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Valuations in Divorce Cases Pose Unique Challenges

Business valuations completed in connection with divorce proceedings can be especially complex. Photo by Kelly Sikkema on Unsplash

The South Carolina State Supreme Court weighed in recently on the long-simmering tension between recognized standards of business valuation and the goal of equity in dividing marital assets in divorce proceedings.

The decision In Clark v Clark (Appellate Case No. 2019-000442), addresses the division of marital assets, specifically the valuation of a minority interest in a family business. The Supreme Court reiterated a lower court’s assertion that the applicability of discounts for lack of control (DLOC) and marketability (DLOM) are to be determined on a case-by-case basis, then affirmed one part of that court’s ruling regarding discounts and reversed another.

The Family Business

George and Patricia Clark were married in 1987. During the marriage, Mr. Clark began working for the family business, Pure Country, a manufacturer of custom tapestry blankets and other items. His father founded the business and eventually transferred his 75 percent interest in it to Mr. Clark. A family court determined at the time that the transfer was a gift, and therefore the interest was not marital property. Mr. Clark purchased the remaining 25 percent of the business from his sister. In 2009, he transferred a 25 percent interest to Mrs. Clark. The related stock agreement limited any subsequent sale of that interest to other shareholders, immediate family members or the business.

In 2012, Mr. Clark filed for divorce. Both spouses hired experts to value Mrs. Clark’s interest in the business. The husband’s expert applied a DLOC and a DLOM. In support of the DLOM, she noted that the sale of interests in privately held companies require more time and resources and involve higher transaction costs than do sales of publicly traded interests. She also considered the restrictive language in the stock agreement from the 2009 transfer.

The wife’s expert applied a smaller DLOM, but later argued that the value should not be discounted at all. He did not apply a DLOC.

The family court found the husband’s expert more credible and agreed with her use of discounts. While it did acknowledge the “debate as to whether … discounts should apply in a divorce setting as the business is actually not being sold,” the court recognized that the valuation standard in such cases is fair market value, which assumes a hypothetical transaction between two willing parties. 

Mrs. Clark appealed the decision to the court of appeals, which agreed that a minority shareholder would not have control over the company and therefore upheld the family court’s decision to apply a DLOC, but reduced the size of the discount. The court of appeals rejected the DLOM, noting the husband did not intend to sell the business and relying on a precedent set in Moore v Moore. “To the extent the marketability discount reflected an anticipated sale, Moore deems it a fiction South Carolina law no longer recognizes.” The court found that because the husband did not plan to sell the business, the restriction on transfers of stock was moot. 

The decision compelled both parties to file appeals to the State Supreme Court.

Split Decision

The husband argued that the court of appeals erred in rejecting the DLOM when each party’s expert had applied one. The wife contended that the DLOM should not be considered because a DLOM accounts for the higher transaction costs inherent in a sale of an interest in a private company, and her husband did not intend to sell.

The Supreme Court affirmed the family court’s decision to apply a DLOM and a DLOC and the appeals court’s decision to reduce the DLOC. The decision states that a party’s interest in a closely held company is valued based on its fair market value, which has been well established as “the amount of money which a purchaser willing but not obligated to buy the property would pay an owner willing but not obligated to sell it, taking into account all uses to which the property is adapted and might in reason be applied.”

That said, the court acknowledges the tension between this principle of valuation and “the desire to fairly and justly apportion marital assets.” The court refuses to draw a bright line on the issue, stating that the applicability of such discounts is to be determined on a case-by-case basis.
The Supreme Court’s decision was not unanimous. Two of the five justices issued a dissenting opinion rejecting the application of either discount, stating that “under certain facts, faithful adherence to the concept of fair market value must yield to reality.”

The decision, while not directly applicable to New York cases, speaks to the complexities involved in divorce-related valuations and the need for valuation professionals to weigh competing considerations. If you have questions regarding the valuation issues in a divorce or another context, Advent’s professionals are here to help.

Read the Decision

You can read the rather colorful decision here:

https://adventvalue.com/wp-content/uploads/2020/06/Op.-27969-George-W-Clark-v.-Patricia-B-Clark.pdf

Changes in Bankuptcy Law a Lifeline for Struggling Businesses

Recent changes to U.S. Bankruptcy Law may provide additional relief for some struggling businesses. Photo by Melinda Gimpel on Unsplash

The novel coronavirus pandemic has caused many businesses to temporarily shut down or scale back operations. Slowly, states are allowing businesses to reopen to the public. But it may be too late for some businesses to bounce back. As a result, the number of businesses filing for bankruptcy is expected to skyrocket this summer.

