The Use of the Independent Financial Advisor in ESOP Transactions
The complexity of transactions involving the use of Employee Stock Ownership Plans (ESOPs) and the rising sensitivity to fiduciary responsibilities has led many plan fiduciaries to seek the advice of independent financial advisors when important transactions occur. Examples include unleveraged purchases and sales of stock, leveraged purchase of shares, the use of hybrid securities, and multi-investor buyouts. This article describes the role and qualifications of the financial advisor, the primary factors in the development of financial advisory opinions, and some practical issues related to the decision by the trustee to hire an advisor.
ESOPs have been part of the corporate finance scene for more than twenty years. While the level of activity in the public markets has abated in recent years, transactions continue to occur in the less visible venue of the closely held company. Improving corporate profitability and greater availability of bank loans has lead to a resurgence in transactions. Notwithstanding the relative degree of complexity of a given transaction, consideration should be given to the use of an independent financial advisor.
Why is the Financial Advisor to the ESOP Important?
Over the years, a number of refinements and changes have occurred in the role of the various players in completing a transaction involving an ESOP. The Department of Labor (DOL), as the government agency responsible for monitoring compliance with the Employee Retirement Income Security Act of 1974 (ERISA), the Internal Revenue Service (IRS), and state and federal courts have increasingly focused on the role of the fiduciary in ESOP transactions. For example, the IRS periodically tightens up its procedures with new announcements such as Announcement 92-182 – Employee Plans Examination Guidelines and Announcement 95-33-Examination Guideline on Leveraged ESOPs.
A 1993 federal district court case, Reich v. Valley National Bank of Arizona, more commonly known as the “Kroy case,” further heightened the potential responsibilities of the plan fiduciary and the financial advisor. A discussion of Kroy is outside the scope of this article, but suffice it say that it is essential that ESOP fiduciaries and advisors must understand its implications.
The effect of all of this has been to clarify and often increase the responsibilities of plan fiduciaries, because they are obligated to act prudently and solely in the interest of the plan participants. One way to meet those responsibilities is to use an independent financial advisor to address questions of adequate consideration and fairness.
Who are the Players in an ESOP Transaction?
A transaction involving an ESOP can have the following participants to the purchasing and selling parties:
- An independent fiduciary (or other trustee) for the ESOP;
- An independent legal counsel for the ESOP;
- An independent appraiser of shares to be purchased;
- An independent financial advisor for the ESOP; and,
- Legal counsel and possibly financial advisors for other buyers (e.g., management).
It may well be in smaller deals that several of the above roles are filled by the same person or entity. However, this duplication of roles raises the fiduciary’s risk profile, particularly if the ESOP was later determined to be inadequately represented. A distinction should be drawn between an independent appraiser and an independent financial advisor. Although this role may be the same individual or company, the appraiser makes an independent determination of the fair market value of the company’s shares and the financial advisor assesses the overall fairness of the transaction, including the pricing and terms. This article attempts to focus on the overall broader responsibility of the financial advisor (whether or not the advisor is an appraiser also) rather than discussing each consultant and their individual roles and responsibilities.
What are the Responsibilities of the Financial Advisor?
The financial advisor acts as a financial consultant to the fiduciary. The role and responsibility of the financial advisor can be categorized as follows:
- Determine the fair market value of the company’s shares;
- Evaluate the transaction from a financial point of view;
- Advise the fiduciary during negotiations and structuring of the transaction; and,
- Render the necessary opinions of fair market value and fairness from a financial point of view and provide suitable documentation for each.
Documentation of the opinions is particularly important because some of them are required by law. The relevant factors in reaching the conclusion of value and fairness should be carefully articulated and supported.
What are the Qualifications of the Financial Advisor?
The qualifications of the financial advisor are very important. Specific factors to consider include:
- General business valuation experience and credentials;
- Familiarity with the type of transaction;
- Knowledge of ERISA and other applicable regulations;
- Adequacy of resources to complete the assignment; and,
- Reputation for fairness, integrity and independence.
