Valuation Considerations in Shareholder Agreement Calculations
My lease is up in December of this year, and I decided for the first time to sell some of my belongings to ensure an easy move. When I was writing the description for my couch I was incredibly detailed – listing the dimensions, color, fabric type, condition and, of course, the price desired. I wanted to make sure the buyers knew exactly what was on the table to avoid any potential miscommunications. (It worked!)
In a way, this is similar to when a company drafts a buy-sell agreement. These agreements are created to ensure a smooth transfer of ownership when a shareholder exits the business. These agreements are designed to avoid shareholder disputes over the buyout price of the company. However, a poorly executed agreement could have the opposite effect, leading shareholders to significant disagreements and costly, time-consuming litigation. In general, buy-sell agreements follow one of three approaches in determining the transaction price for an ownership interest:
Appraisal – A valuation of the ownership interest prepared by a third-party valuation expert.
An appraisal provides the most accurate value by considering the current status of the business, industry and economy as of the selected valuation date. While an appraisal will generally provide the most technically accurate and defensible valuation conclusion, the process of valuing a business can be complex and expensive. Shareholders can cut down on costs by keeping clear and detailed financial records or by selecting modified methodologies to be applied in the appraisal. The agreement can also limit exposure to potential disputes if it defines a set of guidelines for hiring a third-party valuation professional. If you are designing an appraisal-based buy-sell, you should consider consulting a credentialed valuation professional to determine all viable options.
The major drawbacks to the next two approaches are their inability to reflect changes in the company’s value over time and changes in the industry and economy. These limitations often lead to unreasonable results (i.e., a transaction price that is not reflective of fair market value) and disagreements on value. These approaches may also differ materially from the value determined in an appraisal.
Formula – The owners determine the value of the company based on a stated formula.
The formula could be based on revenues, EBITDA, net income, book value1 or other financial metrics. This approach is simpler and less expensive to implement when compared to the appraisal approach. However, if the initial formula is not reasonable, the valuation results are likely to continue to be unreasonable in future years. It is advisable to periodically refresh the formula to ensure it reflects the current business environment.
Agreed-Upon Price – An agreed-upon value of the company determined by the owners based on a stated time interval.
If the owners can agree on a value, this approach is simple to apply and the least expensive to execute. However, the price will likely become stale over time and will require updates, which may not be as easily determined by the parties. As the stated price becomes stale, it will also likely move away from fair market value, resulting in one party overpaying or underpaying. As you might expect, such scenarios often end up in litigation.
Whether you’re selling your couch or your more highly valued ownership interest, it is best to be prepared to ensure an agreeable and stress-free sale. The buy-sell agreement is easily forgotten at the consummation of a business partnership, but it is important to consider it as your business evolves and nears the point of ownership succession.
Based on the pros and cons of the primary approaches above, below are some helpful tips to consider:
- Consult a credentialed valuation expert when drafting your buy-sell agreement.
- Avoid imprecise language; clearly define the valuation provisions (including the standard and level of value).
- If possible, utilize the appraisal methodology for the most accurate value.
- If you choose to utilize the formula or agreed-upon price approaches, be sure to frequently review and refresh those provisions.
- Book value typically measures assets on a historical basis, which may not be reflective of the current value of company’s or it’s fair market value.