Is the ESOP right for your business?

As we talked about in an earlier post, employee stock ownership plans, or ESOPs, are gaining in popularity as a cost effective way to transfer ownership to the company’s employees.

But not every company is a good candidate for an ESOP. Before taking the plunge, consider some key questions than can make or break a successful ESOP:

• Is the business valuable enough?
• Can the company borrow enough to fund an ESOP?
• How stable and predictable are business earnings?
• Does the company make adequate payroll?
• How dependent is the business on departing owners?
• Do owners and employees fully understand and accept the ESOP?

The first order of business in setting up a good ESOP is to figure out the piece of company ownership to be sold to employees. You also need to determine over what period of time this sale will take place.

Once you have established this, it is time to value the shares of the company’s stock. This, of course, requires that you conduct business valuation of the entire firm. Then the current owners can decide if the resulting price per share of stock is something they can accept.

If you are offering an ESOP as a tax advantaged retirement benefit to your staff, you should consider other retirement plans, such as profit sharing, before making your decision. Be sure to consult the applicable laws on whether your corporate structure allows an ESOP to be set up. The rules for different types of company structures, such as US S-corporations or limited liability companies (LLC), may differ.

A company can contribute up to a certain percentage of employee payroll to an ESOP as long as the contribution is used to repay the loan principal and interest used to fund the plan. If the ESOP is not using borrowed money, the percentage contribution is different, so check with your tax authorities on the limitations.

The payroll used in the calculation is a bit tricky. New employees may not be allowed to make contributions right away. Organized labor participants may be excluded altogether. Bear this in mind when estimating the total contributions toward the plan.

If the tax authorities conclude that your company does not run sufficient payroll, the contributions may be reduced. That said, very small companies with just a few employees have successfully established ESOPs.

Don’t forget to factor in the cash required to make purchase of company shares or to pay off the loan used for the ESOP. You will also need cash to buy back the shares from the departing employees. You should make sure the business cash flow is sufficient to cover all these obligations over the plan’s duration.

An important point to bear in mind is just how dependent the company is on the skills and daily contribution of departing owners. If an owner possesses the know-how and skill other staff members lack, the owner departure could prove devastating to the business.

To avoid this, make sure the company has a proper management succession plan in place, allowing for time and training of the professional managers who will take over once the owners leave. Lenders offering funds for an ESOP may require that the departing owners stay on as consultants for some time after the buyout is completed.

Lastly, the entire team at the company needs to decide if everyone is comfortable with the idea of employee business ownership. Staff who become owners must understand that they will assume additional responsibilities for business operations and become privy to sensitive financial and operational information. The employees step up to being independent business owners. If they are unwilling to share in the responsibilities of owning a company, they should not be misled into an ESOP, despite the financial benefits of such a plan.

Is CAPM useful in private company valuation?

If you are valuing a small business, you have run across the need to establish the discount rate. This is part of risk assessment, a key element in any business valuation. In addition to the well known Build-Up model, you also have the capital asset pricing model, or CAPM, to calculate the discount rates.

CAPM has been used by financial analysts for decades to value publicly traded companies. One new element that CAPM introduces is the concept of systematic business risk. If you take a look at the CAMP formula, this systematic risk is captured by a factor called beta. Beta shows how well the company’s financial returns track the overall equities market.

Beta is usually calculated from the total returns of the company being valued. These returns include two components:

• Dividends
• Rise and fall in the market value of company stock

For public companies, both of these components are well known. The situation is different if you are valuing a private company. Most likely, the market value of its stock is not measured regularly. This has been the stumbling block for using the CAPM model in private company valuations.

There are a couple of approaches you can take if you want to use CAPM to value a small privately owned business.

Estimating a proxy beta

If the company operates in an industry where public companies compete, you can pick a number of guideline companies for your analysis. Now calculate the beta for your target private firm by establishing a statistical composite, such as the median beta for the industry group. If your company closely resembles the guideline firms used in the calculation, you can argue that the beta estimate is valid.

Note, however, that the proxy beta is based on returns of other companies, rather than the firm being valued. It may be a close approximation of the real figure, but falls short of the direct factor calculation as is done for public companies.

In some industries dominated by private businesses, there may not be enough guideline company data to run such proxy beta calculations.

Using results of business valuation directly

You can use other valuation methods to estimate the market value of the company. An example would be the market based valuations or the multiple of discretionary earnings method. These methods are well suited for private company valuation and do not require that you calculate the discount rate.

You can run a number of such preliminary valuations, estimate the market value of the company’s stock, and use the results to calculate the company’s beta. Once the beta is known, you can refine your business valuation by applying other methods such as the discounted cash flow that require the discount rate as one of the inputs.