A key component of a buy-sell agreement or other business transition documents is the provision of a predetermined valuation clause should a triggering event occur. Some buy-sell agreements contain a set value or formulaic valuation clauses, while others defer to the use of an independent third party, such as an accountant or business appraiser, to determine value on a periodic basis. Financing and payout terms of the purchase can also be included as part of the buy-sell agreement. In theory, these agreements should reduce conflicts regarding value between buying and selling owners, but this is not always the case in practice.

Definition of Value

As noted above, buy-sell agreements will generally contain a valuation clause with the terms of the buyout and, often, a definition of value. “Fair value” and “fair market value” are two commonly used definitions of value that have very different implications on the dollar value that a business appraiser or accountant would reach when determining the value of a business interest. Therefore, it is important to define the standard of value that will apply to the buy-sell agreement.

Fair market value is the premise of value for estate and gift tax valuations. The term is defined in Revenue Ruling 59-60 as follows:

Fair market value as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

“Fair value” does not have a common definition, and is used differently by CPA’s, attorneys, and the court system. The AICPA uses “fair value” for fair value measurements, while attorneys and courts, use the term in the context of owner disputes. And the difference in the how these are viewed is no surprise.  When drafting a buy-sell agreement, owners must bear in mind the language they wish to use and the consequences of using such language in different contexts between a purchase/sale and in resolving a potential dispute.

Avoid Ambiguous or Unclear Language

The importance of clear language can’t be overstated.  The difference between “fair value” can have one specific meaning, and “fair market value” can have a completely different meaning. The difference between the value calculated on a “fair value” basis and a “fair market value” basis can be in the millions of dollars.

In valuation, certain words and phrases have specific meaning to the appraiser (as “fair value” versus “fair market value”), and casual use of these words may create unintended conflicts in the future. An appraiser can read the valuation provisions and provide suggestions that will eliminate ambiguity. They may also suggest clarification relating to “noncontrolling” versus “controlling” values, discounts for lack of marketability, and discounts for lack of voting rights. Consulting with CPAs and appraisers in advance can help business owners and their legal counsel choose more precise valuation language.

What Is the Stock Worth?

Ensuring that the terms of the buy-sell agreement are in writing and that the owners agree to those terms before the occurrence of a triggering event helps to eliminate potential conflict in the future. At the time the buy-sell agreement is executed, no owner knows who will be bought out, when, or why. Moreover, relations between owners at the formation of the business are most likely good, so they should be able to come to a consensus on the terms. When a triggering event occurs, relationships may be strained; a failure to have a solid buy-sell agreement in place may result in conflict, arbitration, or litigation, all of which can become extremely costly, both emotionally and financially.

Formulaic Valuation Clauses: Pros and Cons

Some buy-sell agreements use formulaic valuation clauses that are simplistic blends of accounting information and valuation multiples. Examples can include:

  • Book value,
  • 50% of the prior 12 months’ revenues
  • seven times earnings, or
  • four times earnings before interest, taxes, depreciation and amortization (EBITDA).

Formulaic valuation clauses are the most simplistic on the surface, but the benefits of their simplicity may be outweighed by their inaccuracy. The pros and cons of a few common valuation metrics are discussed below.

Book value.

Book value is an accounting concept rather than a measure of economic or financial value; it is the accounting value of a company’s owners’ equity (i.e., its total assets minus its total liabilities). The benefit of using book value is that it is a simple method in which value is determined by looking at a company’s balance sheet.

Formulaic valuation clauses are the most simplistic on the surface, but the benefits of their simplicity may be outweighed by their inaccuracy.

 

Another positive of using book value is that it takes into account the company’s working capital and the collection of accounting values for its assets and liabilities.  

One negative can be that fixed asset values will be reported at their depreciated value as opposed to their fair market value (i.e., true economic value). Another negative of book value is that it may fail to consider assets or liabilities that are not on the company’s books, such as identifiable intangibles or goodwill. These assets and liabilities would have to be valued separately and then included in the book value calculation.

Multiples of revenue.

Multiples of revenue can be used for companies in which there is little book value and little net income. Service businesses often fall into this category, as they tend to have more “human capital” as opposed to the land, building, and machinery of manufacturing industries. Service companies ususally pay out most or all of their income in the form of employee and owner bonuses, leaving little to no net income. As such, income multiples would not provide a high value; book value may create a similar problem, as retained earnings would tend to be small for a company that reports little to no net income year after year. Therefore, multiples of revenue can be an indicator of value for service companies.

An advantage of the revenue metric is that revenue is generally easy for an SME to measure, and therefore this method is easy to apply. However, the ease of use may be outweighed by the departure from determining an accurate economic value. Another negative is that it values similarly sized companies at the same value, irrespective of their profitability.