Two recent changes to the U.S. Bankruptcy Code may provide greater relief for small businesses that seek to use the bankruptcy process to reorganize their finances and continue operating. The Small Business Reorganization Act (SMRA) increases access to Chapter 11 for small businesses. The Coronavirus Aid, Relief, and Economic Security (CARES) Act raises the debt threshold that qualifies for this protection. Here’s what small business owners should know.  

SMRA Basics

Effective on February 19, 2020, the SMRA creates a new subchapter (Subchapter V) of the Bankruptcy Code. To be eligible for relief under Subchapter V, a debtor, whether an entity or an individual, must have total debt not exceeding $2,725,625 (subject to adjustment every three years). The SMRA contains provisions for the following key improvements:

Streamlined reorganizations: The new law will facilitate small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor will be able to propose a plan of reorganization. Plus, the debtor won’t be required to obtain approval or solicit votes for plan confirmation. Absent a court order, there will be no unsecured creditor committees under the new law. The new law also will require the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.

New value rule: The law will repeal the requirement that equity holders of the small business debtor must provide “new value” to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory and “fair and equitable.” In addition, similar to Chapter 13, the debtor’s entire projected disposable income must be applied to payments or the value of property to be distributed can’t amount to less than the debtor’s projected disposable income.

Trustee appointments: A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. The revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.

Administrative expense claims: Currently, a debtor must pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the new law, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.

Residential mortgages: The new law eliminates the prohibition against a small business debtor modifying his or her residential mortgages. The debtor has more leeway if the underlying loan wasn’t used to acquire the residence and was used primarily for the debtor’s small business. Otherwise, secured lenders will continue to have the same protections as in other Chapter 11 cases.

Discharges: The new law provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge relieves the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain nondischargeable debts.

CARES Act Provision

In addition to the improvements under the SMRA, Congress decided to temporarily increase the debt ceiling for eligibility to $7,500,000 from $2,725,625 for new Subchapter V cases filed between March 28, 2020, and March 27, 2021. Thereafter, the debt limit will revert to $2,725,625.This change will make more small businesses eligible for Chapter 11 in the midst of the novel coronavirus crisis. However, the CARES Act permanently eliminates the eligibility to file for Subchapter V relief for any affiliate of a public company.

We Can Help

Businesses contemplating bankruptcy often benefit from the input of an experienced business valuation expert. Specialists with experience in accounting, valuation and mergers and acquisitions can help assess the severity of the financial crisis, determine whether liquidation or reorganization makes sense, and provide financial insight on everything from selling assets to shareholder disputes. Contact one of Advent’s business valuation professionals to facilitate the bankruptcy process and, if possible, get your business back on track.

© 2020, Powered by Thomson Reuters Checkpoint 

AICPA Issues FAQs for Valuing Distressed or Impaired Businesses

In light of the coronavirus pandemic, the American Institute of Certified Public Accountants has offered new guidelines for valuing distressed or impaired businesses. Photo by Matthew Henry from Burst

The American Institute of Certified Public Accountants has issued new guidance regarding the valuation of distressed or impaired businesses.

The guidance, which is presented as responses to frequently asked questions, distinguishes between distress, which may be a temporary condition, and impairment, which is usually permanent. The FAQs address the application of valuation adjustments and other considerations related to the coronavirus crisis.

The AICPA highlights both the perils of failing to consider the many implications of the pandemic and the risk of overcompensating for the effects of such an unprecedented event. In addition, it notes that the pandemic may have positive implications for some businesses, such as those that are able to increase market share as weaker competitors crumble.

You can read the AICPA’s guidance here: https://www.aicpa.org/interestareas/forensicandvaluation/resources/businessvaluation/faqs-on-valuation-considerations-for-distressed-or-impaired-businesses.html

Are Your Company’s COVID-19 Losses Covered?

Business interruption insurance may provide some relief to owners forced to close their businesses because of the COVID-19 pandemic. Photo by Alexander Kovacs on Unsplash

The restrictions put in place to stop the spread of COVID-19 – such as limiting crowd size, closing restaurants and bars and canceling sporting events – are critically stressing many businesses.

