company might use a 5% premium. These variances can result in widely different valuation results. While the company’s board and management does not have any direct authority over the appraiser, they should nevertheless review the appraiser’s work and raise issues with both the appraiser and the trustee when they are in disagreement with an assumption or conclusion in the analysis. This is especially the case when management is ultimately in disagreement with the appraised value of the stock or they feel that the appraised value over the ensuing years will, if unchecked, veer the stock price to a level that gravely over-values or under-values the company. Again, the appraisal report is not the ultimate responsibility of the company’s board or management, but if left uncheck and inaccurate, the appraisal can cause serious problems over time. I have witnessed a few instances where the appraised value was essentially unsustainable because the appraisal grossly overvalued the company’s stock and the company’s cash flow could not sustain the required repurchase of shares from the ESOP. While the demographics of the company’s aging ESOP participant base had something to do with this, the true culprit was an excessively high share price. In this case the company ultimately sold itself (at a discount to the prior ESOP valuation!) to terminate the ESOP and prevent further hemorrhaging caused by an excessive repurchase obligation.
Some may disagree that the company’s board and management have no place in impacting an annual ESOP appraisal, but I say that they cannot afford not to be actively involved in reviewing the ESOP appraisal and entering into critical (but respectful) dialogue when they feel that the appraisal is not accurately reflecting the true financial value of the company stock.