Valuation How will the stock's value be determined? Everyone involved in an employee stock program, from founding owners to participating employees, wants to know what the company's stock is worth and how the value is determined. For public companies, the answer is straightforward: the stock price is established through the public stock market and its value is published every day in the news media. For privately held companies, however, no such yardstick exists.
If a private company is establishing an ESOP or other ERISA-regulated plan, the rules in this area are also straightforward: ultimate responsibility for determining the fair market value of the stock lies with the plan's fiduciaries. However, but to meet this responsibility, they are required to obtain the opinion of a well-qualified, independent valuation firm.
For non-ERISA plans (individual-based plans such as stock grants and options), the company's board of directors has the responsibility to determine in good faith the fair market value of their company's stock. The term "good faith" means that the board of directors must honestly and reasonably believe that the value they assign to the stock is a good approximation of its actual fair market value. Generally, it is the Internal Revenue Service (or, in the case of litigation, a court) that will determine whether a board of directors has met this good faith standard.
The "gold standard" for determining fair market value is to retain the services of a professional valuation firm. However, a company can also meet IRS standards for a good faith determination of fair market value by applying a formula (which may be developed in consultation with a professional appraiser or may be developed by the company's in-house financial staff) that is designed to produce a reasonable estimate of value.
Whether a company determines the fair market value of its stock on its own or retains the services of a professional appraiser, its board should be familiar with the commonly used approaches to the task. These include capitalization of earnings, discounted cash flow, comparable sales, industry rules-of-thumb, and asset valuation.
In order to retain latitude and flexibility, an equity-sharing plan should not specify the exact approach that will be used to determine the fair market value of the company's stock. Instead, the plan (again, assuming that it is a non-ERISA plan) should simply state that the company's board of directors will determine the stock's fair market value. The board can then adopt an internal policy on how it will determine the company's share price, which it will be able to change if warranted without having to formally amend the plan documents. As part of the company's employee communications efforts, it should be clarified for the employees exactly how the company's share price will be determined.
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