Many business valuations are done to facilitate the transfer or sale of a business. The terms and valuation of internal transfers are often dictated in the buy-sell agreement. This is a common contract in businesses that have more than one owner. The problem is that often this key document isn’t updated to address changes in ownership or business fundamentals. Too, it often contains flawed language that can severely disadvantage one side at the expense of the other.
I recently appraised a company which had a controlling valuation close to $42M. Two partners each owned 50% of the company. The partners were on good terms and one was wishing to buyout the other. I requested the buy-sell agreement, but the client said that no such document existed. I proceeded on that basis.
As I was close to finishing the project, the client emailed me a copy of a buy-sell agreement executed thirty-five years ago! I read through the details. The document called for the purchase of company shares to be book value. Book value is not a recognized standard of value; it’s a pure accounting construct (the historical cost of assets minus liabilities is book value). The company’s book value was less than $1 million dollars! That’s not a typo: $42M vs $1M. Which side of the deal would you take? Not only had the owners and officers not been aware of the document’s existence, they had no idea of the potential ramifications!
LEGAL PRECEDENT: In the Estate of Cohen v. Booth Computers, the buy-sell agreement used a valuation formula: “net book value, plus $50,000, on the most recent financial statement.” Upon Cohen’s passing the formula generated a value of $178k. Cohen’s heirs had an appraisal performed at over $11M! In court, the New Jersey Appellate, cited the agreement as a legally enforceable contract, and upheld the terms of the agreement at $178k.
This highlights a couple issues: a buy-sell agreement is a legal document drafted by attorneys. Attorneys are not valuation professionals and therefore they may inadvertently omit or misstate key language that can have very real dollar repercussions. And, the valuation profession has evolved greatly over the past 10-20 years, which serves to exacerbate the issue of omission and misstatement. Too, overly simplistic valuation provisions in the contract can create large discrepancies with real world market values.
Fortunately, in my case the partners were committed to a fair and reasonable deal and they had the old buy-sell repealed and a new agreement executed. But what if one member had died first? How do you think the heirs, spouses, and their respective attorneys would have resolved the conflict with over $40M at stake?
I often get calls from owners who started businesses with partners on a handshake, without getting a buy-sell established. They are now in conflict with no easy, or cheap way out. If it’s worth doing, it’s worth doing right. For this same reason, I always advise owners and their advisers to review key corporate documents periodically. It’s much easier to make changes or updates BEFORE an event occurs that creates an inherent conflict between a buyer and a seller!
Jerry Matecun helps business owners to discover key planning and investment considerations vital to build and protect the value of your business and personal assets. For a no cost, confidential conversation regarding your business valuation and exit plans call or email Jerry at 949-273-4200, 616-499-2000 or firstname.lastname@example.org.