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I’ve been working with a client company on the implementation of an ESOP (Employee Stock Ownership Plan). In an ESOP, a qualified plan, the plan buys the stock of the firm from the owners with vested employees now the owners, en masse. One of my roles was being on the team interviewing the critical (and very expensive) ESOP advisors. There’s a Third-Party Administrator, Attorney for the Company, Trustee, Attorney for the plan, and business appraiser (and I found most appraisers don’t do ESOP valuations).

The trustee is the one (individual or firm) with the most on the line, i.e. risk. It is their job to make sure, among other things, the valuation is fair to both sides. My first question to all of them was, “What are the common traps and how do you and we avoid them?”

In every case the answer was, “the valuation.” I’m going to go through the three issues emphasized as potential problems.

Projections: The real hot-button is projections and their validity. Regular readers of this newsletter, and viewers of my video podcasts, know my feelings about projections in the buy-sell world, I feel they’re useless. Everybody projects a nice steady growth rate with even rosier growth of the bottom line.

The trustee of an ESOP is mandated to make sure the firm and the appraiser provide and use justifiable projections. They look at past projections and compare them to actual growth. If there’s a large variance they will call it out. The biggest issue, that can cause the plan and trustee grief, is a valuation (especially when partially based on projections, which is always done on ESOPs) benefits the sellers over the employees, who are the new owners. This means a value derived from optimistic projections.

This is just like in my world; a buyer shouldn’t overpay because they optimistically bought into wonderful projections. But what about in other aspects of business? Salespeople shown how high their commissions will be when nobody has ever previously achieved those levels is just one example.

Methodologies: The second red-flag topic is the improper use of valuation methodologies. An outsider may ask, how is this possible? It’s because there are a lot of assumptions in business valuations, which makes valuing a business an art as well as a science.

  • In the Discounted Future Cash Flow method profits are projected (same as the first issue) and discounted back to a present value. High or low projections, an inaccurate discount rate, or other things can manipulate the end result.
  • In an occasionally used method called the IRS or Excess Earning method, it’s simple to influence the result, just change standard goodwill ratings scale from 1-6 to 1-10. A well-run company rated a 5 out of six (a 20% ROI) is now an 8.33 (same rating percentage but now a 12% ROI).
  • Using comparable sales of much larger firms will distort the value. Imagine a home appraiser comparing a 3,000-square foot house on a cul de sac with 10,000-square foot homes on the water.

Price-Earnings Ratios: A big issue raised by the trustees was the improper use of price-earnings ratios (aka the multiple of earnings), specifically using publicly traded company ratios when valuing small to mid-sized (and even middle-market) firms.

As I write this, according to the Wall Street Journal, the current PE ratio for the S&P 500 is 25.89. For a recent assignment, I researched this subject for private businesses and the PE ratio for middle-market companies is just under 7X (as per GF Data, provided by my friend John O’Dore with One Accord Capital) and just under 4X for small businesses, $1-15 million in sales (as per PeerComps, a database I subscribe to, which is SBA business acquisition loans). For reference, a check of major bank PE ratios shows they are at about 15). Use 15X instead of 4-7X and not only do you inflate the value, you’ve committed fraud.


ESOP trustees have a lot on the line. They have valuation experts on staff to review what the independent appraiser did, because any misrepresentation comes back on them (in the form of a lawsuit).

In my buy-sell world, it is less “regulated” and the above regularly takes place by buyers (trying to deflate the value) and by sellers (hoping to inflate the value). The previous paragraph on PE ratios confirms something I’ve been saying for years, there is a standard range in which businesses sell. For small businesses, it’s 3-5 times profit (after fair market owner compensation). In the PeerComps data (over 9,000 business acquisition loans), the coefficient of variance was just over 25%.

This means the range of the average multiples, which is 4X, was just over one point above and one point below, or about 3-5X. There is a wide range because of the difference, firm to firm, of the non-financial factors including customer concentration, management quality, dependency on the owner, and more. An average of 4X doesn’t mean they all sell at this multiple, some are higher and some lower. But it also doesn’t mean a small business will sell for 7X or a middle-market business will sell for 15X (without very special mitigating factors as there are always rare exceptions).

Going back a few years (more than a few), from the TV show Hill Street Blues, as Sergeant Esterhaus would say, “Hey, let’s be careful out there.”


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