The objectives of this piece are to enlighten business owners and their advisors of the many purposes for a business valuation and discuss the facets of a business valuation in the context of drafting a buy/sell (operating or stockholders’) agreement.
There are several purposes for a valuation of a business, which include those that result from a particular event such as a marital dissolution and the tax compliance requirements related to an estate of a deceased owner or the gift of an ownership interest. Other reasons are based in business planning which involve buy/sell agreements, succession planning and purchase offer assessments. To follow is a list of purposes commonly attributable to a valuation of a business:
- Estate tax compliance
- Gift tax compliance
- Marital dissolution
- Buy/sell agreements
- Employee stock ownership plans- ERISA compliance
- Employee stock ownership plans- transactions
- Evaluation of business purchase offers
- Allocation of business purchase price
- Mergers and acquisitions
- Shareholder disputes
- Litigation support
- Lost profits calculations
- Estate and succession planning
- Business/owner financial planning
- Family limited partnerships
- Charitable donations
- S Corporation conversions
- Intangible asset valuations
- F.A.S.B issued ASC 805 and 350
- Appraisal review
- Appraisal consulting
One of the most overlooked and an underappreciated applications of business valuations from the list above is the buy/sell or owners’ agreement. Since there is no requirement for a business to adopt such an agreement, many business owners do not bother to have one executed, or wind up preparing a poorly drafted document. The problems associated with the lack of a properly drafted buy/sell agreement are most often realized upon the departure of an owner via retirement, death, disability or other termination. Business owners who currently have no buy/sell agreement in place for their businesses often get a dose of reality when asked if it should happen that their business partner dies tomorrow, are they ready to go into business with that partner’s spouse?
A comment frequented by business owners in connection with the need for a buy/sell agreement declares that the owners are all relatives that have and will act harmoniously when business decisions are or will be made. Assuming that the family we are considering is not the Waltons of TV fame, reality tells a much different story.
The drafting of an appropriate buy/sell agreement will involve the company’s attorney as well as a business appraiser, since there are many factors of the agreement that go beyond the price of the shares in the business. Issues such as how and when shares in the company may be disposed, restrictions placed on the potential buyers of company shares, whether the company or other owners have rights to buy the shares at a price offered by a third party and how the buyout prices will be paid are some of the core features of a carefully prepared buy/sell agreement that do not directly involve a business appraisal.
A business appraiser contributes to the preparation of the buy/sell agreement primarily by educating the principals of the company and their advisors to the business valuation process and the various types of value and approaches to the calculation in order that the owners can make informed decisions with regard to the appraisal based on their intentions. The typical clause observed in buy/sell agreements, which states that the price of the shares will be determined by an appraisal by the company’s accountant, leaves too much of the decision making to the accountant and will likely result in an value that can be criticized at many levels by one or more of the owners and their representatives.
Two of the business valuation features that should be spelled out in a buy/sell agreement are the standard and level of value. The standard of fair market value assumes a hypothetical buyer who is willing, able and knowledgeable of relevant facts. However, the buyer is not necessarily a competitor who possesses synergies and background in the industry whereby a higher value for the business is often achieved. This standard of value is referred to as investment value, and should be documented in the agreement if it is contemplated that the business eventually will be sold to a competitor. The level of value represents the value before or after discounts. The discount for lack of control will be applied to a minority interest unless specifically stated otherwise. This will tend to favor the youngest owner who will wind up with all the shares of the company after his/her elders retire. It is common not to apply this discount in order that all owners enjoy the benefits of control ownership. Similarly, it may be determined not to apply the discount for lack of marketability, another discount that is employed in arriving at fair market value. Depending on the ready market for the eventual business sale, this discount may be excluded or reduced accordingly.
Other areas in which a qualified appraiser can be of assistance in the preparation of a buy/sell agreement include the premise of value for the price of the shares (going concern, liquidation, etc.), types of adjustments to the income or cash flow stream to be employed in arriving at business value (related party expense, compensation of an outgoing owner, etc.), the suitability of including life insurance proceeds in company value in the case of a deceased owner, application of tax provisions for non-taxable entities and the date of valuation (date of the transfer of ownership or latest fiscal year-end).
One last matter regularly dealt with during the drafting of a buy/sell agreement is the desire of the owners to insert a formula in place of a comprehensive business valuation for the purpose of valuing the shares. An experienced business valuation analyst is able to advise the owners as to the typical limitations of the formula and its obsolescence over time. Rarely does the formula hold up to varying circumstances and the benefits of its simplicity. The ability to allow the owners to know where they stand are time and again outweighed by the rigidity of the factors utilized in the formula, which prevent the consideration of the many dynamics present in a thorough valuation of a business. The calculation of value should be periodically reviewed by a qualified appraiser to avoid these problems.
With regard to estate taxation, the buy/ sell agreement will only be respected in terms of the stock value if it is found to be a bona fide business arrangement, is not a device for transferring stock to a family member for less than fair market value, and the terms are comparable to those entered into in an arm’s length transaction. Generally, buy-sell agreements between unrelated parties are presumed to meet the requirements, while a buy-sell agreement between family members will likely face scrutiny from the IRS. Should a buy/ sell agreement between family members contain an artificially low value of the company stock, a decedent/ stockholder’s estate must report the higher fair market value for estate tax purposes even though the estate will only be entitled to the lower price of the company stock redeemed in conjunction with the buy/ sell agreement. This is certainly not the outcome intended by the family, and serves as another reason to consider a qualified business appraisal when preparing the buy/ sell agreement.
Daniel Koscielny is a partner with ValuQuest based out of our Buffalo, NY office.