Recently, the United States Department of Labor (DOL) has been extremely aggressive in challenging transactions involving Employee Stock Ownership Plans (ESOPs). There are numerous current DOL investigations of ESOP transactions, and valuation takes center stage upon DOL scrutiny. These elevated trends are expected to remain for some time in the future. In reference to scrutiny of ESOP transactions, Timothy Hauser, the late Deputy Assistant Secretary for Program Operations of the Employee Benefits Security Administration (EBSA) at the DOL, stated that, “valuation is the first, second, third, and fourth problem.” Further, Phyllis Borzi, former Assistant Secretary for the Employee Benefits Security Administration (EBSA) at the DOL was quoted, “valuation issues continue to be very problematic.”
When ranking valuation issues in recent ESOP litigation, the most frequently challenged item is management’s forecasts. Management’s forecasts are a key aspect to determining a company’s value – after all, value is driven by the expected future cash flows of a business. Explained simply, value is a two-part equation – the future expected cash flows (the numerator) and the risk associated with achieving those cash flows (the denominator). Management’s forecasts are used to develop the future cash flow, and the aggressive/conservative nature of the forecasts are assessed in determining the risk rate. Therefore, management’s forecasts have a direct and material impact on the company’s value in multiple ways.
In all valuation engagements, not just in the realm of ESOPs, management is typically responsible for preparing forecasts. Business valuators are not preparing forecasts and then opining on the value derived from those forecasts. Accordingly, management must independently prepare the forecasts, and in doing so, must support the underlying assumptions and data used to develop said forecasts.
The forecasts should be prepared by the management team that will be responsible for achieving the forecasts. Input from all departments, divisions, etc. should be considered to ensure the business, in totality, is appropriately considered. While management may look to outside advisors to review the forecasts for reasonableness and to assist management substantiate the key assumptions therein, ultimately, the forecasts belong to management, and must represent management’s best estimate of future performance.
Although it is recognized that it is impossible to predict the future, management’s forecasts should reflect a “most likely” (not to be confused with a “best case”) view of the future. The forecasts should not deviate significantly from past performance or industry trends, unless there is compelling evidence to support the deviation. Moreover, management must be cautious of industry trends, or cyclicality, which when missed, could inappropriately impact value. Further, management should take care to avoid bias caused by the performance in the most recent year. For example, if the company just came out of the best/worst year ever, and management uses that year as a base for the forecasts, the forecasts could be inappropriately skewed. Accordingly, the forecasts should consider overall historical trends in an attempt to capture a full business cycle. Finally, forecasts must include consideration of sufficient investment in personnel, capex, working capital, etc. to accommodate the forecasted growth in revenue.
While the forecasts belong to management, the ESOP valuator is responsible for thoroughly vetting management’s forecasts for reasonableness. During this review, the valuator should (1) develop a comprehensive understanding of the forecasts and their underlying drivers (2) question management on the underlying assumptions, and (3) scrutinize the reasonableness of the forecasts based on what is known or knowable as of the date of valuation. In doing this, the valuator must compare the forecasts with past performance, industry trends, and the economic outlook, and assess the overall level of conservatism and aggressiveness considered in the forecasts. This assessment not only will help confirm the reasonableness of the forecasts used to develop the cash flows (in the numerator of the valuation equation), but it will also help the valuator to develop the appropriate level of risk in the discount rate (the denominator of the valuation equation).
Similar to the valuator, the ESOP Trustee is also responsible for reviewing, questioning, understanding, and scrutinizing management’s forecasts and the underlying assumptions. The Trustee, in his or her role as a fiduciary, must develop a thorough understanding of the valuator’s analysis of the forecasts, because ultimately, the Trustee will approve (or challenge) the value conclusion based on the forecasts and the valuators assessment.
While forecasts are not the only aspect of an ESOP valuation that the DOL has been challenging, they are the most predominant. As a result, it is in the best interest of not only the participants of the ESOP, but all parties involved in the transaction, to ensure that management used due care in preparing the forecasts; the valuator completed a thorough review, challenge, and assessment of the forecasts; and the ESOP Trustee fully understands and challenges the forecasts and the valuator’s assessment thereof. Furthermore, documentation of the above noted steps should be maintained by all parties, should the DOL elect to challenge the transaction.
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