Minimize Future Conflicts in Buy-Sell Agreements by Choosing the Right Valuation Method
By David E. Kolan, CPA
A transfer of business ownership typically follows a triggering event, such as the death, disability, termination, or retirement of a shareholder. In each of these circumstances, disputes can arise due to the conflicting goals of all the parties involved in the transaction. Resolving these disagreements at the time of transfer can prove costly and time consuming and may even result in irreparable damage or dissolution of the business entity. The best defense against these issues is a strong offense in the form of a well-thought-out buy-sell agreement that anticipates challenges and provides a sound and predictable framework for the smooth transition of ownership and preservation of business interests.
Methods for Determining Business Value
A key benefit of a buy-sell agreement is its ability to define and clearly establish the value of a business from the very beginning so that transactions under the agreement can occur in an orderly and reasonable manner in the future. There are several ways to value business interest, including a fixed-price agreement that allows owners to settle on a future sales price at the time they sign the agreement or a formula agreement, which calculates the business’s value using a pre-determined formula applied to an income-statement metric.
Because these methods do not require formal, independent business appraisals nor do they address future events that can increase or decrease business value, they may result in significant differences between the business value established when partners executed the agreement and at the time they transfer ownership. These discrepancies can call into question the business’s true and reasonable value and expose a sale or other transaction to possible legal challenges.
By contrast, owners employing a valuation-process agreement to value business assets rely on the expertise of qualified business appraisers to establish an initial baseline price at the time partners engage in an agreement and build in periodic valuations into the future. This method helps to set realistic expectations from the onset of buy-sell agreement negotiations, instills confidence in the appraisal process and provides all parties with the reassurance that an agreement signed yesterday will not be outdated tomorrow or five years from now.
Maximizing the Benefits of Valuation-Process Agreements
Valuation-process agreements acknowledge that businesses evolve over time due to a variety of foreseeable and unforeseeable circumstances. By documenting both the valuation methodology and the time frames that periodic valuations will occur in the future, valuation-process agreements keep up with changes in industry and general economic conditions that could affect a company’s sales price over time and in the future.
Maximizing the use of valuation-process arrangements requires interested parties, including legal counsel and financial advisors, to define and understand all of the detailed elements included in a well-drafted agreement.
Standard of Value
The “value” of a business is an ambiguous term that every individual may define differently. Therefore, it is critical that buy-sell agreements clearly identify the specific standard of value they use as a basis for valuations. This may include the commonly used “fair market value” that applies to federal estate and gift tax valuations or the “fair value”, which is defined by state law for shareholder disputes or by the Financial Accounting Standards Board (FASB) for asset impairment measures.
Level of Value
Level of value reflects the ownership interest in a business, whether it be controlling or non-controlling, and the marketability of those interests. For example, parties to a buy-sell agreement may assume they will receive the pro-rata value of that business as a whole. This may not always be the case especially when considering that non-controlling interests are less marketable than controlling interests, which are easier to convert to cash and more predictable in realizing estimated proceeds. When there is a lack of marketability, the business interest may be transferred at a discount. Generally, the less control an interest has over the management of the business, the larger the discount (i.e., a discount for lack of control may be applicable as well as a discount for lack of marketability).
Effective “As of” Date
Well-written buy-sell agreements should specify the dates for future valuations as well as the financial statement timeframes appraisers should use in their future assessments of a business’s value.
The way one party intends to purchase a business from another party is a special consideration that buy-sell agreements should address. For example, if life-insurance proceeds paid upon death of a shareholder are to be used to fund a purchase, the buy-sell agreement should specify whether those funds should be considered corporate assets to be included in the value of the business. Alternatively, a company may specify that it has sufficient resources to fund a required redemption. In either case, the buy-sell agreement should specify the details of the funding mechanism, which all involved parties should review annually.
Appraiser Qualifications and Standards
The parties involved in a buy-sell agreement should consider documenting the name(s) of the appraiser(s) or firm(s) they jointly approve to value business interests as well as the valuation standards the appraiser should follow. This can help to protect against future legal challenges based on different interpretations of the buy-sell agreement.
Transfers of business ownership can be complicated. However, a comprehensive buy-sell agreement that properly defines how assets are valued and addresses the details of buy-out terms under various scenarios, enables business owners to minimize potential conflicts that may result from future events.
About the Author: David E. Kolan, CPA, is a managing director of PKF Advisory, where he serves as a senior transaction and business advisor to domestic and international companies. He can be reached at (954) 712-7027 or via email at dkolan@PKFAdvisory.com.