ESOP%20Issues%2011-14%20v7

New and Notable ESOP Valuation
Issues
Paul D. Trost
GreatBanc Trust Company (Moderator)
Steve Whittington, CFA
Willamette Management Associates
Christopher Horner
Dickinson Wright PLLC
The ESOP Association’s Las Vegas Conference & Trade Show
November 13-14, 2014

2
Introduction
Paul D. Trost
• Paul is with GreatBanc Trust Company, joining in 2014 from North Star Trust Company,
where he was in the ESOP services group since 2004. He was previously employed by
Duff & Phelps, LLC, where he focused on corporate valuation matters, ESOPs, ERISA,
fairness opinions and related corporate finance transactions. He is an active member of
the NCEO and the ESOP Association as a member of the valuation advisory committee.
Christopher Horner
• Chris is an attorney with the Washington, D.C. office of Dickinson Wright PLLC. His
practice focuses on leveraged ESOP transactions, including the design and
implementation of such transactions. In addition, Chris regularly counsels shareholders,
directors and executives of closely held businesses to craft successful liquidity and
business succession strategies.
Steve Whittington, CFA
• Steve has significant experience in many areas of business valuation, concentrating
particularly on ESOP and other corporate transactions. Steve specializes in the following
ESOP-related services: feasibility studies, post-transaction cash flow analysis,
transaction financing, fairness and solvency opinions, annual employer stock
valuations, and general consulting.

3
Presentation Overview
1. Background of the Department of Labor’s increased scrutiny of ESOP
transactions
2. Valuation topics covered in recent judicial opinions
3. The GreatBanc Settlement Agreement
4. Questions?

Section 1
The Department of Labor’s increased scrutiny of ESOP transactions

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Valuation and ESOP Litigation
Litigiable Issue Number of Occurences
Standing 32
Fiduciary Status 31
Management of Plan Assets (Non-Stock Drop) 27
Distributions 24
Management of Plan Assets (Stock Drop) 24
Valuation 22
*Source: Employee Ownership Report (May – June 2014) / Volume XXXIV, No. 3. Survey measured court litigation from
1990 through 2012.

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United States Department of Labor (DOL)
• Valuations have been “an area of chronic problems” that the Employee
Benefits Security Administration has aggressively pursued in the
previous year….DOL is pursuing a “big number” of cases for 2014. The
Focus needs to be on assessing the reasonableness of management
projections of future earnings. Deputy Assistant Secretary Tim Hauser.
• “[V]aluation issues continue to be very problematic.” Assistant
Secretary Phyllis Borzi.

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Recent Judicial Decisions
• Duty of Prudence Not Implicated by Improper Financial Reporting
• Qualified Independent Appraiser Not an ERISA Fiduciary
• Lack of Qualifications and Independence of Appraiser Contributes to
Disqualification of ESOP

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Malcolm v. Trilithic, Inc., 57 EBC 2862 (S.D. Ind. 2014)
• Duty of Prudence Not Implicated by Improper Financial Reporting
– Plaintiff alleged that the board of directors, officers and members of ESOP’s
administrative committee colluded or were complacent in the fraudulent
recording of a $175,000 fictitious sale of inventory to bolster accounts receivable
to inflate profitability reported to the company’s lender.
– Plaintiff further alleged that certain defendants breached their fiduciary duties by
falsifying financial reports which caused a material understatement of the equity
value of the employer securities to the detriment of participants and their
beneficiaries, and other defendants participated in the breach or failed to remedy
the breach after receiving notice.
– Held: The defendants did not breach their fiduciary duty by failing to investigate
purported false sale. The plaintiff presented insufficient evidence that purported
false sale had an effect on value of employer securities or raised red flags about
prudence of investment in employer securities that would trigger duty to
investigate by fiduciaries.

9
Perez v. Oden and Thielking (N.D. Fla. Dec 13, 2013)
Qualified Independent Appraiser not an ERISA Fiduciary
• Former shareholder used corporate assets to cover personal expenses and
these transactions were recorded as an asset on the balance sheet (i.e.
advances to officer). The aggregated transactions represented the most
significant asset of the sponsor company.
• Initially, the DOL alleged that appraiser used a book value approach to value
employer securities, which inflated the equity value of the sponsor company
and caused the ESOP to pay in excess of fair market value of the employer
securities it purchased from terminating participants.
• Subsequently, the DOL conceded that the appraiser was not an ERISA
fiduciary, but asserted that the appraiser knowingly participated in the fiduciary
breaches by the former shareholder and trustee because it assisted them in
concealing the misappropriation of the corporate assets.

