As discussed in the first installment of this article, when a co-owner departs a business, responsibly drafted buy-sell agreements are critical for ensuring that all parties are pleased with the value of their company. There are several types of agreements, all of which have common pitfalls that could lead to shareholder disputes and litigation. The best approach to guarantee an effective buy-sell agreement and avoid costly pitfalls is to use a Process agreement, ask a single qualified, credentialed appraiser to value the business, and value it at least annually. This will ensure that when a triggering event does occur, your buy-sell agreement will be clearly interpreted for fair results.
Process agreements have six defining elements: standard of value, level of value, “as of” date, qualifications of the appraiser, appraisal standards and funding mechanism. Each of these elements has its own pitfalls, which need to be carefully addressed to ensure an effective agreement.
Standard of Value
Every valuation is defined in part by the standard of value. Because there are several types, the agreement should specify the standard used, whether fair market value, fair value, investment value, going concern value, or liquidation value. The fair market value standard is generally understood to follow the IRS definition and is well defined in many publications. If the agreement calls for any other standard of value, the words on the page must be crystal clear. One of the best ways to ensure the standard of value is properly interpreted is to attach an example to the agreement that illustrates the language used.
Level of Value
If the agreement does not direct the experts, they will decide which level of value to use, so it is critical to be clear. Here is a chart that illustrates the optional levels that might be considered.
If the business is to be valued on a strategic control value, the outcome will be very different than if a financial control value is used. Then the question is: does the appraiser consider discounts for marketable or nonmarketable minority levels of value? For example, two appraisers valuing the same company both started out with the same $100 per share for a financial control marketable minority value. The company appraiser decided that a 40% marketability discount should be applied, resulting in a price per share of $60. However, the valuator representing the shareholder decided that the appropriate level of value was strategic control value, and applied a control premium of 40%, resulting in a value per share of $140. These are two very different results, for which both appraisers could find language in the agreement to support their interpretation. If the agreement had clearly stated what level of value to use, there would have been no opportunity for dispute.
“As of” Date
The “as of” date, which is specific to a particular triggering event, is also critical to the appraisal process. This date establishes the time for valuation. However, there are other business issues that ought to be considered as part of the “as of” date that are frequently left open. For example, rights after death, if there are any, may include rights to receive the price in the agreement, collateral, voting and distribution, and other ownership interests in the business.
Qualifications of the Appraiser and Appraisal Standards
The agreement should specify qualifications of the appraiser. There are several terms used, including appraiser, qualified appraiser, licensed general appraiser, investment banker, and accountant. Are all appraisers alike? No. Make sure your buy-sell agreement calls for qualified and credentialed business appraisers to ensure that you receive the most accurate, well-informed appraisal. The most typical credentials are Certified Valuation Analyst (CVA), Accredited in Business Valuation (ABV), Accredited Senior Appraiser (ASA) and Certified Business Appraiser (CBA).
If a buy-sell agreement calls for a funding mechanism that involves some kind of insurance, specifying the intent of the insurance as either a funding mechanism or a corporate asset is key. Is the valuation determined before or after receiving the life insurance proceeds? Is the policy owned by the proper party? These details are critical to the valuation.
So, how can you be sure that your agreement has been drafted responsibly and will result in equity and fairness to all parties? Here’s how: ask a qualified appraiser to prepare a valuation based upon the agreement in place. Ask the appraiser to identify any areas where the agreement could be interpreted differently and what the difference in value would be.
This approach will enable you to:
- Know the value now
- Understand the process of the agreement
- Identify any issues regarding unclear valuation defining terms and allow you to make changes before a triggering event occurs
- Help the parties involved gain confidence in the process and know the value for other purposes, such as estate planning, insurance needs, etc.
Work with your attorney to develop your buy-sell agreement and be sure to contact a business valuation expert during this process to review the agreement and make certain that it will protect your company’s assets in the future. For a free consultation, please contact Royce at (626) 857-7300 or at RStutzman@vicenticpas.com.
Royce Stutzman, CPA/ABV, CVA is Chairman and leader of the Valuation Group at Vicenti, Lloyd & Stutzman LLP, a 59-year CPA and business consulting firm in Glendora. You can hear a recent webinar on effective buy-sell agreements presented by Royce on the Vicenti website at www.vicenticpas.com.
“Co-Owner Leaving the Biz?” Parts I and II originally published by Manufacturing Executive Institute (MEI) at www.mfgexecutive.com.