Putting The Right Price On A BusinessOctober 10, 2010
By Mark S. Campbell, CPA/ABV, CFF, JD, Manager
A well-constructed buy-sell agreement among owners of a particular business entity can prove to be invaluable to that particular business and can often help to avoid shareholder disputes and litigation.
Perhaps the most important issue that must be understood and addressed in buy-sell agreements is the type of valuation mechanism that is desired. There are three main types of agreements based on the nature of the valuation mechanism, and each has advantages and disadvantages. They are fixed agreements, formula agreements and process agreements.
Fixed agreements are the simplest type of agreements, as they fix the price of future purchases at a specific dollar amount. Because of this simplicity, the advantage here is that they are easy to understand and inexpensive. An example of this type of agreement would be to state that each share is worth $10, and the value is set annually by a Board of Directors.
There are disadvantages of fixed agreements, however. Circumstances change, and what may make sense at the time it is created may be unfair to the buyer or seller when a triggering event occurs. Agreements that have built-in resets - such as through an annual action by the Board of Directors - can work in some cases, but often people do not follow through, creating future ambiguity. Also, setting a price through negotiation can often lead to problems (and litigation) because of differing points of view of the negotiating parties, and such disparities can make any agreement made under such negotiations suspect.
Formula agreements use a formula to determine value, one that is typically applied to a current balance sheet or income statement fundamentals. An example of a formula agreement would be one which states that a company is valued at five times its earnings. The advantages of these types of agreements are very similar to the advantages of fixed agreements in that both are easily understood and inexpensive. Additionally, unlike a fixed agreement, prices will vary based on the fundamentals used.
Much like fixed agreements, though, there are problems that can arise here. The primary disadvantage is that no formula can provide reasonable and realistic valuations over time due to myriad changes that occur within individual companies, local and national economies and industries. In addition, questions could arise over the method of accounting being used, one-time or unusual items in a financial statement, and the kinds of earnings measurements that are appropriate for use in earnings-based formulas.
The final kind of agreement, a process agreement, very specifically defines the process by which the valuation is determined after a triggering event. The main advantage of this approach is that it mitigates the inflexibility of the first two methods and generally withstands the test of time. Understandably, the thoroughness of this kind of agreement can lead to a disadvantage as well - it is more expensive to implement. However, the cost of retaining one or more appraisers at the time of a triggering event is worthwhile if it means avoiding future litigation expenses. Process agreements must be well-crafted and avoid any ambiguity to create a cohesive valuation approach.
With process agreements, the first area that should be addressed is specific valuation instructions. Such instructions would describe the appropriate standard of value to use, as well as other key elements - standards of value including fair market value, fair value, investment value and other such examples. Additionally, the level of value should be described in these agreements as they address control and marketability and, thereby, whether any discounts or premiums are applicable for the valuation. What's more, the valuation date should be clear - this is the date when available information pertaining to a valuation should be considered by appraisers.
The next area that should be addressed in a process agreement is the appraiser's qualifications and appraisal standards. Because appraisal firms also change over time, it is often better to address the appropriate qualifications of the selected appraiser(s) as opposed to a specific firm or firms. Areas to address would be the training, education and experience of the appraiser. In addition, specific credentialing should be discussed. The two most prominent credentials whose members must follow specific standards are ABV (Accredited in Business Valuation, issued through the American Institute of Certified Public Accountants) and ASA (Accredited Senior Appraiser, issued through the American Society of Appraisers).
Lastly, process agreements should address funding mechanisms. These are essential parts of any agreement and provide for the agreed-upon value to be both affordable to the company and achievable by the selling owner. Typical mechanisms include life insurance, corporate assets (cash), sinking funds, third-party borrowing and seller-owner notes.
One final area that should be reviewed, especially with closely held companies, is coordination between the owner's Last Will and Testament and the agreement. Ideally, the will should reference the agreement for all business interests in the company.
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