New Case Points Out Opportunity for Buy-Sell Valuations
An accurate business valuation is an important part of any buy-sell agreement. Unfortunately, many closely held businesses do not have an adequate valuation provision in place that protects shareholders during a transition by requiring a current fair market valuation.
This month’s business valuation case study highlights an issue that may not arise until it’s time for an owner to exit their business. It indicates that many clients may either not have a buy-sell agreement or have a shareholder agreement based on a fixed price or a specific formula that may be outdated. Valuation professionals can help their clients prepare for a future business exit by regularly reviewing their buy-sell agreements from a valuation and business perspective. Doing so will set up shareholders for a better experience when exiting a business.
If you require the perspective of a valuation services professional, we’d love to discuss how KSM can help. Please contact a member of our team or complete this form.
New Case Points Out Opportunity for Buy-Sell Valuations
Time and time again, we see or hear about trouble with the valuation provision in buy-sell agreements at closely held businesses. This provision should be designed to avoid owner disputes over value when an owner exits the business due to some triggering event, such as retirement, death, divorce, and the like. But, all too often, the provision has not been crafted correctly, which leads to fireworks—as a new case illustrates.
New case. A company’s shareholder agreement included a buyout provision that would be triggered if one of the owners files a petition to dissolve the company. The price of the buyout was based on a fixed per-share value set forth in the shareholder agreement. When the relationship of the owners deteriorated, one of them filed a petition to dissolve, so the company exercised its buyout option at the fixed price, which had not been updated. Lawsuits were filed, and the court ruled that the shareholder agreement is enforceable and the fixed price is what should be paid [Estate of Connie Collins v. Tabs Motors of Valley Stream Corp., No. 160529/2019 (NY County 2021)]1
Of course, a fixed value, no matter how it’s set, can go stale very quickly, especially with a firm in the midst of change, such as a startup or one going through decline. Unless the value is updated, someone will not be happy when a triggering event occurs.
Other buy-sell agreements use agreed-upon formulas or methodologies for determining buyout value, such as a multiple of earnings or market-based method. The trouble here is that the formula or method could become obsolete if there are changes in the environment (e.g., economic or regulatory) that impact the company and industry. Unless the formula or method is adjusted, the value may not reflect reality.
Best way. The buy-sell agreement should ideally have a provision that allows for a qualified business appraiser to perform a valuation. The provision typically states whether one
appraiser or multiple appraisers will value the company. Additionally, the purchase price determination provisions may set forth the standard of value and level of value the valuator will assume in performing the valuation. The selection of terms related to the valuations, how and by whom the valuation will be performed, and the manner upon which disagreements will be resolved are critical components of any agreement.
Some appraisers feel that it’s best to have one appraiser—not several—do the valuation. Either way, the process works very much the same as any valuation. After the owners agree on who will do the appraisal, the expert then provides an initial draft valuation. After receiving input from the owners and any other key people, the appraiser finalizes the valuation. This gives the valuation expert the chance to do a reappraisal regularly. The advantage of this is that the owners always know the current price for the buy-sell agreement and how that price is determined. This helps the owners with estate tax planning and such matters as life insurance funding for the company or the other owners if there are cross-purchase agreements in place.
According to a 2015 survey, 17% of attorneys polled say they use a predetermined fixed price without the use of an external advisor, and 39% say they use a formulaic method contained in the agreement.2 That means less than half of the attorneys polled say they use a business valuation professional to perform the valuation upon a triggering event. Although this survey was done several years ago, these types of practices are slow to change, which translates into an opportunity for appraisers.
What to do. Contact existing or potential clients to review their buy-sell agreements from a valuation and business perspective to identify potential problems. If the provision calls for a fixed price or formula, suggest that they change it to a formal valuation process, which can mean recurring business for your practice.
For whatever reason, some owners may not want to change the mechanism in their agreements. That’s fine, but you can suggest that they simply add language that helps avoid trouble. If they have a fixed-price provision, explain to them that the fixed price can be kept, but language can be added that calls for a valuation when a triggering event occurs. Or you can add language that says the valuation should be done if the fixed price is very stale (the appraiser can suggest a time frame). Owners who want to stay with a price based on a formula or methodology can add language that allows for a valuation to be done when a triggering event occurs if there is any dispute over the calculation of the formula or how the methodology is applied.
Owners should also be advised to select an appraiser right away—it may be easier to agree now as opposed to some point in the future when they may be at odds with each other.
1Case analysis and full opinion available on the BVLaw platform at bvresources.com/products/bvlaw.
2Survey conducted by Dixon Hughes Goodman LLP, published in Buy-Sell Agreements: How to Avoid the Valuation Pitfalls, Business Valuation Resources, June 2015; bvresources.com/products/buy-sell-agreements-how-to-avoid-the-valuation-pitfalls.
We're Looking for
At KSM, you’ll be encouraged to find your purpose, exercise your creativity, and drive innovation forward.