Guest Post - Valuations for Buy-Sell Agreements

Today’s post is an article written by Chuck Faunce, ASA, who is a Director, Business Valuation and Litigation Services, at Gorfine Schiller & Gardyn in Owings Mills, Maryland. It discusses various approaches to business valuations, which come up when a shareholder or member departs the business and a buy-sell agreement kicks in (often funded by insurance). These valuations are often fiercely litigated in business divorce cases and shareholder disputes, as well.

You can reach Chuck directly at CFaunce@gsg-cpa.com, or 410-517-6843.

Valuations for Buy-Sell Agreements

Buy-sell agreements dictate the terms of transfer for a departing owner’s interest in a company, including a clause that describes how the value of the departing owner’s interest will be determined. These agreements can be triggered by events such as resignation, termination, retirement, death, disability, divorce and personal bankruptcy, and frequently identify a funding mechanism such as life insurance, company cash, or a loan from the departing owner.

They are frequently litigated because the valuation clause disadvantages either the departing or the remaining owners. These valuation clauses can take several forms.

Fixed price: This approach is inexpensive but, as the business matures, the fixed price is likely to significantly over- or under-state the business’s value if not updated regularly. In that case, one side wins but the other side loses.

Formula: This approach is also inexpensive, but as the business matures and capital markets change, the formula is likely to significantly over- or under-state the business’s value if not updated regularly. Once again, one side wins, the other loses.

Shotgun: Using this approach, one party offers to buy or sell, and the other party has to sell or buy under those terms. This approach doesn’t account for differences in the parties’ resources or negotiating positions and again is likely to significantly over- or under-state the business’s value.

Valuation experts can help reduce the potential for conflict by working with the attorneys who draft buy-sell agreements to create a “process” valuation clause.

Process: This approach identifies the calculations necessary to reflect the dynamic nature of the business, economy, industry and capital markets. Best practices suggest that the valuation process should be performed at the time the agreement is signed and then updated at regular intervals, typically every year or two. The initial valuation is more time consuming and expensive than other approaches, but updates are less time consuming and less expensive since the parties are already familiar with the process.

Defining the valuation process allows owners to negotiate inputs to the valuation before the buy-sell clause is invoked. This is the best way to achieve results that satisfy both the departing and remaining owners and thus reduce or eliminate the incentive to litigate. As an added benefit, this process provides business owners with an efficient way to track the value of what may be their most valuable asset.