Project Expected Future Cash Flows Not Best or Worst Case
We have just returned from NCEO’s conference in Denver. It was an excellent opportunity to meet new ESOP companies, talk to persons interested in ESOP transactions, and chat with many of our favorite professionals in the business of providing services to ESOP companies. The NCEO conference was a great opportunity for anyone at any level to learn something new about ESOPs. One of the consistent buzzwords or buzzphrases we heard at the conference was “sustainable ESOP.” We engaged in several conversations discussing what exactly is a sustainable ESOP and how you establish one.
We believe that four aspects of an ESOP should be considered at the outset in order to develop a sustainable ESOP – some of these can be implemented as the ESOP matures, but before you start an ESOP, consider all four of these. Over the next several weeks, we will present three more posts outlining various considerations when designing an ESOP for the long-term. Today, we address the initial transaction and the search for Fair Market Value. What the sellers receive and the impact on future cash flow are one of the greatest factors in long-term success of a new ESOP. If the value is too high, it can cripple the company going forward and if the value is too low, the sellers isn’t selling to an ESOP. For a good ESOP transaction to occur, the selling owners must walk away feeling that they have been appropriately compensated for the work they put in and for the risk they had taken to build their business. The buying ESOP in turn wants to see that business carry on and perform better than ever. To ensure that both occur, the sellers must receive fair market value for the stock sold to the ESOP and the company must have the wherewithal to service the necessary debt associated with any stock purchase. The two are inextricably linked.
Even if the sellers walk away with what is perceived to be fair market value at the time of the transaction, it does little good to a seller taking a promissory note as part of the purchase price if the sponsor company (the “Sponsor”) cannot service that note going forward. Because of the importance of the Sponsor Company’s ability to fund a good ESOP transaction that satisfies all parties, projections of expected future cash flow must be realistic. As the name suggests, “expected” does not equate to “best case” cash flows. By the same token, it also does not mean “worst case” cash flows either. One way to ensure realistic expectations of future cash flow is to make such projections with debt capacity of the Sponsor Company in mind. The parties should ask: Are the “expected” future cash flows achievable and necessary to meet transaction indebtedness? If the Sponsor does not meet the projections, what cash flow would be needed to repay transaction indebtedness? It is important to ask these questions for legal as well as practical reasons.
Under ERISA, the ESOP can pay no more than adequate consideration for the company stock. With respect to any transaction involving stock that is not readily tradable on an established market, adequate consideration is the “fair market value of the [stock] determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.” Unfortunately, the Department of Labor (“DOL”) has never finalized regulations to assist fiduciaries in determining fair market value. Rather, the DOL merely proposed regulations in the late 1980s with respect to “adequate consideration”. Most practitioners nevertheless refer to those regulations as guidance as to how the DOL will enforce the provisions relating to adequate consideration and fair market value. The proposed regulations require that the fair market value be determined “as of the date of the transaction” and be reflected “in written documentation of valuation.”
In addition to the requirements of ERISA, the Internal Revenue Code (the “Code”) provides additional requirements. Under the Code, the trustee (or named fiduciary) of the ESOP must have the stock appraised by an “independent appraiser.” Combining the requirements of ERISA and the Code, the trustee has the independent appraiser provide a written valuation setting forth an opinion of the fair market value of the stock– i.e., “the price at which [the stock] would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell….” Then the ESOP trustee determines, in good faith, whether the price to be paid in the transaction is “not more than fair market value.”
In practice, the independent appraiser typically provides a range of value and the trustee negotiates the transaction price with the sellers (and often the Sponsor as well). Upon consummation of the transaction, the Trustee must ensure that the transaction price is within the range provided by the independent appraiser – assuming, of course, that the range adequately reflects fair market value. Recent litigation by the DOL indicates that it perceives a problem with that process or that problems have occurred in the process more frequently as of late. The allegations in the complaints filed by the DOL and the recent provisions of a settlement (the “Settlement”) with GreatBanc Trust Company (“GreatBanc”) indicates that the DOL not only wants the trustee to determine FMV, but also wants the trustee to consider precisely what we suggest should be considered for a sustainable ESOP – i.e., the debt capacity of the company. In that settlement agreement, the DOL has specifically insisted that when GreatBanc makes its adequate consideration determination, it must “analyze and document in writing  whether the ESOP sponsor will be able to service the debt taken in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock)”.
While the Settlement only applies to GreatBanc as a matter of law, the DOL has repeatedly stated that the Settlement provides guidance to all trustees and others considering ESOP transactions. At a minimum, the Settlement outlines steps that the DOL believes are appropriate steps in the context of determining whether the price paid by an ESOP for shares of the Sponsor’s stock in an ESOP transaction exceeds the fair market value of such purchased shares and the terms of the transaction, taken as a whole, are fair to the ESOP from a financial point of view.
Such consideration of debt capacity, however, is not merely prudent from a legal point of view (as noted in the Settlement), but has great practical value as well. . What good is a “high” fair market value if the Sponsor is not able to repay the debt associated with that fair market value determination? For example, what good is a $90m fair market value when after five years the sponsor is worth only a few million and the selling shareholders have received only $15m because the sponsor couldn’t service the high debt associated with the transaction? On a smaller scale, what good is an $18m valuation where after 10 years the sponsor only pays a total of $5m? In each of those instances, the ESOP related debt was an excessive drain on the Sponsor. The participants saw little value in the ESOP, and not surprisingly, a culture of employee ownership was never developed.
So how does one consider debt capacity in the context of determining fair market value? The first place to consider debt capacity is when providing the valuator with projections of future free cash flow. The most used valuation method is the discounted cash flow method. Under that method, the valuator estimates a future period’s expected cash flow and calculates its net present value by discounting it at a market rate of interest. Reasonable and supportable projections of future revenue growth demonstrate the value of the Sponsor and should, therefore, indicate the amount of debt the Sponsor is able to service. Inflated projections, on the other hand, may drive a higher fair market value, but such unsustainable projections of future revenue growth will lead to an unrealistic view of the debt capacity of the Sponsor. Considering growth in the context of loans that must be paid back to a lender, it is likely that such projections of future cash flows will fall in line with “expected” levels of income as opposed to “best case” levels of income. Whether or not the projected cash flows are “conservative,” it is also prudent to structure the purchase price and debt repayment in a manner that only a conservative portion of the projected free cash flow is required to service the debt. Then, if the projections are not achieved, a sufficient “cushion” remains for servicing the debt.
If you consider the debt capacity of the company at the outset, this will help protect the business held by the ESOP going forward and assist it in addressing the large debt burden that can arise in a 100% ESOP transaction. In the next entry, we will discuss how the structure of the transaction can be adjusted to also protect the cash flow of the going concern. Tune in next week.
As always, if you have any questions, please drop us a note or contact one of our attorneys here at ESOP Plus.
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