Bakersfield Office    
661 527 9080
Central Coast Office
805 585 5760

Blog

Buy-sell agreements govern the transfer of ownership interests between shareholders in closely held companies. They are essential tools to protect shareholders’ interests in the event of triggering circumstances like death, disability, or divorce. However, unclear valuation provisions can lead to disputes and delays. This article provides an overview of valuation considerations for attorneys and shareholders when drafting buy-sell agreements.

Why Buy-Sell Agreements Matter

Buy-sell agreements establish a process for determining the buyout price and payment terms if a triggering event occurs. Well-crafted agreements avert potential conflicts by defining the valuation approach upfront. Without clearly outlined terms, the buyout transaction can get bogged down in lengthy and costly battles between shareholders.

 

Key Valuation Considerations

Pricing Mechanisms

Buy-sell agreements often rely on valuation formulas, such as a multiple of earnings or book value, to determine the buyout price. We’ve seen many agreements that set the price at either 1x book value or 3x last year’s net income. We typically see this after one of the shareholders disputes the formula-based value and retains us to provide a current fair market value.

Although formulas provide simplicity, the result doesn’t necessarily reflect fair market value at a triggering event. For example, a multiple established five years earlier may no longer make sense if the company’s growth or risk profile has changed substantially.

Obtaining an independent appraisal at the triggering date better captures value based on the company’s current condition. Appraised values minimize disputes that can arise when using outdated pricing formulas.

Third-Party Valuation Provisions

Attorneys have two primary options for third-party valuations:

  • Single Appraiser: One appraiser, agreed upon upfront, performs a binding valuation at the triggering date. This approach saves time and costs versus using multiple appraisers. The agreement can either state that a single appraiser will be used, to be appointed upon the triggering event, or name a specific appraiser in the agreement.
  • Multiple Appraisers: Each shareholder selects their own appraiser, with a third one sometimes brought in to resolve differences. While common, it can be time-consuming and expensive. (We’ve been involved in multi-appraiser situations where it took longer to identify and retain the appraisers than for the selected appraisers to complete the work.)

 

Key Provisions to Define

To protect all shareholders’ interests, buy-sell agreements should clearly define:

  • Appraiser qualifications: For business interests, require credentials like Accredited Senior Appraiser (ASA), Chartered Financial Analyst (CFA), Accredited in Business Valuations (ABV), and Certified Valuation Analyst (CVA). By listing recognized certifications, shareholders can ensure that the appraiser possesses the qualifications to deliver a reliable valuation.
  • Standard of value: Fair market value is typical. Fair market value represents the price at which an asset would change hands between knowledgeable, willing parties in an arm’s length transaction.
  • Valuation date: This is usually the date of the triggering event. Ambiguous dates can lead to disputes, particularly when the company’s revenues are growing or declining rapidly.
  • Level of value: Is the interest valued pro rata based on total company value without discounts, or as a minority interest considering appropriate discounts for lack of control and lack of marketability? The standard should align with the situation or what the shareholders agree to when drafting the agreement.

Having precise valuation terms prevents complications down the road and smooths ownership transitions. When drafting buy-sell agreements, shareholders and their attorneys should consider engaging valuation professionals to define the appraisal process clearly.

For further reading, I highly recommend Z. Christopher Mercer’s Buy-Sell Agreements for Closely Held in Family Business Owners.

Shannon Lowther, CFA, ASA, ABV, is the Managing Partner of Central Pacific Valuation, providing business valuation services throughout the Western United States.