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Perez v. Oden and Thielking (N.D. Fla. Dec 13, 2013)
Qualified Independent Appraiser not an ERISA Fiduciary
• Held: ERISA § 502(a)(5), which authorizes DOL to bring a civil action “(A) to enjoin
any act or practice which violates any provision of [ERISA], or (B) to obtain other
appropriate equitable relief (i) to redress such violation or (ii) to enforce any provision
of [ERISA],” does not authorize a suit against a non-ERISA fiduciary for appropriate
equitable relief on grounds of a non-fiduciary’s ‘knowing participation’ in a breach of
fiduciary duty ...in the absence of a prohibited transaction.
• The District Court dismissed all claims against the Valuation Firm and held that the
DOL failed to state a claim upon which relief can be granted under ERISA because (1)
there had been no prohibited transaction by the Valuation Firm, (2) there was no “act
or practice” by the Valuation Firm that violated ERISA, and (3) the remedy sought
(disgorgement of professional fees and an injunction to prohibit all future valuation
work for ERISA covered plans) would not be “appropriate equitable relief” under
ERISA Section 502(a)(5).

11
K.H. Company, LLC Employee Stock Ownership Plan v. Commissioner
Appraiser Neither Qualified Nor Independent for Purposes of 401(a)(28)(C)
• United States Tax Court considered whether IRS abused its discretion
in determining purported ESOP was not qualified under section 401(a)
and trust was not exempt under section 501(a). This question hinged
on, inter alia, whether a qualified independent appraiser performed the
appraisal.
• Section 401(a)(28)(C) requires that a qualified independent appraiser
must perform all valuations of securities that are not readily tradable on
an established securities market and that the standards for appraisers
are similar to those set forth in the regulations promulgated under
section 170(a)(1).

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• Treas. Reg. § 1.170A-13(c)(5)(i)(A) provides that a qualified appraiser is
an individual who includes on the appraisal summary a declaration that
he or she holds himself or herself out to the public as an appraiser or
performs appraisals regularly.
– Subject appraiser failed to duly execute statement that the “undersigned holds
himself out to be an appraiser,” thus the ESOP failed to meet this requirement.

13
• Treas. Reg. § 1.170A-13(c)(3)(ii)(F) provides that the qualified appraiser
who signs the appraisal must list his or her background, experience,
education, and membership, if any, in professional appraisal
associations.
• Furthermore, Treas. Reg. 1.170A-13(c)(5)(i)(B) provides that a qualified
appraiser is an individual who includes on the appraisal summary a
declaration that he or she is qualified to make appraisals because of his
or her background, experience, education, and membership, if any, in
professional appraisal associations.
– Subject appraiser failed to execute the appraisal report and neither the appraisals
nor the appraisal summaries list the information referenced in the Treasury
Regulations, thus the ESOP also failed to meet these requirements.

Section 2
Valuation Topics Spotlighted in DOL investigations and judicial opinions

15
Control Premiums
Perez v First Bankers/Rembar ESOP
• A control premium can be considered in a situation where an ESOP
buys a majority stake of the common stock of the subject company
– The DOL takes the position that an ESOP trustee may pay a control premium for
employer securities only to the extent that an unrelated third party would pay a
control premium [Prop. DOL Reg. §2510.3-18, Preamble §B5]
• Is control in both form and substance passed to the ESOP?
– The ESOP is a “captive shareholder”, does it ever have operational control?
• Must assume the ESOP’s control will not be dissipated within a short
period of time after purchase.
– Multi-stage transactions? Does the ESOP pay a control premium multiple times?
– Creeping control (minority to a majority interest)

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Control Premiums (continued)
Perez v First Bankers/Rembar ESOP
• The majority shareholder sold his interest in Rembar (87 percent)
based on a valuation that included a 25 percent control premium.
• The DOL alleges that a prohibited transaction (ERISA Section
406(a)(1)) took place because the ESOP overpaid for the company
stock.
• The issue wasn’t why a control premium was contemplated but what
the control premium represented:
– Subordinated note to the shareholder had covenants that gave that shareholder
control of the board of directors of the company
– The note would not be repaid for 10 years
– The shareholder would “control” the company for 10 years despite the fact that
the ESOP paid for “control”