The financial advisor should be familiar with a wide range of valuation techniques, including those considered most accepted and utilized in the industry. Knowledge of the financial markets and accepted valuation techniques is also very important. “Rules of thumb” and other more generalized methods of valuation are likely to prove less useful in a complex ESOP transaction.
Fair Market Value and the General Concept of “Fairness”
The determination of fair market value of the stock is a crucial question because it is required; yet it is sometimes the easiest portion of the assignment. Fairness can be a much more difficult concept, particularly when a leveraged transaction is involved. It is vitally important that the ESOP and its participants be treated equitably in relationship to other shareholders. The test of financial fairness can be divided into two broad categories: (1) valuation and (2) allocation of equity among the owners.
The issue of valuation arises from ERISA’s mandate that the ESOP cannot pay more than adequate consideration for the securities it acquires or sell securities for less than adequate consideration. It can however, pay less and sell for more. As part of the test of adequate consideration, the financial advisor must determine the fair market value of the securities. It is incumbent upon the appraiser to look at valuation from the perspective of the interest being sold (or bought) as well as the structure of the transaction.
The fairness of the transaction from a financial point of view requires an analysis of fair market value in the context of the transaction, as well as the overall treatment of the ESOP in relationship to other participants in a deal. Major questions often relate to allocating equity when shares are purchased in a multi-investor buyout, or to allocating the sales proceeds when the consideration paid includes cash, stock, notes receivable, contingent deferred payments, and non-compete or employment agreements.
The allocation of equity can be a very complex process in a multi-investor leveraged ESOP. Transactions involving cash equity at the time of the purchase by the ESOP are much more straightforward because all of the parties are purchasing their securities with the same “currency.” The use of debt instruments adds substantial complexity because equity interests must be allocated appropriately.
The various methods of equity allocation have not been fully agreed to in the financial, regulatory, and legal communities; therefore the reader should be aware of possible philosophical differences that can lead to radically different conclusions.
Fairness Opinions and ESOP Transactions
The issue of the fairness of a transaction to all of the parties involved is often addressed by obtaining a fairness opinion from the financial advisor to the transaction. While a fairness opinion is not required in every transaction, there are certain situations in which ESOP fiduciaries and participants would benefit from an independent opinion of the transaction. The fairness opinion, which is a document that states whether or not a proposed transaction is fair from a financial viewpoint, provides a safe harbor to the ESOP fiduciary from charges of uninformed decision-making, violations of the business judgment rule, and conflicts of interest. It also, more importantly, protects the rights of the participants and enables the fiduciary to negotiate the best possible deal for the ESOP. Its purpose is to provide an objective standard against which directors, shareholders, fiduciaries, and other interested parties may measure proposals and opportunities presented to the company. 1 The facts of a particular proposal may lead the parties involved to believe that an analysis of other alternatives should be considered. Circumstances in which it would be prudent to obtain a fairness opinion include:
- An offer in which competing bids that differ in structure, pricing and/or terms is received, which would require an interpretation and clarification of the effective price, considering all factors.
- Transactions between the ESOP and a party in interest (i.e., a prohibited transaction); particularly when the seller remains in the role of a significant owner or manager.
- An offer is unexpected and unsolicited or hostile. This differs from the questions that would arise in a situation where an offer has been solicited and several competing bids have been received.
- There is a lack of agreement among the directors as to whether an offer is adequate.
- Judgment is needed about the treatment of ESOP-related debt and an equitable employee benefit going forward.
- There are various levels of shareholder sophistication, and it must be demonstrated that efforts were expended to assure fairness to all parties involved.
- An offer is complex, or differing offers have been made to differing classes of shareholders.
- The company has experienced a recent history of poor financial performance.
The scope of a fairness opinion analysis is broad and extends beyond the rigid or “canned” analysis of a computer-generated financial model. The financial advisor is retained to assist the fiduciary in determining whether an offer is made to the shareholders at a fair price — a determination that requires an examination of the present and future prospects for the company; the existence of other alternatives; the ability to obtain financing to complete the transaction; and the overall effect of a proposal on employees, customers, suppliers, creditors, and the community in the case of small, closely held companies.
