Six Common Valuation Pitfalls in Shareholders’ Agreements
The purpose of a buy-sell agreement is to ensure a smooth transfer of ownership and avoid disputes over the buyout price when an owner dies or otherwise leaves the business, but a poorly written buy-sell can have the opposite effect: Ambiguity, missing terms or poorly conceived valuation mechanisms increase the likelihood of disputes when a triggering event occurs. Here are six potential pitfalls to avoid.
1. Using a Fixed Price or Formula
Some buy-sells set a fixed buyout price or call for the price to be calculated using a valuation formula, such as book value or a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). This approach offers simplicity and low cost.
Although these metrics may provide a reasonable measure of value when executing the agreement, they’re unlikely to reflect changes in the company’s value over time. This shortcoming can lead to unreasonable results and disputes down the road.
2. Providing for a Negotiated Price
Other buy-sell agreements require the parties to negotiate the buyout price when an owner dies or another triggering event occurs, but the parties have conflicting interests: The buyer wants to pay the lowest possible price, and the seller wants to receive the highest possible price.
Bridging the gap between the buyer (the company or its remaining owners) and the seller (the departing owner or his or her heirs) can be challenging. Disputes often arise, defeating the original purpose of the agreement.
3. Failing to Establish Qualifications for Experts
The most reliable way to value a private business interest is to obtain an independent appraisal from one or more qualified experts at or near the buyout date. This helps ensure that the price accurately reflects the qualities that distinguish the company from others in its industry.
It’s critical for experts to possess credentials from a reputable business valuation organization and to be independent of the company and its owners. Also, consider establishing minimum levels of education and valuation experience.
4. Neglecting to Specify the Standard and Level of Value
Always define the term “value” in a buy-sell agreement. Typically, fair market value is the appropriate standard of value. But if left undefined, the meaning may be uncertain and lead to disputes.
Similarly, the buy-sell should specify whether to value a minority interest in the company (which may be discounted for lack of control and marketability) or the owner’s proportionate share of the company’s entire value.
5. Overlooking the Valuation Date
A company’s value can change dramatically over time. For example, a company’s value may soar after a merger or new patent is announced. Or its value might plummet after loss of a key executive or major customer. Unless a buy-sell agreement provides a mechanism for selecting the valuation date — such as the last day of the company’s most recent fiscal year or quarter — disagreements are likely.
Though it’s tempting to use the date of the triggering event as the valuation date, this approach is susceptible to manipulation by owners who time their departures to maximize the buyout price. Plus, it’s easier to use a valuation date that coincides with the end of an accounting period.
6. Setting Unreasonable Time Limits
The valuation process can’t be rushed. The expert must gather and analyze financial data, conduct management interviews and site visits, and write the valuation report.
Disputes may arise if time limits for agreeing on a negotiated price are unrealistically short. In addition, it may take time for the parties to find qualified business valuation experts — and an expert might have other engagements to finish before starting your case.
Imprecise Buy-Sell Leads to Unpleasant Surprises
A recent Ohio appellate court case, Kashmiry v. Ellis, illustrates the dangers of relying on a buy-sell agreement that’s not carefully drafted or followed. In this case, the agreement provided two mechanisms for valuing the company’s stock: 1) annual valuations of the company’s shares unanimously agreed upon by the shareholders, and 2) valuation by a qualified appraiser after a triggering event.
The shareholders failed to obtain annual valuations. So, after a minority shareholder was terminated (a triggering event), the company invoked the second valuation mechanism. The appraiser valued the shares at a fraction of the price for which the shareholder had acquired his shares five years earlier (around $7,500 per share, based on a multiple of the company’s gross revenues), in part because she applied substantial minority interest and marketability discounts.
The trial court valued the stock at $7,500 per share, criticizing the appraiser for ignoring the original purchase price of the stock. The appellate court reversed and remanded, finding it inappropriate to give controlling weight to a single, five-year-old valuation.
We have no updates on whether the trial court revisited its valuation or the parties settled their differences. But litigation might have been avoided if the shareholders had followed their buy-sell agreement by obtaining annual valuations of the stock. In addition, the issue of valuation discounts might have been settled outside of court if the parties had more clearly defined the term “value.”
Involve a Valuation Pro Upfront
Don’t wait for a triggering event to consult a business valuation professional. During the drafting of a buy-sell agreement, he or she can help ensure that the valuation provisions are fair, complete and unambiguous. It’s also critical to review buy-sell agreements on a regular basis and amend them as needed.