At the heart of every successful buy-sell agreement are well-reasoned business valuation provisions. By thinking through valuation matters and anticipating potential sticking points while the owners are on good terms, you can help facilitate future buyouts — when relations might be strained.

Estimating value

Several possible valuation approaches can be used to set the price in a buy-sell agreement. Some agreements use a formula or rule of thumb, such as book value or some multiple of earnings or cash flow. Others base the price on the shareholders’ judgment of value. But these methods can easily lead to under- or overvaluation, or to conflicts among the shareholders.

Usually, the best approach is to provide for valuations by one or more independent valuators, either periodically or at the time of a triggering event. A buy-sell agreement that requires an independent valuation may call for a single expert or two or three experts. Some agreements, for example, provide for the buying and selling parties each to select a valuator. If their valuations are within a specified percentage of each other, the average of the two sets the price. But if their valuations are too far apart, a third expert chooses the “winning” valuation.

Clarifying key terms

A leading cause of disputes in buyouts is when the buy-sell agreement fails to provide valuation guidelines and define terms such as:

Standard of value. “Value” can mean different things in different contexts, so the agreement needs to spell out whether the price should be based on fair market value, fair value, investment value or some other standard.

Application of discounts. Parties to buy-sell agreements often assume that value is based on their pro-rata share of the value of the entire business on a controlling basis. But without further direction, a valuator might adjust this value to reflect discounts for lack of control or marketability. To avoid unintended consequences, the agreement should specify which discounts or premiums, if any, apply.

Valuation date. Business valuations are valid as of a specific point in time, and the valuation date can have a big impact on the result. The agreement should specify whether the date used is the date of the event that triggered the buy-sell agreement, the last day of the company’s most recent fiscal year or some other date. Using a specific date rather than the date of the triggering event discourages owners from timing voluntary departures to maximize the buyout price.

Timing. It’s important to specify when the valuator(s) will be selected. Many buy-sell agreements provide that the parties will select a valuator after a triggering event occurs. But it may be difficult for the parties — who now have conflicting interests — to agree on one expert.

A more effective strategy may be to select a valuator to value the business when the agreement is signed and then have the valuation updated annually (or every two or three years). This allows the parties to become comfortable with the valuator’s methods and get a handle on what the buyout price would be. Knowing your company’s current value is critical in today’s volatile markets. If a triggering event happens, the buyout price can be based on the most recent valuation or an updated version if conditions have changed significantly.

Hiring a valuation pro

Valuations derived from independent, credentialed professionals usually stand up well under court examination and in arbitration. Plus, the perceived objectivity of an outside expert helps engender trust from both the buyer and seller of the business interest. By planning for possible contingencies and incorporating reasonable, clearly defined valuation guidelines, you can help ensure a smooth transition in a difficult time.

(This is Blog Post #1332)