By Jeffrey D. Jones, ASA, CBA, CBI
One of the critical documents a business owner should have whenever there is more than one partner/shareholder in a small business is a Buy-Sell Agreement. Over the years, we have had the opportunity to read many Buy-Sell Agreements. Virtually all of the Agreements have three things in common:
a. They are generally written under the implicit assumption that the other guy is going to die first
b. The valuation procedures are unclear, unworkable or grossly unfair to at least one of the parties
c. The mandated periodic valuations by the shareholders are rarely kept current
In my capacity as a business appraiser and business broker, I have discussed the valuation problem inherent in Buy-Sell Agreements with numerous attorneys. The following business issues and suggestions may be helpful, when you are called upon to prepare a Buy-Sell Agreement for your company or a client.
A Buy/Sell Agreement should cover the four D’s of Shareholder/Partner involvement which are:
- Death (who wants to deal with the spouse or family)
- Divorce (Do you want the spouse as a partner?)
- Disability (What happens when a Partner/Shareholder can no longer work for an extended period of time.
- Dissolution (What to do when a Partner/Shareholder wants out).
The valuation results may vary greatly depending upon the use of the appraisal. Furthermore, the standard of value to be used when valuing less than 100% contract becomes an important issue. Are minority ownership interests to be valued based on Fair Market Value (which may require a large discount from company value) or Fair Value (usually meaning pro rata of company value)? These issues should be spelled out in the Agreement.
The company should consider paying for Key Man Insurance to insure that the funds will be available to buyout departing Partners/Shareholders. The mandate for the Key Man Insurance and procedures for determining value should be included in the Agreement.
Determining the market value of a company and/or a partial ownership interest is an important element of any Buy-Sell Agreement. Many agreements use Book Value as a basis of valuation, while others use a formula or “Rule Of Thumb” method. Book Value may be representative of the company’s tax basis in its tangible assets, but it is rarely representative of the company’s Fair Market Value. One or more of the parties to a Buy/Sell agreement is bound to be treated unfairly when Book Value or a fixed formula method is used to determine value.
Formulas and “Rules Of Thumb” methods are usually mathematical computations that often do not take into consideration the unique aspects of the subject company. These methods do not specify the procedures to be used in the computation nor fully state which assets are being included or excluded.
A few of the agreements we have read state that the company’s accountant should conduct the appraisal. This presents a major conflict of interest for the company’s account because he will have difficulty being independent when required to represent all parties. Furthermore, the accountant may not be trained or qualified to conduct the appraisal, which would likely result in a faulty value. Left to chance, the courts are likely to rule on the strict interpretation of the agreement, regardless as to the fairness for the parties. Some agreements call for each side to a dispute to hire an appraiser and if they can not agree, then a third appraiser is hired to either do another appraisal or render a decision after having reviewed the first two appraisals. The cost of hiring 2 to 3 appraisers can be very expensive. There are better methods of determining value.
Several of the attorneys we have met are solving these valuation issues by putting a provision in the Buy/Sell agreement that a qualified independent business appraiser shall be hired by the respective parties to determine value. A provision in the Buy/Sell agreement can set out a procedure wherein the parties agree to hire an independent qualified business appraiser having specified appraisal qualifications. The following language is for concept only and should be rewritten by counsel to insure compliance with applicable laws and procedures, as well as the intent of the Partners/Shareholders.
Upon the occurrence of an event requiring a determination of value under this Agreement, the Partners/Shareholders agree to engaged an independent business appraiser to provide an opinion of the value utilizing standards of value specified herein on a (minority interest) (controlling interest) (enterprise) basis as of the date specified in the agreement. In preparing its valuation opinion, the appraiser will be provided with such access to the books and records of the Company and its management as is customary in appraisals of this type in the course of due diligence procedures. The valuation conclusion of the appraiser will be binding upon the Partners/Shareholders individually, as well as upon their estates and beneficiaries, and the Company (if it is a party to the Agreement).
Said appraiser must be acceptable to all parties concerned and have senior designations from one
or more major national business appraisal organizations, such as the American Society of Appraisers and the Institute of Business Appraisers). The normal and customary fees and expenses for an appraisal shall be split equally between the involved parties.
It has been our experience that the procedures stated above are far less expensive and results in less litigation than most other procedures for determining value. When the need arises, contact a business appraiser who meets the above criteria.
Jeff Jones is nationally recognized as an experienced business appraiser and business broker and has earned senior level professional designations from national associations representing the appraisal and brokerage industry. He is President of Advanced Business Brokers, Inc., and President of Certified Appraisers, Inc. Both companies are headquartered in Houston, Texas.
Jeff has written many articles on the subject of appraising and selling businesses. He is the co-editor of the “Handbook of Business Valuation” and “Merger and Acquisition Handbook for Small and Midsize Companies” both published by John Wiley & Sons.
As a consultant with SCORE, the Small Business Administration’s consulting arm, he conducts seminars and provides consulting services for new and experienced entrepreneurs.
Jeff holds a Masters Degree from Pepperdine University. He is a designated member of the American Society of Appraisers (ASA); the Institute of Business Appraisers (CBA); Texas Association of Business Brokers (BCB); and the International Business Brokers Association (CBI).