By Mark Blazevic & James Travis
Universal Advisor, 2006 Issue No. 2
Some of the more interesting valuation assignments we receive are related to buy-sell agreements. These are the agreements that shareholders execute to address the process for transferring an interest in the company and how these transactions will be valued. A well-written buy-sell agreement specifies, with the necessary detail, how various transfers (due to shareholder death or disability, employment termination, or any party’s desire to sell his/her interest) will occur. While these transactions may appear self-explanatory, a poorly written agreement can lead to broad differences in interpretation and disagreements. Trying to agree on these basic points once a transfer is proposed, or a dispute has arisen, typically results in an expensive, time-consuming process that could have been avoided with a better prepared agreement.
There are several valuation-related directives that should be included in a buy-sell agreement. These directives provide a road map to the appraiser and the parties. The following six should be addressed in the agreement in some detail.
Standard of value. The word “value” has many meanings to a valuation professional. The standard of value should be articulated, including a definition, if necessary, in terms that are readily recognized and consistently applied by appraisers. A “fair market value” valuation may result in a very different amount than a “fair value” appraisal. The term “value” is generally insufficient direction to perform an appraisal consistent with the agreement’s intent.
- Level of value. Level of value is an important concept to appraisers. In this context, “level” is meant to reflect the ownership characteristics of the interest. Business interests are generally regarded as controlling or minority (non-controlling) and marketable or non-marketable. Controlling interests in closely held companies are generally considered to be much more marketable than minority interests. Marketability is defined as the ability to convert an asset to cash very quickly, at minimum cost, and with a high degree of certainty that the expected amount of the proceeds will be realized. Two appraisers could agree on the value of a business, but if only one applies a marketability discount, their conclusions could be materially different. The level of value should be stated in the agreement. It’s also advisable to state whether a lack of marketability (LOM) discount is to be taken. We’ve seen parties take a position that no LOM discount is appropriate, because the buy-sell agreement creates a market for the shares. This may or may not be consistent with the parties’ intents.
- The “as of” date for the valuation. Some buy-sell agreements aren’t clear about the date as of which the valuation(s) should be determined. This is extremely important since value can change from one date to another.
- The funding mechanism. If a party is required to purchase an interest, how will they pay for it? Frequently, buy-sell agreements don’t provide a specific funding mechanism (life insurance, sinking funds, or pre-agreed payment terms). An agreement is no better than the ability of a party to meet its requirements, so this factor should be considered when drafting it.
- Qualifications of appraisers. Some buy-sell agreements provide a specific list of firms that the parties agree are mutually acceptable, either for a single-appraiser option or the multiple-appraiser option. In other cases, the specific qualifications of an acceptable appraiser are defined (professional credentials, experience, and independence).
- Appraisal standards to be followed. Some buy-sell agreements go so far as to name the specific business appraisal standards that must be followed by any selected appraisers. For example, the agreement may state that the appraiser(s) must follow the Uniform Standards of Professional Appraisal Practice (USPAP) and the Business Valuation Standards of the American Society of Appraisers.
Investors are often unaware of the disputes that may result from a poorly written agreement and are uncomfortable addressing these issues with their business partners. If no agreement exists, or a poorly written one governs transactions, there’s a strong possibility that strangers (i.e., the judicial system) will resolve the dispute in a manner that will please no one, with major business operation disruptions and significant professional fee costs. An investment in a well-written agreement, with the assistance of an experienced attorney and valuation professional, can save substantial time and expense in the future.
Plante & Moran is the nation’s 12th largest certified public accounting and business advisory firm, providing clients with financial, human capital, operations, strategy, technology, and family wealth management services. Plante & Moran has a staff of more than 1,500 professionals in 16 offices throughout Michigan, Ohio, Illinois, and Shanghai, China. Plante & Moran has been recognized by a number of organizations, including FORTUNE magazine, as one of the country’s best places to work.