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Key Valuation Elements to Consider in Your Buy-Sell Agreement

by Kurt Litzelfelner, The Daily Record, February 2017 A shareholder buy-sell agreement for a closely held business is not unlike a will for estate planning. You probably won’t need one until a “triggering event” in the agreement occurs. Typical triggering events in a buy-sell agreement of a closely held company that require a business valuation can include death, disability, divorce, personal bankruptcy, retirement, and quitting or being fired from your job at a company in which you also have an ownership interest. Buy-sell agreements typically have one of four types of valuation mechanisms: 1) a fixed price; 2) a formula (usually based on net asset value or a multiple of some type of earnings); 3) a “shotgun” agreement[1]; or 4) a formal defined business valuation process. This article will focus on issues to consider in buy-sell agreements having a formal business valuation process.

While many agree to the merits of a formal business valuation process using an independent valuation expert, the valuation process language in buy-sell agreements is often poorly drafted and confusing to a valuation expert. This can lead to unintended consequences that unfairly favor one owner over another. Before a triggering event occurs, shareholders would be well advised to ensure the language in the agreement reflects their intentions.

Shareholders who want to utilize a valuation process in their buy-sell agreements should make sure that the provision contains sufficient detail so that it will not be ambiguous to an independent valuation expert. In his book, Buy-Sell Agreements for Closely Held and Family Business Owners[2], Z. Christopher Mercer lays out what he calls the six defining elements to address in a buy-sell agreement in which some type of valuation process is used. The six elements are listed below, along with my own observations.

    1. Standard of ValueValue means different things to different people. For instance, compared to a buyer solely seeking an adequate financial return, a business could be worth a lot more if sold to a strategic buyer that could eliminate redundant overhead or use its existing distribution channels to sell a company’s products. As a result, a formal standard of value should be included and defined (or at least referenced) in the agreement. A common standard of value used in business valuations is fair market value, which is defined as “the price at which a property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter in not under compulsion sell, both parties having reasonable knowledge of relevant facts.”[3] This standard of value is used in all valuations for federal estate, gift and income tax purposes. Generally, this standard does not take into account the synergies that a strategic buyer may be able to obtain and be willing to pay for in an acquisition.
    2. Level of ValueThis addresses whether the particular shareholder interest is to be valued on a “control” or “minority” interest basis. For any interest over 50%, the value will usually be on a control basis. However, under the fair market value standard, a minority interest (e.g. 15%) typically would be valued based on its particular characteristics, including its lack of control prerogatives. That is, owners of this type of interest often do not have the power to control the affairs of the business or affect a sale or liquidation. In addition, there is no formal market for minority interests in closely held businesses. As a result, minority interests are typically valued at less than the pro-rata share of the company’s control value due to their lack of control characteristics and lack of a formal trading market. In some instances, the difference between a 15% interest valued as a minority interest as described above, and as a pro-rata control value can be significant (and a point of contention among owners) if the level of value to use in the valuation is not determined ahead of time in the buy-sell agreement.
    3.  The Valuation as-of DateThe “as-of” date is the date on which a value is being sought related to a triggering event (e.g. death, disability, retirement, employment termination, etc.). For instance, is the date of value the actual day the triggering event occurred or another date, such as the most recent fiscal year-end (when year-end financial statements are prepared), or some other date? The use of different valuation as-of dates could lead to significantly different values, particularly if a major event affecting the business occurred between two contemplated dates. Make sure this is clearly spelled out in your buy-sell agreement to avoid disputes after the fact.
    4. Appraiser QualificationsIt is not uncommon to see a buy-sell agreement state that any business valuation required under the agreement shall be performed by the accounting firm currently employed by the company. In addition to a potential conflict of interest among shareholders in some circumstances, not all accounting firms have professionals on staff qualified to perform business valuations. In fact, many do not. Business owners should seek out qualified professionals who have the experience, training and credentials to perform such business valuations. In the United States, there are four organizations that provide training and certification to those interested in providing business valuation services of closely held companies to the public. These organizations are the American Society of Appraisers (ASA), American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBA) and the National Association of Certified Valuators and Analysts (NACVA). If a formal business valuation process is being contemplated in your buy-sell agreement, confirm that the individual retained to perform a valuation is qualified to do so.
    5. Appraisal Standards In drafting a buy-sell agreement, it is a good idea to reference the standards of one or more of the organizations listed above to ensure that the valuation is prepared in accordance with professional industry practices. Each of these organizations has its own set of business valuation standards that members must follow. (However, there are many similarities between among them.) These standards generally establish the minimum requirements for developing and reporting on the value of a businesses, business ownership interests, securities or intangible assets. The business valuation standards for all four of these organizations can be found on their respective websites.
    6. Treatment of Life Insurance ProceedsOftentimes, companies purchase life insurance on their owners so that if one dies, the proceeds from the life insurance can be used by the company to purchase the shares from the deceased owner’s estate. However, there can be confusion about how to handle these proceeds from a valuation perspective. For instance, will the proceeds be treated as an asset of the business for valuation purposes, or just as a resource for repurchasing the decedent’s ownership interest? In the former case, the value of the business will be higher than if the proceeds are not treated as a corporate asset, but rather simply as a means to repurchase the ownership interest. If your company owns life insurance on its owners, you would be well advised to address this in your buy-sell agreement. The financial impact to the estate, the remaining shareholders, and the company can be significantly different depending on which of the above scenarios is used. The time to address these six key elements in your buy-sell agreement is before a triggering event occurs and you are left arguing with others about the original intent. Different interpretations over these key elements can have a significant impact on the valuation of your business or business ownership interest. By updating your buy-sell agreement with language that specifically addresses these key elements, you will be in a much better position to avoid disputes that arise at the time of a triggering event and ensure that each of your company’s shareholders are each treated as you originally intended.

 Kurt J. Litzelfelner, ASA is a Director at StoneBridge Business Partners. He can be reached at (585) 295-0550 or at

[1]  A provision in the agreement that gives a shareholder the right to purchase the shares of another shareholder at a specified price.  If the other shareholder does not wish to sell his shares, the other shareholder must then buy the offering shareholder’s shares at the same price.

[2]  Z. Christopher Mercer, Buy-Sell Agreements for Closely Held and Family Business Owners, (Memphis, TN: Peabody Publishing, L.P., 2010).

[3]  Internal Revenue Service Revenue Ruling 59-60.

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