One possible form of relief to this financial crisis is insurance coverage, including business interruption and contingent business interruption coverage. Business interruption insurance (also known as business income insurance) is a type of insurance that covers the loss of income that a business suffers after a disaster.

The loss of income covered may be due to disaster-related closing of the business facility or the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.

However, there are likely some hurdles to obtaining coverage based upon disruption from COVID-19. For example, a typical business interruption provision reads:

“We will pay for the actual loss of business income you sustain due to the necessary suspension of your ‘operations’ during the period of ‘restoration.’ The suspension must be caused by the direct physical loss, damage, or destruction to property. The loss or damage must be caused by or result from a covered cause of loss.” 

A “direct physical loss” has been held to exclude economic losses unaccompanied by a distinct and demonstrable loss of the physical use of the business property. Furthermore, after the SARS epidemic in the early 2000s, insurance companies began to exclude viral outbreaks from typical coverage, though exclusions for losses in connection with viruses may not be ironclad.

Coverage depends on the particular policy, and a policy review may prove useful. Not all insurance policies are identical in the coverage they provide.

You will likely find that more expensive policies often provide better coverage than lower-cost policies. Also, coverage for COVID-19 related losses might be contingent on whether the policy provides business interruption coverage as a basic term of the policy or as an endorsement. An endorsement will often provide broader coverage than the base policy because of the additional premium for the endorsement.

Insurance companies will certainly oppose paying business interruption losses in connection with COVID-19, though with advice from your insurance broker and/or attorney, filing a claim may be a good first step. In addition to filing the claim, Advent believes business owners ought to:

  • Analyze your policy and review the law. Don’t be afraid to consult your company attorney if you have questions. For example, if the policy does not adequately define “physical damage” (which can be required to recover business interruption losses) and that term presents ambiguity in the specific context of your company’s loss, you may be covered. 
  • Make note of virus exclusions. One can imagine this law is undeveloped and there is not clear precedent on coverage. Also, some policies may contain civil authority provisions, which could offer coverage for losses suffered in connection with government-ordered shutdowns.
  • Stay informed regarding legislative developments and any other pertinent changes. Finding every possible basis for recovery under your business’s policy will only enhance any potential recovery.

To learn more about the quantification of lost profits, please contact one of the experienced professionals here at Advent.

The Difference Between Price and Value

Photo by Mackenzie Marco on Unsplash

When a business is sold, it often sells for more (or less) than the appraised value. This may come as a surprise to laypeople, but valuators understand that there are many valid reasons that “price” and “value” may differ. Businesses that understand this subtlety are better positioned to make informed decisions.

Price is specific to an individual buyer and seller. It’s the amount of cash (or its equivalent) for which anything is bought, sold or offered for sale. It requires an offer to sell, an acceptance of that offer and an exchange of money (or other property). Some strategic or financial buyers may be willing to pay more than others because they can benefit from economies of scale or synergies that aren’t available to all potential buyers.

The term “value” often refers to “fair market value” in a business valuation context. The International Glossary of Business Valuation Terms defines fair market value as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Fair market value is essentially a consensus of what the universe of potential buyers would agree to pay for a business, a business interest or an asset. In the real world, sales may occur for more (or less) than fair market value, because the individual parties have their own perceptions of the investment’s risk and return, are under duress to buy (or sell), or lack relevant knowledge about the transaction or the subject company.

Another reason that value and price frequently differ is timing. In many cases, a valuator’s work is done months or years before the company is sold. Differences in market conditions or the company’s financial performance between the two dates could cause the company’s selling price to vary from its appraised value.

Real World Example

To illustrate how price and value may differ, consider the sale of a medical practice. There are primarily three potential buying groups for medical practices:

  • Another physician,
  • A physician group, or
  • A hospital.

To determine fair market value, a valuator would consider potential transactions to purchase the practice by all three of these groups, under the cost, market and income approaches. But in the real world, only one specific buyer would make an offer. So, for example, the analyses involving a physician or physician group wouldn’t be relevant if a hospital is buying the practice.

Price and Value Aren’t Synonymous

It’s critical for buyers and sellers to understand that the appraised value of a business interest may not reflect its future selling price. Value can vary substantially, depending on the effective date and the purpose(s) specified in the appraiser’s report.

When the purpose of a valuation is to establish an asking (or offer) price, valuators may provide a range of values that considers various buyers and transaction scenarios. This range can help a buyer and seller arrive at a reasonable selling price that’s based on the individual parties’ expectations of risk and return.

