VALUATION CLAUSES FOR BUY-SELL AGREEMENTS
By Stewart L. Appelrouth CPA, CVA
and Edward S. Sachs CPA/ABV
Buy-sell agreements are usually prepared with the good intention of avoiding conflict and making certain decisions for the future, at a time when the parties are either first beginning their venture or are at a point at which there is no discord between them. Ultimately the good intention is to avoid any disputes should the reasons for a buy-out come to pass. Oftentimes, when it comes time to use the buy-sell agreement, circumstances are much more difficult, usually because the triggering event is a separation of business partners or the death of one of the participants. Unfortunately, it is at this time that the partners find out how difficult it is to interpret the agreement they have written.
Most buy-outs are triggered by one of the following events: disability, death, retirement, or separation of the partners themselves may not be the parties negotiating the final buyout. If death or disability has occurred, the spouse, personal representative or guardian may be the negotiating party. Alternatively, if the scenario is an unfriendly separation, legal counsel may be involved. In either case, interpreting the language of the agreement and divining the intent of the parties becomes increasingly difficult and usually leads to protracted negotiations, often litigation.
It is important to clearly spell out not only the circumstances by which a buy-out is triggered, but also how any dispute amongst the parties will be settled. Of course, the less left to chance, the less a chance for such dispute. The mediation and/or arbitration clause should appear in all buy-sell agreements. The mediator or arbitrator to be used should be defined, and consideration should be given to the appointment of a two-person panel made up of both a legal and business valuation expert.
For starters, properly defining what is being bought out is critical. It is the defining step in any valuation matter. What are we valuing? Does the interest being valued include just fixed assets, cash, receivables and payables? Or does it include any intangibles such as a license, a long-term lease agreement, contractual obligations, goodwill, or a corporate trademark? Keep all of the factors that make the business operation tick in mind.
Appelrouth, Farah & Co., for example, recently handled a matter in which the agreement was very specific in defining what would be bought out in a medical practice setting. However, the agreement failed to include the practitioner's phone number as an asset. In reality, the telephone number probably had more value than any other asset as it was the main form of referral for business for this doctor, and all patients utilized the number.
How the buyout will ultimately be paid must also be spelled out. If the payment will be paid over time, be sure to indicate the interest rate or benchmark (e.g., 1 percent over prime) to be utilized. The terms of the buyout payment may ultimately have an effect on the value of the interest being bought out. A typical valuation is prepared on the basis of "fair market value," normally defined as "willing buyer, willing seller, neither under any compulsion and both having reasonable knowledge of the relevant facts." It assumes a cash transaction.
When valuing a business interest, one should always consider the utilization of a business valuation expert. In the buyout agreement, consideration should be given to the hiring of a professional to value the interest at the time of the buyout. One option is to choose a single professional. The agreement could have a primary and a back up valuation expert appointment clause. Another option is to allow for each party to choose a valuation expert. Further agreement can be made if the two chosen valuation experts differ by more than a certain amount or percentage and agreement of value cannot be reached. For example, a third expert chosen by mutual agreement of the first two experts could either mediate or arbitrate the valuation issue. If the parties cannot agree on who should value the interest, the agreement should name someone who will be responsible for choosing the expert at the time of the buy-out.
Many professionals profess to be able to value businesses. However, only an expert who has demonstrated expertise in the area or is a credentialed business valuation expert holding certification from either the AICPA, NACVA, IBA or ASA should be employed.
If the business or enterprise being valued does not war-rant the complexities of a full valuation engagement, the parties may want to agree to a formula or other valuation method. Again, the parties should retain the services of a valuation expert as a consultant at the time of the drafting of the buy-sell agreement to assist in the choice of formulas or methodologies and any other parameters that should be established. If the entity is a manufacturer, the income approach could be agreed upon. Professional practices need to specify whether the valuation is to consider personal or practice goodwill. If the separation is due to retirement, disability or death, the responsibilities of the exiting partner (or his or her estate) to the continuity of the practice must be specified.
Depending on the type of business involved, the valuation may lend itself to the use of the market approach to valuation, the use of guideline companies for comparative purposes and analysis. If so, the parameters for these calculations, as well as sources that would be appropriate for the analysis, should be set forth in the agreement.
In any buy-sell arrangement the parties should address the issue of a non-compete clause. This is vital to the valuation and additional determination should be made as to how the non-compete agreement is to effect the valuation.
With the utilization of an expert early on, the parties could narrow the areas of valuation that typically are the points of difference. Based on the type of business and its financial structure, an agreement could be reached in the buy-sell as to how a valuation expert is to normalize the company's income for purposes of capitalizing historical income or discounting future returns. The parties should address the adjustments and the basis for adjustments to the financial statements to reach normalized income. Determine a level of reasonable compensation or how it will be determined. Should the valuation expert be capitalizing or discounting earnings before interest, taxes, depreciation and amortization (EBITDA)? What expenses should be considered as ordinary and customary business expenses verses perquisites of ownership?
A model for building a discount rate can be put right into the buy-sell agreement. There are two primary techniques for determining a company's discount rate: the build-up method and the Capital Asset Pricing Model (CAPM) method. The most commonly used method for the smaller, closely held company is the build-up method. The CAPM method requires the utilization of comparative companies, making the method more difficult to obtain and more open for speculation and disagreement.
If the build-up method is to be utilized, determine what information will be used for the risk-free rate, the common stock equity risk premium, the small stock risk premium, and possibly even a guideline for determining the company specific risk. The risk free rate is the return an investor could obtain from a low-risk guaranteed investment. Long-term Treasury bonds are the usual benchmark. The equity risk premium is the extra return earned by an average equity investor. Ibbotson Associates Stocks, Bonds, Bills and Inflation Yearbooks are an excellent source for this data. The small stock risk premium can also be found in the Ibbotson Yearbooks. This measures the difference in risk between a large company and a smaller capitalized company. Finally, the company-specific risk is a subjective determination based on additional risk factors inherent to the specific company being valued such as the company's industry, financial risk and structure, operational characteristics, management structure and diversification of company operations.
A further determination should be made in the buy-sell agreement on how to value non-operating assets of the business. This would include investments, non-operating real estate and any other property, which doesn't have any relationship to the operations of the business.
Further, the parties' position on discounts and premiums should be addressed. Should the business valuation expert be allowed to use a discount for lack of marketability? If the interest being bought out does not have control, should a minority discount or control premium be applied? If so, what should be the benchmark studies or cases utilized to determine the discounts? The IRS, the SEC and various courts have accepted and relied upon a series of restricted stock studies conducted over the past 30 years for the determination of the discount. Again, the use of a valuation expert in analyzing the characteristics of the subject company, relative to the characteristics of the companies cited in the studies to be utilized for determining discounts would be suggested.
While defining the various parameters of the business valuation in the buy-out agreement may seem tedious, costly and unnecessary, the biggest problem encountered when preparing a business valuation is determining the intent of the par-ties in the original agreement. Because the partners are either at odds or one of the partners is no longer available, that task becomes one of great contention.
The seeds of a good ending to the business relationship are planted in the drafting of the valuation clauses in the buy-sell agreement. Spare no time and expense in drafting the agreement and it will be repaid several times over during the valuation - the process will be much easier for those involved and, ultimately, the transaction will be less costly.
