An attorney asked me a question the other day: What is the best way to structure the valuation portion of a buy-sell agreement? It's a fair question, the answer to which may be useful to more people than just him.
I've seen the valuation portion of buy-sell agreements set up in different ways. Some versions I've seen (although there no limit to the creativity that can be employed here) include setting a fixed price, using book value or adjusted book value, using some sort of formula (such as a multiple of sales or EBITDA), or requiring an appraisal. There are pros and cons to each method, and I examine such from an appraisal perspective below.
Fixed Price: The pros of this method are that it's easy to implement and it's generally a low cost approach. The downside is that this method is typically the least fair way of determining the value of an interest in a company. Value changes over time, in both directions, and by setting a single price, someone's going to get taken advantage of. I would avoid this method at all costs, but if you decide to structure it this way, put a clause in to reset the fixed price value regularly, preferably no less than once a year.
Book Value, or Adjusted Book Value: Again, this is an easy and low-cost method to implement, but still not the optimal approach, in my opinion. The problem with book value is that it rarely corresponds to the actual value of a business. In certain situations, such as with asset holding companies, or professional practices, an adjusted book value approach can make some sense. However, you must be certain that the operations and direction of the company won't change over time, because if it does, it can lead to negative results.
Using a Formula: Formulas can be useful and are fairly easy to implement. Some industries, have rules of thumb that have been used for the determination of value in a buy-sell. The problem I see with this type of method is where the way the company evolves over time can change whether the formula still makes sense. For example, suppose a rule of thumb suggests a value of one times the company's gross revenues. However, if 5 years down the road, a change in operations results a company with relatively high revenues and very low relative cash flow, it makes the formula approach difficult to implement fairly.
Requiring an Appraisal: This is typically the most expensive approach because it requires the company to spend money on a professional. However, an unbiased valuation professional can determine a value that is most likely the most fair to all parties involved. Admittedly, as a business appraiser, this method has the potential to benefit me the most. However, in a lot of ways it makes sense to just get it done right rather than trying to get by on the cheap and get it wrong.
So really, what is the best approach? When all is said and done, in my opinion the best way to implement the valuation portion of a buy-sell agreement is to use the following steps:
- Set a period of time aside where the parties try to negotiate a price for the buy-out.
- If no agreement is reached, require an appraisal by someone with a good valuation credential, paid for by the company. Be sure to define the appropriate standard of value within the buy-sell agreement, preferably fair market value without discounts.
- Based on that appraisal, allow the parties another chance at negotiation.
- If no agreement can be reached, or if the party whose shares are being purchased disagrees with the value determined by the appraiser, allows the party time to obtain (and pay for) his/her own appraisal.
- Again, allow the parties another chance at negotiation.
- If still no agreement can be reached, have the two designated appraisers jointly choose a third appraiser to "arbitrate" the value of the interest, and have the third party appraiser's decision be binding on the parties.
The benefits are that it is fair to all parties and if a negotiation can yield a fair result for all parties, incurring further expenses in unnecessary. Admittedly, one of the major downsides to this approach is the time it could take to implement if all steps were completed, and it could end up costing a fair amount of money in that same scenario. However, it is likely to yield a very fair result, and would likely result in less time and expense than would be incurred if the parties were to go to court to settle the matter.