2020 was a year like no other, and ESOP companies were forced to reckon with this truth well before the full effects of the economic crisis were known. When valuing their stock shares at 12/31, they had to ask themselves a few important questions, including: How does our 2020 performance affect our valuation? How should our valuation methodologies change? and How will we know if our 12/31/2020 valuation is accurate?
How 2020 Performance Affects Valuations
When the economy tanked in 2020, the performances of many businesses – even historically successful ones – took a hit. ESOP companies worried that this setback necessitated a lower valuation. Fortunately, business valuations have a forward-looking perspective, meaning that a single-year blip in performance is unlikely to have a major impact on a business’s valuation.
Though this knowledge is comforting, ESOP companies still had a problem to contend with. They needed help adjusting their valuation methodologies. If 2020 is not representative of future performance, what metrics are important when valuing company stock?
Consideration of Valuation Methodologies
Valuation methodologies that your leadership team has relied upon for years may not be the best methodologies to use in 2021. Placing too strong of an emphasis on 2020 performance will – most likely – result in an inaccurate valuation, but ignoring it altogether won’t be accurate, either. When valuing your ESOP, there are a few things you should think about.
Formulaic approaches can lead to distortion.
Using formulas to value your entity might be simple, but when formulas rely on extraordinary data, the resulting projections will be distorted. Depending on how quickly your company can bounce back from the economic downturn, forecasts that use 2020 numbers may need to discount – or perhaps ignore altogether – drops in performance that are attributable to COVID-19.
2020 numbers may still be relevant.
Depending on your business model, how well you were able to adapt, and how quickly your industry recovered from the initial economic strains of the coronavirus outbreak, 2020 numbers may still be relevant to your valuation. You can adjust actual performance numbers with independent industry research that predicts if your industry will return to normal operations in 2021. By removing activity that is unlikely to be repeated in future years and replacing those numbers with well-vetted estimates for future performance, your valuation will be that much more accurate.
Know how PPP loans affect your valuation.
Although PPP loans are temporary, they should not be ignored. If your loans will ultimately be repaid, you should treat them as debt and subtract those amounts from value as you would any other loan. But if PPP loans will be forgiven, they should not reduce your valuation. Any remaining proceeds should increase your ESOP stock value to reflect the boost to your cash reserves. Talking to your accountant about your PPP loans can be helpful, because how you treat PPP loans for valuation may differ from how you treat PPP loans on the books for GAAP purposes.
Consider utilizing partial data or budgets.
Assessing your performance each quarter can help you see how your activity was affected by the COVID-19 outbreak. For example, if your first quarter was unaffected by the economic shutdown, you may find it useful to use the first quarter of 2020 as a basis for your forecasts rather than annual activity. You can also look to your budget and plan that you established for 2020 to get an idea what would have occurred if the economy hadn’t been struggling.
Use multiple valuation methodologies.
To get the most accurate estimate of value, use more than one valuation method. Market approaches and Income approaches – like discounted cash flow that relies on predictions of future cash flows – can be especially helpful in ESOP companies, but only if management’s estimates are strong. Use a combination of both to get the most accurate results.
Ask for help from experts.
Your management team should work closely with ESOP valuators and industry experts. Management’s forecasts are important, but help from valuators and industry experts can temper management’s biases, which tend to place a heavier emphasis on what has happened most recently.
Consider using an external trustee to review your valuation.
If you’ve always used an internal trustee to verify your ESOP valuation, consider hiring an external trustee this year. Professional trustees require more documentation from management, request informational presentations by the valuator, and have a committee of experts to help approve the valuation. Your internal trustees may be adequate when business performance has been steady, but they may hold the same biases as management and may not know how to adjust those biases.
Value May Still Be Uncertain
ESOP company valuations are – and will always be – estimates. It’s ok if you still don’t know for certain how your business will bounce back from economic upset. With help from experts, you can get your valuation as accurate as possible, and with any luck, next year you’ll have an even better understanding of where your company stands. If you have questions about your ESOP valuation, contact one of our Meaden & Moore advisors today.