Getting specific to crack open the conversation
A “valuation process” buy-sell agreement is an agreement that stipulates the process for determining a value of the business. This differs from a fixed price agreement, which states the dollar value of the business right in the agreement; a formula agreement, which states a formula for valuing the business (X times annual sales, for example); and a shotgun agreement, where one person has a right or obligation to buy (or sell) at a some price, and the other party has the right or obligation to sell (or buy) at that same price.
Valuation process buy-sell agreements outline valuation processes through which future transactions will be priced. In nearly all cases, process agreements call upon the use of one or more business appraisers in the process of determining the price at which a future transaction will occur.
There are six important elements relating to valuation in a well-written buy-sell agreement.
They are: 1) Standard of Value, 2) Level of Value, 3) the “As Of” date, 4) the Qualifications of the Appraisers, 5) Appraisal Standards, and 6) Funding Mechanisms.
1. Standard of Value. The standard of value is the type of value to be used in a business appraisal. The proper identification of the standard of value is the cornerstone of every valuation. The parties to the agreement (that’s you and your fellow owners) should select that standard of value. If you don’t, the appraisers will have to select it for you—and you may not like their choices.
Will value be based on “fair market value,” “fair value,” “investment value,” or some other standard? These words can result in dramatically different interpretations from a valuation perspective. Some agreements simply specify “the value” of the company or interest, which is not adequate to define the standard of value. The likelihood of a successful appraisal process falls to near zero if the standard of value is not clearly specified.
Fair market value is the most common standard of value. Fair market value assumes a willing buyer, a willing seller, neither under any compulsion to buy or sell and both parties have reasonable knowledge of the relevant facts. Fair market value is commonly used by the IRS and the courts. It assumes a hypothetical arm’s length sale without regard to a specific buyer or seller.
Fair value is a court-determined value provided for under some states’ laws. Frequently, a valuation under the fair value standard does not have discounts for lack of control and lack of marketability.
Investment value is the value to a specific owner or prospective owner. This type of value considers the owner’s knowledge, abilities, expectations of risk and earning potential. An example of investment value is when a transaction provides unique motivators or synergies to a particular buyer that is unavailable to the typical buyer.
2. Level of Value. Will the value be based on a pro rata share of the value of the business, or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process—and to the owners of your business who are parties to your buy-sell agreement. Again, if you don’t make a knowledgeable choice, someone else (the appraisers) will make it for—or against—you. There is no presumption of malice or lack of independence in this statement. The problem is that many agreements are subject to differing interpretations regarding the appropriate level of value.
The differences bring into play things appraisers call “minority interest discounts” and “marketability discounts.” A discounted value will always be lower than an un-discounted value. The reason you want to specify the level of value is that, if you decide discounts are okay, then that level defines the rate from which the discounts are to be taken. That’s pretty much common sense.
Two appraisers could agree on the total value of a business, but if one applies to a minority interest discount or a marketability discount, their conclusions may be dramatically different. This is not surprising, because their conclusions represent two different levels of value. One appraiser will have valued the business, while the other will have valued an interest in the business. The desired level of value needs to be crystal clear in your agreement.
3. The “as of” date for the valuation. Every appraisal is grounded at a point in time. That time—referred to as the “valuation date,” “effective date,” or “as of” date—provides the perspective, whether current or historical, from which the appraisal is prepared. Unfortunately, some buy-sell agreements are not clear about the date on which the valuation should be determined by appraisers. This can be extremely important, particularly in corporate partnerships and joint ventures when trigger events establish the valuation date. Because value changes over time, it is essential that the “as of” date be specified.
4. Qualifications of appraisers. If you don’t decide on the kind of appraiser(s) you want to help with your buy-sell agreement, then, unfortunately, almost anyone can be named by you or other parties to your agreement. Do you want a college professor who has never done an appraisal as your appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? Or how about a shareholder’s brother who has an MBA but has never valued a business before? You get the picture. Your buy-sell agreement has to specify the qualifications of appraisers who may be called if your agreement is triggered.
One way to solve this problem is for all of the owners and the company to agree on aqualified independent appraiserbefore you sign your agreement. Unfortunately, many buy-sell agreements are silent on this issue. Absent clear specification of the appraiser qualifications, there is no assurance that appraisers considered for buy-sell valuations will be qualified to provide the required services. And rest assured that after a triggering event, the interests will diverge among the shareholder who has been triggered, the other shareholders, and the company. Getting agreement may be virtually impossible.
5. Appraisal to be followed. Some buy-sell agreements go so far as to name the specific appraisal standards that must be followed by the appraisers. Business appraisal standards provide minimum criteria to be followed by business appraisers in conducting and reporting their appraisals. And you certainly want your appraiser to follow minimum standards!
Some agreements state that the appraiser(s) must follow theUniform Standards of Professional Appraisal Practice, theAICPA’s Statement on Standards for Valuation Services No. 1 (SSVS-1), theNACVA Professional Standards, or other standards.
6. The funding mechanism(s). The funding mechanism is thought of separately from valuation. However, there may be interrelationships between the valuation and the funding mechanism that should be considered in your buy-sell agreement. For example, your company may have life insurance on the lives of its shareholders. If an owner dies, what happens to the life insurance? Does the agreement specify the use of life insurance proceeds? A failure to treat insurance proceeds clearly in a buy-sell agreement could lead to different treatments for purposes of the agreement and for estate tax purposes. This would not be a good result!
And does the agreement tell the appraisers how you want to them to treat the proceeds in their valuations? Does the agreement provide for the company to issue a note to a deceased or departed shareholder? If so, what are the terms of the note?
An agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed-upon price. An agreement that is silent can be like having no agreement at all.
What’s so hard about specifying these defining elements? Getting specific often makes people talk about things they don’t even want to think about. But think about them they must. If you think it is difficult to address these issues with your partner(s) in the here and now, just think how difficult it will be when one of you is in the hereafter.
Know this: If these defining elements are unclear in your buy-sell agreement, then they may be the only thing you will be able to think about following a trigger event, until the situation is resolved. Absent a clear agreement, this can take lots of money and time, and create lots of hard feelings. In addition, dealing with these issues under adverse circumstances will absolutely distract you from running your business.
Mercer, Z. Christopher. (2010). Buy-Sell Agreements For Closely Held and Family Business Owners. Memphis, TN: Peabody Publishing LP. Fishman, Jay et al. (2012) Practitioners Publishing Company Guide to Business Valuations.