17
Seller Financing
Perez v PBI Bank/Miller’s Health Systems ESOP
• In an ESOP transaction, a valuation advisor is often asked to opine on
the fairness of several elements of the transaction besides the
purchase price itself
– If an ESOP transaction uses leverage, a valuation advisor will look at the
reasonableness of the interest rates associated with the leverage
– This leverage can include subordinated seller notes
• ERISA §408(b)(3)(B) states that a loan to an ESOP is exempt from
§406 if “…such a loan is at an interest rate which is not in excess of a
reasonable rate.”
• Therefore, a transaction’s structure would be deemed “fair to the
ESOP” if the leverage was at this so called “reasonable rate”

18
Seller Financing (continued)
Company Bank
ShareholdersESOP
Company obtained $40M bridge loan from
bank at 8.25%
Repay $40M bridge Loan
$40M Loan to
ESOP
(“Inside Loan”)
at 5%
ESOP pays $40M cash for 100% of company
stock

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Seller Financing (continued)
• In the formation of the Miller’s Health ESOP, a series of transactions
occurs, at the end of which the purchase of $40 million in company
stock is leveraged with a “seller note” at an interest rate of 12 percent.
• The complaint alleges that “the selling shareholders’ indirect loan to the
ESOP at 12% was far in excess of a reasonable rate of interest.”
• The DOL judges the interest rate excessive in comparison to the other
interest rates of loans used in the series of transactions.
– The loan from Miller’s Health to the ESOP had a rate of 5.09 percent.
– The loan from the bank to Miller’s Health was 250 bps plus LIBOR = 8.25
percent.

Section 3
The GreatBanc Trust Settlement Agreement

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The GreatBanc Trust Settlement Agreement
• The settlement focuses on the process fiduciaries should follow in the
context of ESOP transactions.
• The settlement outlines guidelines The Department of Labor expects all
fiduciaries to follow and understand when an ESOP purchases or sells
shares.
• These policies and procedures set the framework for fiduciary conduct
in transactions that involve non-publicly traded stock.
• Is a fiduciary required to follow these guidelines?

22
Selecting a Valuation Advisor
Independence is imperative
• Precludes having performed work on behalf of:
– Plan Sponsor;
– Seller/counter-party
• Not have a familial or corporate relationship with any of the above.
– Fiduciary should collect the information and consider the independence of an
advisor.

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• Feasibility Study-Generally speaking, a feasibility study is a 1)
preliminary value range of the company stock and 2) a cash flow
scenario analysis to determine if the company can accommodate a
levered transaction
• Section B of the Settlement Agreement Attachment
– The Trustee will not use a valuation advisor for a transaction that has previously
performed work-including but not limited to a “preliminary valuation”-for or on
behalf of the ESOP sponsor
• Generally speaking, this provision in the Agreement attempts to remove
a potential conflict of interest for a valuation professional who may do
work for the sellers first, and the ESOP trustee second.

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Qualifications
1. Consider other advisors as appropriate
2. Ask for background/qualifications
3. Review the qualifications
4. Document the inquiry
5. Investigate any civil or criminal actions involving the advisor
6. Check references
Again, the fiduciary should collect the information and consider the qualifications of an
advisor.

25
Information Used in Financial Analysis
Fiduciary is responsible for determining fair market value for which it
should undertake a prudent investigation (good faith)
Consider all relevant facts and circumstances as part of the due diligence
What information is typically applied when evaluating a company?

26
Information Used in Financial Analysis
The information requested, provided, and used must be reviewed and
understood by the fiduciary
• Projections
– Consider the sources of the financial projections provided
– Test reasonableness
– Understand how valuation advisor integrates these into its analysis

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Projections
• In most ESOP transactions, a valuation advisor will rely primarily on an
income approach, in particular the discounted cash flow (DCF) method
– Projections represent the “best thinking” by company management
– DCF method makes the most sense from a “going concern” standpoint (i.e.,
value in continued use)
• Projections are a vital part of the valuation process
– Company “controls” projections
– Valuation advisor “controls” the discount rate
• How does the fiduciary take all of this into account?

