08 Aug What is Your Business Worth?
Valuation in Buy-Sell Agreements
A partnership with four owners that I began working with recently had forwarded me their partnership agreement. The agreement was 15 years old and they had never had it updated.
They asked me to help them prepare a new and revamped buy-sell agreement to better protect themselves from life events like death, disability, divorce, or if one of the partners wanted out in the future.
In looking at the agreement, I see what I see so many times in these situations. The buy-sell agreement appeared to be a cookie-cutter template. The agreement was not customized to the business. To the uninformed, it might look sufficient.
But I knew the truth.
As a lawyer who cut my teeth arguing in court over business disputes and partnerships gone wrong, I saw holes everywhere in the agreement.
The problem with this cookie-cutter approach is that every business is different. Not adequately addressing certain areas, like what the business is worth, can be as detrimental as not having an agreement at all.
Since valuation is one of the areas in buy-sell agreements that I find is most often overlooked, let’s take an overview of this critical aspect of your business.
Why Is Business Valuation So Important?
It is all but certain your business will undergo a buy-sell (a/k/a transfer) event in the future. Whether it is death, disability, divorce, or departure of an owner, one of these is going to impact your business eventually. Due to this inevitability, it is paramount that the owners agree to a procedure for determining the value of their business and their equity in the business when preparing a buy-sell agreement. This is because, at that point in time, no one knows who will be a buyer and who will be a seller under the buy-sell agreement. Therefore, it is in everyone’s mutual best interests to clearly define how the business will be valued, who will value it, and the procedure that will be followed in making that determination.
Failure to do this could seriously affect you or your heirs financially.
Common Valuation Methods
Four common valuation methods include:
(1) the set price method,
(2) the book value method,
(3) the formula method, and
(4) the appraisal method.
Each method has its pros and cons as you’ll see below.
Set Price Method
The first method is the set price method. The owners usually attach a schedule to the back of the buy-sell agreement that has the value on it.
A lot of template-type buy-sell agreements that I see have this valuation method. At first glance, it may seem fair. You and the partners all agree on a valuation number and that’s what you put in your agreement. Simple and easy, right?
Here are the problems:
True Valuation Is Often More Involved Than The Owner Thinks. Valuing businesses is its own profession today. There are multiple certifications and there a businesses that focus solely on valuations. There’s a lot to know. It may be counterintuitive, but just because you are the owner of the business does not mean you are a good judge of its value. Valuing businesses and business interests involves complex market knowledge and financial and tax considerations. In my experience, most owners have very little idea of the true worth of their business. I’ve seen wrong answers vary from way too low to way too high. The bottom line is that very few owners should attempt to set their own prices in a buy-sell agreement without the assistance of a qualified business appraiser.
Keeping the Value Updated. To keep up with changing business conditions, the set value should be updated by mutual agreement of all partners every year or every other year at the latest. A big problem is that owners often forget to update the value until something happens to trigger the buy-sell agreement, which is too late. By the time of the triggering event, the set value favors either the buyer or the seller depending on whether the agreed-on price is too high or too low.
Formula Method
If you are going to use the formula method, it is a wise idea to pay a competent and qualified business appraiser to design the valuation formula for your particular business.
Then, and this is critical . . . .
Have that business appraiser perform an actual valuation of the entity to show you exactly how the formula will work with real numbers before a triggering event occurs.
Heed this warning: If your business changes through expansion or contraction, then your formula likely needs to be revisited and reworked. I’ve seen some nightmare stories of valuation formulas that have generated a zero or even a negative number, so beware!
If your business is cyclical and is susceptible to feast or famine years, you should think twice about using the formula method. It could significantly overvalue or undervalue the business.
Other important things to think about with formula valuations: What base will you use to calculate the multiple (e.g. six times earnings)? Will you use net income? Net income before or after owners’ salaries and perks? Or will you use income before depreciation, income, and amortization? Tread carefully . . . Each of these earnings figures could produce wildly different results.
Book Value Method
The book value method may be enticing because it is simple, easy to understand, and you don’t need to spend money on an appraisal. But beware. Book value of a business often is far less than fair market value. One notable example is a 2013 New Jersey case where the court upheld a company’s book value even when the company’s fair market value was approximately 60 times greater (!!!) than the book value. Despite that gulf of a discrepancy in value, the court held that the company’s buy-sell agreement that required the usage of the book value method was clear and unambiguous. The court stood firm in holding the parties to the agreement they had entered into.
Appraisal Method
It is my experience that the appraisal method is the fairest to all parties. Unfortunately, the downsides to this method are that it is more expensive and at least one of the owners will probably not like the value reached by the business appraiser.
But despite its apparent expense, I believe the appraisal method can actually save the business and owners money in the long run. If there is litigation regarding the valuation of the business, that litigation is usually multiple times more expensive than getting a qualified business appraisal at the outset.
If you choose the appraisal method, your work is not done. Your buy-sell agreement should specify who picks the appraiser (e.g. Do the owners all agree on one appraiser or does each owner have the right to pick her own appraiser?). Also, if each owner picks her own appraiser, what happens if the appraisers’ valuations are vastly different from each other? A well-crafted buy-sell agreement should specify how these occurrences will be resolved.
Get Clarity Now
With valuation, if you wait until a triggering event to try and figure out what your company is worth, it’s too late. If you are not sure what your company is worth and you don’t have a sound way to figure it out, now is the time to get clear on it.