If you’re planning to buy or sell a business interest, the professionals at Advent Valuation Advisors are here to help.

© 2020, Powered by Thomson Reuters Checkpoint

Considering a Business Acquisition?

You wouldn’t perform a surgery on yourself. The same holds true when buying a business. Unless you’re well-versed in performing a comprehensive financial analysis of a business, it doesn’t make sense to buy one without using a due diligence and valuation specialist. A due diligence report:

  • Verifies the accuracy of the seller’s information.
  • Outlines a detailed understanding of the business.
  • Contains vital information that can be used for negotiating the transaction, obtaining financing, establishing the tax and accounting basis of the assets, and integrating the acquired entity into the buyer’s business.

Most of all, due diligence identifies possible deal-breakers. A seller may “prepare” a business for sale, making it look better than it really is, in order to obtain a higher price. A professional due diligence review guards against the overstatement of assets and understatement of liabilities. It also provides an analysis of historic earnings and the likelihood that forecasted operations can be met.

One crucial, but often overlooked, part of due diligence involves the tax consequences of the proposed transaction. Depending on the operating structure of the acquiring company and the target (for example, a C corporation, S corporation or partnership), it may be better to receive assets versus stock. Keep in mind that a badly structured sale can result in a tax disaster.

Contact Advent Valuation Advisors to learn how due diligence can keep a sale from resulting in costly errors.

© 2020, Powered by Thomson Reuters Checkpoint

Understanding the Terms of Engagement

When you need to know how much your business is worth, one of the first questions to ask is, how much work – and how much expense – will it take to get the job done?

In many circumstances, a comprehensive valuation is required or preferred. Sometimes, however, a relatively straightforward, and less costly, calculation of value may be sufficient. The purpose of the valuation will often dictate the scope of work that is appropriate.

Both the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA) have defined the scope of various assignments used to value a business, business ownership interest, security or intangible asset. In its Business Valuation Standards, The American Society of Appraisers (ASA) defines three types of engagements:

  • An appraisal engagement is the most comprehensive. It considers all relevant information as of the appraisal date and results in the expression of an unambiguous opinion of value, which is supported by all procedures the appraiser deems relevant.
  • A limited appraisal engagement is based on consideration of limited relevant information and limited procedures deemed necessary by the appraiser. It results in an estimate of value.
  • In a calculation engagement, the appraiser and the client may agree on the procedure or procedures to be performed. The appraiser collects limited information, performs limited procedures and provides an approximate indication of value.

The American Institute of Certified Public Accountants defines two types of engagements:

  • In a valuation engagement, the valuation analyst applies the approaches he or she deems appropriate. The result is a conclusion of value.
  • In a calculation engagement, the analyst and the client agree ahead of time on the procedures the analyst will perform, and these procedures are generally more limited than in a valuation engagement. The result is a calculation of value.

A full appraisal or valuation engagement will generally result in the production of a comprehensive report that describes in detail the procedures performed, while a calculation may result in an estimate, with limited additional information provided to the client. In any of the engagements described above, the resulting value may be a single amount or a range.

So, how does a business owner determine which type of engagement is appropriate?

The right tool for the job

There are times when a calculation may be sufficient. For instance, a small business owner who receives an offer to sell his or her business may simply want to gauge the fairness of that offer. According to the AICPA’s Statements on Standards, a calculation engagement also may be acceptable when acting as a neutral party in a dispute. For a matter involving the IRS or the Tax Court, a full valuation resulting in an opinion/conclusion of value is generally preferred.

The use of calculations in court matters has become a contentious matter. In a piece in the November 2019 issue of Business Valuation Update, Michael Paschall, an accredited senior appraiser and attorney, criticizes a phenomenon he terms “calculation creep,” the increased use of calculation engagements in litigation settings.

He claims the “incomplete and potentially biased aspects of calculation engagements represent a dumbing down of the valuation process and profession,” and calls on the governing bodies in business valuation to bar calculations for litigation, ESOPs, IRS purposes “or any other context where a reliable opinion of value is needed or third-party reliance is present.”

In Hanley v. Hanley, a case decided in June 2019 in New York State Supreme Court in Albany, the court rejected a value calculation produced by an accountant retained by one of the parties. The decision cites several concerns, including questions about the independence of the valuation professional and the lack of documentation in the valuation report, which did not describe the limited procedures or approaches used in the calculation.

