One exit strategy for a business owner is to sell your company to an ESOP; especially if there are no serious buyers. However, those transactions are highly regulated by the federal government and must be done right.
Here, the owners, husband and wife, founded their business in 1980. Their company designs and sells equipment such as conveyors and bottling machines for soft drink manufacturers. To retain workers, the company offered generous benefits, including an ESOP and payment of 100 percent of employees’ health care premiums. Over the decades, their company attracted major corporations as customers, including Coca-Cola, Dr. Pepper, and Snapple.
The owners owned a majority of the company stock and served as the executive officers of the company (the husband serving as CEO and the wife as CFO). They were also two of the three members of the board of directors and were two of the three ESOP co-trustees; with the 3rd board member and ESOP co-trustee being a company insider. The husband was the chairman of the board of directors.
There had been some interest from buyers, but no offers were made by November 2010 when the owners decided to sell their majority equity interest in the company to the ESOP. A bank was hired to serve as the ESOP’s transactional trustee. When contacted, the company’s ESOP lawyer told the bank that the estimated purchase price was $21 million.
The transaction closed about 6 weeks later, after the valuation was completed, at a purchase price about $20.7 million. The purchase price was financed by cash of $1.9 million (through a company loan to the ESOP; cash of $8.5 million (from ESOP’s cash reserves); and an ESOP note for $10.3 million.
The bank resigned as ESOP trustee after the closing. Thereafter the husband and wife served on the three person board of directors which was elected by the 3 co-trustees of the ESOP, two of which were the husband and wife. Thus, after the closing the husband and wife controlled the ESOP, the 100% shareholder, that elected the 3 person board of directors; which hired and fired the officers of the company. This control could only change by the voluntary resignation or death of the husband and wife.
In 2014, amid a downturn in the soda industry, the husband (the wife having passed away in 2011) forgave $4.6 million of the note, and the interest rates associated with the note was reduced to 3 percent. Nevertheless, the United States Department of Labor sued the bank and the husband in a Virginia federal district court, accusing them of facilitating a deal with a purchase price in excess of its fair value.
The court concluded that the ESOP overpaid the owners $6.5 million for their stock and held the bank and the owner jointly liable to repay this amount. The court held that the bank was not prudent in its goal to ensure that the ESOP paid “no more than adequate consideration” for the owners’ stock.
The purchase price of just under $21 million translated to a $406 per share. This contrasted with the previous ESOP valuations that ranged from $215 per share in 2005 to $285 per share in 2009.
The valuation consultant for the deal had also performed the earlier valuations. He used a capitalization of cash flow methodology. His said that the much higher $406 per share valuation was primarily due to a premium for purchase from the owners of control of the company and an add back of ½ of the company’s health care expenses in calculating the capitalized cash flow under the assumption that post closing management would bring health care expenses in line to market by reducing company’s employee health care cost obligation by 50%.
The court found these assumptions flawed because the owners were not giving up control since they controlled the 100% shareholder, the ESOP, serving as 2 of the 3 ESOP co-trustees; which in turn selected the board of directors, which in turn hired and fired the company’s officers.
The court concluded that the bank and the owners should have also known that the valuation was flawed for these reasons, resulting in a significantly overvalued stock price.
The court also found that the bank should have insisted upon projections, since it was aware that the incoming president was apprehensive about the company’s future. In addition, the court said that the bank did not push the valuation consultant to use the discounted cash flow method, finding that it “is, on the margins, a more commonly used and reliable method for evaluating the fair market value of closely-held stock.”
Overall, the court found that the bank did a poor job in its due diligence. The court felt that the bank rushed its process to accommodate the owner’s desire for a year end closing. Also, the court felt that the bank should have only looked out for the interests of the ESOP when in fact the bank’s employees testified that they wanted to be fair to both the ESOP and the owners.
This case is referred to as Pizzella v. Vinoskey, Case No. 6:16-cv-00062, United States District Court, W.D. Virginia, Lynchburg Division (August 2, 2019)
The takeaway: using an independent trustee for an ESOP transaction does not ensure that the owner will not have liability for a purchase price that is too high. The owner can manage the risk of a flawed valuation by using ESOP professionals that are experienced and highly regarded and insisting that the ESOP trustee, valuation consultant and ESOP lawyer take enough time to conduct a thorough due diligence process.
But even that may not be enough. If a valuation is much higher than earlier valuations the owner should be satisfied that the higher price is justified by facts and reasonable assumptions.
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