The story is, unfortunately, a common one: Multiple individuals join together to start up or invest in a business. Things go well, and the company prospers, but at some point it becomes necessary to buy out the interest of one of the original owners. Generally, this is due to a shareholder’s death or disability or the voluntary or involuntary termination of a shareholder’s employment.
Despite the existence of a buy-sell agreement, one of the parties now involved with the pending transaction isn’t happy with its terms. In many instances, attorneys are hired, lawsuits are filed, and the fight drags on for years. In such cases, the buy-sell agreement simply did not fulfill its intended purpose.
The primary purpose of a buy-sell agreement (BSA) is to minimize disruptions upon the occurrence of an event that necessitates the purchase of an owner’s interest in a privately held company having multiple owners.
However, significant effort should be expended up-front to ensure that the BSA is more than a boilerplate agreement, as one size does not fit all when it comes to ensuring that the agreement adequately addresses the owners’ objectives and the potential scenarios that could occur with respect to the specific circumstances of the owners and the company.
Furthermore, the document should be periodically re-visited, as circumstances (both with the subject company and the individual owners) are bound to change over time. These efforts ideally would involve the input of management, the company’s attorneys and accountants, and outside business valuation experts. While it may seem that this collaboration and continual attention to the BSA would be an inconvenience, we believe it is much better than the alternative (i.e., costly litigation and a major business disruption).
With respect to BSAs, if there is going to be a point of contention upon the invocation of its terms, it is typically centered on the price to be paid for the owner’s interest. Unfortunately, although a BSA may be quite lengthy and adequately address various legal issues, we often encounter BSAs that give valuation-related issues only cursory attention and, thus, needlessly give rise to legal disputes over the value of an owner’s interest.
This article discusses the handful of valuation issues that every BSA should address.
Of course, the BSA will usually stipulate how the purchase price of the subject interest is to be determined. Often, the dollar price per share is actually stipulated within the agreement (“fixed-price agreement”) or will be determined through the use of a pre-determined formula (“formula agreement”). While both the fixed-price agreement and the formula agreement share the advantages of being easily understandable, simple to include in the agreement, and readily implemented, they rarely capture the true economic value of the interest to be purchased.
A "fixed-price agreement" is static and will not capture the constant change in value that occurs with almost any company. While some agreements attempt to compensate for this by mandating that the shareholders regularly meet and determine a more current agreed-upon price, it is our experience that these meetings rarely occur. Furthermore, if they do occur, usually it is only for the first few scheduled meetings, and very little (if any) real thought goes into setting the stipulated price. Again, the possibility that the stipulated price does not necessarily reflect the actual value of the interest may not worry shareholders while the agreement sits in a filing cabinet; however, when the agreement has to be invoked and real money is on the line, the party who is facing unfavorable terms is likely to think and act differently.
In contrast to a fixed-price agreement, a "formula agreement" results in different values at different points in time. An example of a formula agreement is to apply a multiple to a metric that reflects the most recent year’s earnings (e.g., four times earnings before interest and taxes). The problem with a formula agreement, however, is that formulas are always backwards-looking, whereas valuation is a forward-looking concept. (In other words, as a buyer, I care only about what my return is going to be next year, not what it was last year or in prior years.) Furthermore, a formula will never be comprehensive enough to capture and normalize all of the unique events that can impact a company’s earnings in any given year.
Ultimately, the use of a fixed-price or formula agreement will likely result in a calculated price that fails to reflect the true economic value of the interest to be transferred. The only means by which to capture the current circumstances surrounding the company and the most reasonable outlook for its future earnings is through the use of an appraiser who assesses the company at the specified point in time. This is called a “process agreement,” which can be drafted to incorporate the use of a single appraiser or perhaps two or more appraisers.
For example, the process agreement may call for the buying and selling parties to each select an appraiser to determine the value of the interest. If these values are not within a certain percentage proximity to each other, the parties will then agree upon a third appraiser. Although it can involve more time and expense upon invoking the provisions of the BSA, the process agreement is generally the most equitable, since the appraiser or appraisers will consider the unique characteristics of the company at the specified point in time as well as the company’s current outlook.
Two of the most common issues for BSAs that mandate the use of an outside appraisal are (a) the lack of specifics with respect to the standard of value and (b) the level of value to be utilized. Level of value and standard of value are related concepts and are especially pertinent in the valuation of a minority or non-controlling interest in a company.
“Level of value” relates to whether or not the determined value should take into account the lack of control and lack of marketability of a subject minority interest. For instance, in determining value, should a controlling shareholder’s above-market wages be adjusted to reasonable compensation if the minority shareholder has no ability to make such an adjustment?
Similarly, with respect to the “standard of value,” the terms fair value
and fair market value
represent two completely different concepts in the world of business valuation:
- “Fair value” is generally defined as the determination of the value of the interest without incorporating these attributes and the related discounts.
- “Fair market value,” on the other hand, is defined as the price for a subject interest as negotiated between unrelated hypothetical buyers and sellers. Inherent within this definition is the concept of discounts for lack of control and lack of marketability associated with a minority interest in the privately held company. In other words, a hypothetical buyer who is looking to purchase a non-controlling interest in a private company will never pay a pro-rata amount of the value of the business as a whole, given the lack of prerogatives of control and the related difficulty in monetizing his or her investment should the investor choose to sell the investment.
The difference between fair market value and fair value for the same interest may be 50% or more, depending on the characteristics of the interest. Thus, when drafting the BSA, the importance of defining the standard of value should be apparent. Unfortunately, with respect to determining the price of the interest, many BSAs haphazardly include terms such as “market value” or just plain “value” in their provisions, which leaves the appraiser no hint of the shareholders’ intentions when the agreement was drafted and sets the stage for full-blown litigation upon the agreement being invoked.
Proceeds from life insurance policies represent another issue that is often left unaddressed. The company may be the beneficiary of a life insurance policy on a shareholder, with the intention of providing the company the means of buying out the deceased shareholder’s interest pursuant to the terms of the BSA. However, because the insurance proceeds will typically not match the value of the interest to be purchased, there will ultimately be a windfall to either the company or the deceased shareholder’s estate, depending on the terms of the BSA.
Who ultimately receives this windfall may, in large part, be determined by how the appraiser treats the insurance proceeds. In this context, whether the appraiser (a) considers the cash proceeds as a business asset in the valuation of the company or (b) excludes the proceeds and considers the proceeds solely as a funding mechanism could have a dramatic impact on the value conclusion. Again, many BSAs are silent on this issue, leaving the appraiser directionless with respect to a key assumption.
This discussion represents only a few of the issues surrounding buy-sell agreements regularly encountered in our practice. It is our experience that the best outcomes for BSAs are achieved if:
- the parties avoid the trap of using fixed-price or formula agreements that may materially misprice the value of the interest to be transferred;
- the parties drafting the agreement consult with a valuation professional during the drafting process in order to ensure that all pertinent valuation issues are addressed; and
- the shareholders and their advisors regularly revisit the terms of the document to ensure that it continues to capture the intentions and needs of the shareholders.
While these steps may seem like an unnecessary nuisance and be somewhat more costly to the shareholders in the beginning, it is a small price to pay compared to the ultimate litigation costs that arise out of an agreement that is lacking in fundamental areas.