One of our primary professional areas is litigation support. Within the area of litigation support we are often asked to value a partner’s interest in a business. Within this area we have to look at the existing Partnership Agreement that brought these business partners together in the first place. Within the context of the Partnership Agreement, the biggest mistake we see is not developing a proper process within the buy-sell section of the agreement to establish the company’s value.
Recently I read Unlocking Private Company Wealth by Z. Christopher Mercer, ASA, CFA, ABAR and wanted to share some of the information regarding the typical methods used in a buy-sell agreement to establish price and why they are not all created equal.
A Fixed Price Buy-Sell Agreement.
Under this type of arrangement the owners need to agree on the price for their interest in the company at a point in time. This is easy when you set the price the first time, but over time becomes a problem because values can go up or down and the company, owner’s circumstances and market conditions can change. Upon a triggering event the agreed upon price may be higher than current value. If this occurs and you were the remaining partner after a death you would overpay for their shares. If the price was lower than the current business valuation and an event occurs that triggers the agreement, you or your estate will suffer from a low price while others benefit.
As time goes by the price that was agreed upon may not be representative of what the fair market value is for your interest in the company.
A Formula Buy-Sell Agreement.
The formula buy-sell agreements use a formula(s) to establish the price of transactions once a triggering event has occurred. The biggest issue with the formula approach is that it does not take into consideration the changes in the economy, financing, industry or the company. Devastating results can occur when a formula does not allow for adjustments that would usually have a small impact on value, but can have the opposite effect if the adjustments are not made. If adjustments are necessary, who decides on what adjustments are acceptable or not acceptable? When partners are at the final bargaining table for their member interest you have people who want opposite results from the application of the formula. This is a disaster waiting to happen.
Multiple Appraiser Buy-Sell Agreement.
In this scenario the buy-sell agreement requires both parties to select an appraiser. This method has been called the baseball valuation method. (Who’s on first?) You now have two appraisals. Generally speaking, if the two appraisals are within 10% of each other, the values are often averaged together. More often than not, the values are greater than 10% apart. This may require a third appraiser to value the company. This third appraisal may be the final value price or may be averaged with the values of the original two appraisals, depending on the verbiage in the buy-sell agreement. This, coupled with legal fees, creates a very litigious and expensive way to value your company when there is a triggering event.
Single Appraiser Buy-Sell Agreements.
This is the single best way to address the value of the company. In this scenario all parties would agree upon the background, experience and credentials of the appraiser. The ideal time to do this is when drawing up the buy-sell agreement. The appraiser would provide a rough draft of the valuation to all parties of the buy-sell agreement. This allows a chance for all parties to discuss revisions and make comments. When the appraiser has reviewed and processed all comments the final conclusion of value becomes the price in the buy-sell agreement. It is important for the appraiser to perform a revaluation annually, or within two years at the most.
If a triggering event occurs, that may also require a revaluation depending on how much time has passed since the last revaluation was performed and the agreed upon conditions stated in the Partnership Agreement.
With this process there is little room for disagreement between the parties; therefore alleviating almost all of the problems mentioned previously.
If you currently have a buy-sell agreement and you are not aware what will happen when you have a triggering event, I encourage you to discuss this with your partner(s) and revise your agreement to include the single appraiser process discussed here.
When looking for a qualified appraiser to discuss your partnership valuation issues don’t hesitate to call Matt at Analytic Business Appraisers, LLC. He can be reached at 480-857-7449.