At the end of the day, any valuation is only as credible as the professional who renders it. The judgment of the valuation professional is a key ingredient in every phase of the assignment, from determining the appropriate scope to selecting the best methods, reconciling the results of different procedures and, ultimately, deriving the indicated value.

Advent’s valuation professionals can walk you through the process and help you determine what type of engagement will best meet your goals.

Recession, Election Fears Weigh on Values

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Business brokers say fear of a recession and uncertainty over the upcoming presidential election may be driving down business valuations, according to the third-quarter edition of Market Pulse, the quarterly survey of business brokers conducted by the International Business Brokers Association and M&A Source.

Fifty-three percent of business brokers surveyed cited the prospect of a recession as the biggest concern affecting U.S. business valuations, followed by the presidential election and the trade war with China.

“Small business owners are worried that a recession is coming, and trade issues are causing volatility. All that nervous energy means buyers are dialing back a bit – particularly on the smaller market deals.” said Craig Everett, PhD. Everett is director of the Pepperdine Capital Markets Project at the Pepperdine Graziado Business School, which compiled the survey results.

The national survey is intended to capture market conditions for businesses sold for less than $50 million. It divides that market into three classes of main street businesses with values of $2 million or less, and two lower middle-market ones in the $2 million to $50 million range.

The survey found that businesses selling for $5 million to $50 million garnered a 9 percent premium over asking price during the third quarter, while the smallest main street businesses, those worth less than $500,000, sold for just 85 percent of asking price, the lowest percentage in four years.

Scott Bushkie, managing partner of Cornerstone Business Services, told Market Pulse that falling business confidence has slowed the activity of the individual buyers who account for most main street business acquisitions.

“Confidence always gets shaky as we enter an election season,” said Bushkie, whose firm has an office in Iowa, where the first caucus of the 2020 presidential campaign will be held February 3. “There’s this general escalation of reports pointing out economic weaknesses and policy flaws, and people sometimes internalize that negativity. I think we may be feeling that even earlier than normal this time around.”

Seller financing

Market Pulse found that sellers provided roughly 10 percent of the buyer’s financing in deals that closed during the third quarter. Earn-outs and retained equity were less common.

“Lenders always like to see sellers keep some skin in the game,” said Justin Sandridge of Murphy Business Sales-Baltimore East. “When sellers aren’t willing to finance any of the purchase price, that sends warning signals to buyers and lenders alike. Refusing to provide seller financing is like holding up a giant ‘no confidence’ sign, and it’s likely to scare other parties away from the deal.”

Market Pulse’s third-quarter survey of 236 business brokers and M&A advisors was conducted from October 1-15. The respondents reported completing 210 transactions during the third quarter.

Price Multiples Decline During Third Quarter

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Small business sales during the third quarter of 2019 yielded EBITDA multiples about 26 percent lower than a year before, according to the latest edition of DealStats Value Index. It’s one of several developments noted in the report that point to an emerging buyer’s market.

The median EBITDA multiple – the ratio of selling price to earnings before interest, taxes, depreciation and amortization – slid to 3.7 for transactions completed in the third quarter, down from 4.0 during the preceding quarter and the peak of 5.0 reached during the third quarter of 2018. The EBITDA multiple during the third-quarter of 2018 was the highest quarterly mark since at least 2013.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the business being valued.

Over the longer term, DealStats notes that EBITDA multiples have generally trended downward since 2017, falling to a six-year low in 2019.

It’s important to bear in mind that DealStats data only reflects transactions reported to the service, and the data is subject to revision as additional sales are reported. For instance, the median EBITDA multiple for the April-June quarter was initially reported as 4.2. That was revised to 4.0 in the latest report. The spike to 5.0 during the third quarter of 2018 was previously reported as 4.4 and 4.5.

The delays in reporting may limit the value of information regarding trends gleaned from the quarter-to-quarter gyrations of multiples.

EBITDA margins decline

Businesses sold in 2019 have tended to be less profitable than those sold in recent years, according to the DealStats data. The median EBITDA margin (measured as a percentage of revenue) was just below 11 percent during the third quarter, up slightly from the second quarter, but down from 12 percent in the first three months of the year. EBITDA margins have generally trended lower since 2013.

A long time to sell

Businesses are taking longer to sell, according to DealStats. The median number of days for private businesses to sell was 221 for deals closed during the first half of 2019. That marked the fifth straight half-year period (dating back to the first half of 2017) where the median exceeded 200. From 2013 to 2016, the median never topped 200 days.