The fairness opinion document is generally a short document, typically a letter, but may vary in length and detail and is dependent on the complexity of the transaction, the financial advisor, and the needs of the fiduciary. Generally the document is a letter addressed to the fiduciary that outlines the major considerations of the opinion, describes the due diligence process including all of the documents reviewed, and offers the advisor’s opinion of the fairness of the transaction from a financial viewpoint. While the document itself may be short, the supporting documentation is substantial, and reflects the degree to which the proposed transaction was analyzed.
Evaluating the financial aspects of a tender offer or the acquisition of shares by an ESOP is a challenging and complex task. The expert retained to render a fairness opinion must be aware of IRS and DOL regulations, ERISA provisions, specific plan provisions, accepted investment analysis practices, the specific facts and circumstances surrounding the transaction, and furthermore must sometimes be willing to protect the interest of the ESOP participants through active negotiating of terms and pricing.
Observations From Experience
The authors’ experience as financial advisors to ESOP fiduciaries has led to a number of practical observations. Following are useful considerations for a fiduciary when the ESOP is the purchasing entity.
- Properly allocating equity in a multi-investor deal can be difficult, particularly if the non-ESOP participants (i.e., management) have preconceived notions or objectives about the amount of equity they should receive outside the ESOP. The trustee will receive assistance in protecting the interests of the plan participants by using an independent advisor.
- The calculations needed to conduct an equity allocation analysis in a multi-investor buyout are performed in financial models that are not intuitively obvious. The concepts are complex and the assumptions require substantial documentary support. Experience is an important factor in determining the appropriateness and reasonableness of the conclusions.
- The presence of arms’ length negotiations is a question of fact. Quite often the selling shareholder remains with the company, typically as a senior manager, in a continuing ownership position. This person may also be a fiduciary of the ESOP, which further complicates matters. If these conditions are present, it is incumbent on the financial advisor to document carefully the determination of fair market value.
- The financial advisor and the fiduciaries must also consider the issue of prudence of the investment. Is it a good idea to make this investment in a retirement plan?
Following are comments from the perspective of representing the ESOP in a sale situation.
- The history of prior appraisals must be considered. What does one do if the non-marketable minority interests appraisals of previous years show a greater fair market value than the sales price of the entire company without any intervening explanatory event? It may be impossible to reconcile the market reality of the sale of the business with an earlier valuation that existed when shares were sold to the ESOP.
- The proceeds of the sale must be allocated fairly to all the selling shareholders. The ESOP cannot be treated less favorably than other shareholders. This can be complicated by the issue of expenses and the presence of stock, notes, or outside agreements as consideration for the sale.
- The prudence of the sale should also be considered. Is the timing of the sale correct? For example, would it be better to wait until improving trends in operations reflect better financial performance and presumably greater value?
- From time to time, the legal counsel for the company will also be legal counsel for the ESOP. At such times, the financial advisor is operating without independent counsel representing the ESOP, which requires that the advisor be cognizant of what role the attorney is playing and who the attorney is representing.
- The adequacy of the consideration paid is crucial. If the financial advisor is brought into the transaction after a preliminary deal is struck, then it will be very awkward when the necessary adjustments in price are proposed. This circumstance presents the greatest single reason for bringing the financial advisor into the transaction as early as possible.
- Non-compete and employment agreements are frequently necessary to facilitate the sale of a closely held business. The allocation of the real purchase price must be fair to the ESOP participants.
Regulatory, legal and business trends are all moving toward increased responsibilities for ESOP fiduciaries. Fiduciaries must demand quality work from ESOP financial advisors and be in a position to recognize pitfalls before they occur. At the same time, it is important for the fiduciaries to recognize that financial advice can be of great benefit in starting transactions and providing comfort as they perform their fiduciary responsibilities.
Reprinted from Mercer Capital’s ESOPval.com – Spring/Summer, 1996. It also appeared in the Summer, 1996 (Volume 8, No. 2) issue of the NCEO’s Journal of Employee Ownership Law and Finance.