Multiples of earnings.

A third potential formulaic valuation clause is using a multiple of a profit measure, such as price-to-earnings (i.e., the market value of the interest’s common equity relative to a multiple of earnings). Using earnings multiples does consider a company’s profitability; however, sometimes this profitability may be influenced by one-time items that make the company’s unadjusted earnings either higher or lower than if such earnings were adjusted for the one-time item. One example of this could be proceeds or expenses from a lawsuit, for which such adjustment could also include adjustment of legal expenses for the year in question.

In determining value, a professional appraiser will make normalizing adjustments for unique or nonrecur-ring events, which a formula may not consider.

Multiples of EBITDA.

There are more sophisticated earnings formula clauses as well, such as multiples of EBITDA. These formula clauses may potentially result in a purchase price that is vastly different from the fair market value of the interest being sold because they fix a valuation multiple and fail to take into account changes in market conditions, growth prospects, profitability, and capital structures.

Formulaic valuation metrics do not take into consideration things such as changing market conditions (perhaps industry multiples are on the rise, and a once-typical 7 times earnings ratio is now too low), growth prospects (a company that has just been awarded a new significant contract will likely be worth more if such contract results in incremental future cash flows), profitability, and capital structures.

Dynamic Valuation Clauses: A Better Solution

Dynamic valuation clauses specify obtaining a periodic valuation for a company’s equity. For example: “Every year, the company will obtain a valuation from a qualified accountant (or appraiser).  The appraisal will constitute a ‘certificate of value.’ If no such certificate of value has been obtained in the last three years, then an appraiser will be hired to perform a valuation.” In reality, owners of privately held companies may agree to have an appraisal every year, but after a few years, they usually stop.  The appraisals are expensive, and in the absence of triggering events, the owners’ mentality becomes, “why bother?”

Then, a triggering event occurs. For example, if an owner dies unexpectedly and there is no current certificate of value, the surviving owners follow the buy-sell agreement to buy out the deceased owner’s interest.  This will require the determination of value. In this situation, the annual appraisal provides a value before the triggering event occurs and before any parties are identified as the buyer or seller. The appraiser delivers the valuation report, and the owners have an opportunity to read it, provide comments, and then have the value as a data point. And if a triggering event occurs, conflicts over value should be reduced, as the parties have already agreed on a value within the past year.  It is important to keep the valuation provisions of buy-sell agreements up to date, as market conditions and other factors will change from year to year.

Sometimes buy-sell agreements will require appraisals only after the triggering event occurs; for example: “Upon the occurrence of a triggering event, both parties will hire an appraiser to value the equity interest of the owner who is selling his or her interest. If the appraisals are within 10% of each other, the values will be averaged, and that average will be the transaction price at which the interest will be purchased. If the two appraisals fall outside of 10% of each other’s value, then a third appraiser will be selected, and such appraisal will be used for determining the value for the transaction.” In such a case, the third appraiser may help determine the final conclusion of value, but sometimes these situations end up in court because one of the parties feels cheated.

Terms of Repurchase

Buy-sell agreements may also specify the terms of repurchase. For example, once the valuation has been determined, the buy-sell agreement may provide that 20% of the purchase price is to be paid on closing, with the remaining 80% paid over a finite number of years at a specified interest rate. Accounting for these terms in writing at the time of the creation of the buy-sell agreement helps define how the purchase price will be paid.

If financing is used, owners should be cautious about stating a fixed rate; Owners may want to draft financing terms that reflect the market rates of the time, such as “the prime rate plus 2%.” All of these terms should be discussed and understood by the owners at the time of the drafting and execution of the buy-sell agreement.

The Value of Foresight

Buy-sell agreements are useful tools to provide for the orderly transition of equity interests in privately held business entities. When constructed correctly and reviewed annually, they serve multiple beneficial purposes. 

  • They provide for the purchase of an owner’s equity interest in the business due to a triggering event, whether voluntary or involuntary;
  • They limit ownership to the parties that are suitable to the business partners;
  • They provide an agreed-upon price at which a buyer and seller can transact before a conflict and buyer/seller valuation biases arise;
  • They provide agreed-upon terms for the payment of the transaction price related to the sale;
  • and They bind additional owners to the provisions of the buy-sell agreement.

Investing the time and money to create a clear and unambiguous buy-sell agreement is a worthwhile cost that can help reduce future problems. Privately held SMEs with multiple owners should ensure that the entity and owners have a buy-sell agreement in place and that such agreement has been reviewed by competent and experienced professionals