Fireball Island: Hot Valuation Topics for ESOPs

Transcription

1 The New South Chapter of the ESOP Association: Fall Conference October 17 th 18 th, 2012 Orlando, Florida Fireball Island: Hot Valuation Topics for ESOPs Robert H. Buchanan, J.D., ASA Winter Park, FL Nicholas J. Heinz, ASA Memphis, TN Ray Kukreja, CFA Atlanta, GA

2 Agenda Price Protection Fair Market Value vs. Economic Value Repurchase Obligation Equity-Based Compensation 2

3 Price Protection 3

4 Price Protection Background and Description Second-stage ESOP transaction Highly-leveraged deal = significant decline in stock value Interests of participants long-term vs. short-term Protection offered to certain participants that stock price will be immune from adverse impact of additional debt When Might It Not Be Necessary ESOP contributions are pre-funded Ownership increased through share redemption Distributions to be made after the debt is paid off 4

5 Price Protection Issue What is fair to a participant who retires right after a follow-on leveraged ESOP transaction? Example Pre-Transaction Post-Transaction Enterprise Value $100,000,000 $100,000,000 Existing Debt 20,000,000 20,000,000 Transaction Debt 0 40,000,000 Equity Value 80,000,000 40,000,000 Shares Outstanding 1,000,000 1,000,000 Equity Value / Share $80.00 $40.00 Change in Value - -50% 5

6 Price Protection Companies Using Price Protection Typically Have a highly leveraged transaction Expect slow growth May have many participants at or near retirement age Considerations In Price Protection Variable vs. fixed price protection Participants / shares eligible for protection Duration of price protection 6

7 Price Protection Dilution From Price Protection Estimate per share value in each of the protected years Fair market value of the unprotected shares ($44) Value of the variable price-protected shares ($88) Project the number of protected shares to be repurchased in each of the projected years (100) Calculate and discount the price protection amount (100 x $44 = $4,400) Cost Of Protection Variable Fixed Cash Flow Growing More Less Cash Flow Declining Less More 7

8 Fair Market Value vs. Economic Value 8

9 Fair Market Value vs. Economic Value Background S corporation ESOPs exempt from income tax Exemption from taxes enhances value through: Reinvestment of cash into the company Regular dividend payout To conform to the willing buyer concept, installation and annual updates require assumption of C corporation tax rate In a sale scenario, tax benefit derived from S corporation need to be addressed, as the ESOP would be giving real cash benefit accruing from its status 9

10 Fair Market Value vs. Economic Value Issue When an S corporation ESOP is contemplating a sale, what value should a valuation analyst estimate such that the transaction is fair from a financial point of view? Fair Market Value = willing seller and willing buyer concept Economic value = enhanced cash flow enjoyed by an S corporation ESOP 10

11 Fair Market Value vs. Economic Value Example S Corporation C Corporation Pretax Income $10,000,000 $10,000,000 Income Tax 0 4,000,000 Net Income 10,000,000 6,000,000 Exit Multiple 5x 5x Value $50,000,000 $30,000,000 Would a willing buyer agree to pay $50MM? If the ESOP were to sell the company for less than $50MM, would it be fair to the participants? The gap between economic value and fair market value may be overstated due to costs of converting to an S corporation 11

12 Fair Market Value vs. Economic Value Conclusion A buyer would pay more for an S corporation ESOP: Not because of tax status, which is not transferable But because of productive deployment of enhanced cash flows that increase the value of a company Economic value is difficult to determine: Level of distributions may change Investment returns are uncertain Relative future tax rates are unknown Dependent upon holding period assumption Trustee s decision will depend on expectation of whether greater value will accrue from holding existing position relative to the price offered 12

13 Repurchase Obligation 13

14 Repurchase Obligation Background Congress-mandated requirement to make a market for shares held by employees It is a company (and not an ESOP) obligation Repurchases are required for: Retirement, death, disability or termination Diversification All ESOP companies face repurchase liability Increasing awareness for the need to plan as: Debt is paid off Baby-boomers retire 14

15 Repurchase Obligation Repurchase Obligation Management Recycling: Company makes distributions to ESOPs to allow ESOPs to repurchase shares from participants Repurchased shares are allocated to other ESOP participants ESOP ownership percentage remains unchanged Redemption: Shares are redeemed from participants Repurchased shares are retired ESOP ownership percentage declines (if <100% ESOP-owned) 15

16 Repurchase Obligation Question What is the impact on equity value of the method used to manage repurchase obligation? Example Recycling Redemption Equity Value $10,000,000 $10,000,000 Less: Cash for Repurchase / Redemption 1,000,000 1,000,000 Plus: Tax Savings from Contributions 400,000 - Equity Value (post-repurchase/redemption) 9,400,000 9,000,000 Shares Outstanding (pre-redemption) 100, ,000 Shares Redeemed - 10,000 Shares Outstanding (post-redemption) 100,000 90,000 Per Share Value $94 $100 16

17 Repurchase Obligation RO may lower value directly through its impact on operations, if the share purchase inhibits the company s ability to fund its growth Capital expenditures Acquisitions Hiring employees Working capital and short-term liquidity RO may lower value indirectly via increased DLOM, higher discount rate and/or lower multiple Assumes that any investment made by the company will generate a return higher than its cost of capital No consensus on treatment of repurchase obligation within the valuation community 17

18 Equity-Based Compensation 18

19 Equity-Based Compensation Issue In many professional services firms key employees request some sort of equity-based compensation over and above their ownership through the ESOP Example A firm had seen its business negatively impacted by the Great Recession, its stock price fall substantially, and had several dissatisfied senior managers Long-term incentive plan ( LTIP ) was instituted to incentivize and retain key employees (~15 individuals) Synthetic stock issued with maximum number of units equal to approximately 10% of total outstanding shares 19

20 Equity-Based Compensation Example (cont.) Participants eligible for future cash payment based on cumulative EBITDA during four 3-year periods Dilution spread over the performance periods Reward earned subject to interpolated EBITDA results: Percentage of Performance Goal Satisfied Percentage of Performance Shares Earned Less than 90% 0% 90% 50% 100% 100% 110% or more 110% Valuation of LTIP liability based on BSOPM Estimated dilution = LTIP value / Equity Value (~7%) Trade-off from potential dilution was more than offset by a motivated management team 20

21 Equity-Based Compensation Valuation Considerations Measuring outstanding awards Forecasting future awards Measuring Outstanding Awards Valuing a liability that would dilute current shareholders Common methodology is the BSOPM Variables: Expected Term Risk-Free Rate over Expected Term Volatility Strike Price Current Stock Price Expected Dividends 21

22 Equity-Based Compensation Other Considerations One-time or ongoing program? Expected issuance in the future? Compensation cost is expensed over the requisite service period (generally the vesting period) Compensation cost recognized only for awards for which employees render the requisite service Examine the historical compensation cost trends What does the forecast assume regarding equity compensation expense? Future awards dilute current shareholders! 22

23 Thank You! Questions Robert H. Buchanan, J.D., ASA Winter Park, FL Nicholas J. Heinz, ASA Memphis, TN Ray Kukreja, CFA Atlanta, GA