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Projections (continued)
Perez v GreatBanc Trust (Sierra Aluminum)
Fiscal Years Ending on or Near December 31, Terminal
2014 2015 2016 2017 Year
$000 $000 $000 $000 $000
Present Value of Discrete Net Cash Flow
Projected EBITDA 8,149 9,660 10,110 10,110 10,110
Less: Depreciation and Amortization Expense (2,253) (2,400) (2,550) (2,550) (2,500)
Equals: Projected EBIT 5,896 7,260 7,560 7,560 7,610
Less: Provision for Income Taxes (2,064) (2,541) (2,646) (2,646) (2,664)
Equals: Debt-Free Net Income 3,832 4,719 4,914 4,914 4,947
Plus: Depreciation and Amortization Expense 2,253 2,400 2,550 2,550 2,500
Less: Capital Expenditures (7,500) (2,500) (2,500) (2,500) (2,500)
Less: Net Operating Working Capital Additions (480) (463) (75) (25) (50)
Equals: Net Cash Flow to Invested Capital (1,894) 4,156 4,889 4,939 4,897
Multiplied by: Partial Period Adjustment 1.0000 1.0000 1.0000 1.0000 1.0000
Equals: Adjusted Net Cash Flow to Invested Capital (1,894) 4,156 4,889 4,939 4,897
Multiplied by: Present Value Factor 0.9578 0.8787 0.8062 0.7396
Equals: Present Value of Discrete Net Cash Flow (1,814) 3,652 3,941 3,653
Equals: Total Present Value of Discrete Net Cash Flow 9,432
Present Value of Terminal Net Cash Flow
Terminal Year Net Cash Flow 4,897
Multiplied by: Anticipated Long-Term Growth Rate 3%
Equals: Anticipated Terminal Year Net Cash Flow 5,043
Multiplied by: Direct Capitalization Multiple 16.7
Equals: Terminal Year Value 84,057
Multiplied by: Present Value Factor 0.7396
Equals: Present Value of Terminal Year Net Cash Flow 62,170
Value Summary
Total Present Value of Discrete Net Cash Flow 9,432
Plus: Present Value of Terminal Net Cash Flow 62,170
71,600$
Equals: Indicated Market Value of Invested Capital
on a Marketable, Controlling Interest Basis
[Rounded]

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• The DOL is concerned that projections provided by company
management may be overstated.
– Projections are provided by company management; if the seller is part of
management—potential conflict
• The Agreement requires the trustee (may be with the help of the
valuation advisor) to identify in writing the individuals responsible for
providing the projections
– Direct conflicts of interest
– “Agents” of someone who may have a conflict of interest
– How did the Trustee consider these conflicts

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• The Agreement states that any analysis of the projections should
consider how they reconcile to the company’s historical five-year
averages.
• Metrics listed in the Agreement include:
1. Return on assets
2. Return on equity
3. EBIT margins
4. EBITDA margins
5. Ratio of capital expenditures to sales
6. Revenue growth rate
7. Ratio of free cash flows to sales

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• Document, document, document
– If the company is projected to meet or exceed its historical performance (or the
historical performance of the group of comparable companies)
– Any adjustments made to the projections by management or by the valuation
advisor or by the trustee
– If any adjustments are made, why they are reasonable
• PROCESS, PROCEDURE, AND DOCUMENTATION MATTER

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Review of Financial Analysis
How is the information used and how is the valuation performed?
• Methods
• Significant assumptions
• Financing part of the transaction?
• Ability to repay debt and address other obligations
• Specific metrics
• Overall impact of the transaction on the company
• Fairness—financial perspective and relative to other parties
Most importantly, the Trustee will determine the prudence of accepting and
relying on the valuation analysis.

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Other Information Used in Financial Analysis
The information requested, provided, and used must be reviewed and
understood by the fiduciary
• Financial Statements
– Are financial statements audited?
– How much scrutiny is appropriate? Reliability?
– Does the fiduciary need to conduct its own audit?
• Comparable Publicly-Traded Companies Information
– What is comparable and why?
– Historical and projected comparability

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Other Notable Matters
• Fair Market Value of Debt
• Claw-Back
– Consideration of any arrangement to protect ESOP against possible adverse
consequences
• Other Professionals
– May delegate fiduciary authority to another qualified professional to aid the ESOP
trustee in exercise of duties if prudent

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Disclaimer
• The Presenters gather their data from sources they consider reliable; however, they do not
guarantee the accuracy or completeness of the information provided within this presentation.
The material presented reflects information known to the Presenters at the time this
presentation was written, and this information is subject to change. The Presenters make no
representations or warranties, expressed or implied, regarding the accuracy of this material.
The views expressed in this material accurately reflect the personal views of the authors and do
not necessarily coincide with those of their employers.
• The Presenters do not provide accounting, tax or legal advice. The information and material
presented herein is provided for informational purposes only and is not intended to constitute
accounting, tax or legal advice or to substitute for obtaining accounting, tax or legal advice from
an attorney or licensed CPA.

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