Three Methods to Estimate Value for Buy-Sell Purposes
The COVID-19 pandemic has had a significant impact on business values. Some companies have increased in value, while many others have lost value. During these volatile conditions, it’s wise for business owners to review the valuation provisions in their buy-sell agreements to ensure that they reflect current conditions and will produce a fair price for departing owners.
When an event triggers a buyout, buy-sell agreements usually call for one of the following three valuation techniques:
1. Prescribed formulas. Some agreements call for a simplified formula, such as a multiple of earnings or revenue, to set the buyout price for a departing owner’s interest. However, these prescribed formulas are unlikely to produce an accurate value, especially with the passage of time.
For example, suppose the value of ABC Co. increased significantly during the pandemic. ABC’s buy-sell agreement includes a valuation formula of four times annual earnings from the end of the most recent fiscal year. If an owner left ABC in June 2020 and the buyout price was based on earnings as of December 31, 2019 — before the pandemic affected the company’s performance — the formula would likely understate the market value of the departing owner’s shares.
2. Negotiated prices. Requiring the parties to negotiate a buyout price when an owner departs allows the parties to factor in recent events. But forcing the owners to agree on a fair price in a potentially high-stress, adversarial environment invites litigation if the parties are unable to reach an agreement. A potential way to lower this risk is to provide for an independent appraisal if the parties can’t agree on a price within a specified period.
3. Independent appraisals. Obtaining outside appraisals may seem time-consuming and costly, but it’s often a smart use of resources. Business valuation professionals provide objective, market-based evidence of the company’s current market value, which can help diffuse stress and reduce potential conflicts.
Some agreements call for each side to hire a separate valuator. Then, if the opinions differ significantly, the parties might average the results or hire a third expert to bridge the gap.
Valuation professionals also can be useful before a triggering event happens. When drafting or reviewing a buy-sell agreement, a valuator can help select the appropriate valuation method and evaluate whether the agreement covers all the value-related bases. This input can be particularly valuable because certain technical issues may fall outside the comfort zone of many attorneys and business owners. Examples include the appropriate standard of value (fair market value, fair value, or strategic value), level of value (controlling; marketable, minority; or nonmarketable, minority), and preferred expert qualifications.