Revenue multiple falls

DealStats reports that the median sale price-to-revenue multiple this year is 0.45, down from 0.49 in 2018 and the lowest multiple in at least a decade. Businesses in the finance/insurance sector garnered the highest multiple, at 1.75, followed by information at 1.70 and professional, scientific and technical services at 0.89.

The highest EBITDA multiple was noted in the information sector, at 11.1, followed by mining, quarrying and oil and gas extraction, at 8.5. The lowest multiple was 2.6 for the accommodation and food service industry.

Business valuation professionals use transactions such as those collected by DealStats to derive a business’s market value. If you have questions about how comparable sales influence the value of your business, or how much your business is worth, please contact us.

Buy-Sell Agreements: What You Should Know

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For many of our clients, their investment in their business is the most significant financial asset they own. Many are baby boomers (individuals born between 1946 and 1964) who have reached or are approaching the transition from working to retirement. As that transition occurs, their small or medium-sized businesses will be sold or otherwise passed on to the next generation of owners.

It is often during these times of transition that the importance of buy-sell agreements becomes evident. Buy-sell agreements spell out the terms for transferring an interest in a business upon the death or departure of an owner. The time to create such an agreement is not during a transition, but rather at the start, when all of the owners are involved and an orderly transition can be planned. In our role as appraisers, we have seen many clients who either don’t have a buy-sell agreement or whose agreement simply doesn’t work as the shareholders expected.

As a shareholder, ask yourself three questions:

  1. Do you have a buy-sell agreement?
  2. Do you know what your buy-sell agreement says?
  3. How is your buy-sell agreement funded?

Even in companies that have agreements in place, we often find that they are not current, have a price determination that isn’t fair or workable for all parties, or lack funding arrangements for events that trigger a transfer. These situations can result in protracted litigation or even the demise of the business. If you have a buy-sell agreement, it may be time to review it.
The four most common ways that business owners exit their privately held businesses are a sale to a third-party, gifting ownership interests to family members, selling to employees and liquidating. Buy-sell agreements can provide guidance in all of these situations. Read your agreement to see if the language delivers the results you desire in each situation. 

A review of your agreement should focus on three key areas: triggering events, pricing and funding.

Triggering Events

The agreement should define the transfer process for triggering events such as shareholder retirement, termination of employment, death, disability, sale, divorce and bankruptcy.

Pricing

Transaction prices in buy-sell agreements are usually defined by a fixed price, a pricing formula or an appraisal.

Fixed prices are easy to understand and easy to set initially, but may be difficult to reset as time passes and interests diverge. The provisions are rarely updated, and inequities are likely to result.

Formula-based pricing provides a mechanism to update the value based on various metrics in the business. However, a formula selected at a point in time rarely provide reasonable and realistic valuations over time. Changes in companies, industries and the local and global economies may impact the true value of an enterprise relative to any set formula. And formulas may be subject to multiple interpretations.

If appraisals are used, all parties will understand the valuation process from the start, and they’ll know what to expect when a triggering event occurs. Appraisers can incorporate key business drivers and risks into the determined value. Periodic appraisals provide a mechanism for keeping a buy-sell agreement up to date, so that all parties know the current value of the business and their interests. An updated valuation provides valuable information for business and personal financial planning, as well.

We recommend clients consider appraisals of their businesses. Though this comes at an additional expense, owners should make the small investment to understand what their business is worth with an annual or periodic valuation. They will potentially save much more in litigation or exit costs later.

Funding

The buy-sell agreement should spell out how transactions will be funded in situations where the company buys shares back from shareholders. Management’s plan should spell out several key points:

  • Who will buy the shares? Other shareholders, the company or a combination?
  • Should the company hold life insurance to fund share purchases if an owner dies?
  • What are the terms of the transaction (down payment, interest rate, security)?
  • Are there any restrictions on share payments under the company’s loan agreements?

We have seen a variety of other deficiencies in buy-sell agreements. Some lack the signatures of current shareholders. Others have not been updated for several years. In others, the level of value is not identified.

As you can see, there are a number of issues which, if handled poorly, could result in your buy-sell agreement creating as many problems as it solves. Used properly, the buy-sell agreement is a great tool to provide guidance for all kinds of triggering events that affect shareholders. We encourage you to discuss these matters with shareholders and your attorney. If you are in need of a current appraisal, please call us.