Properly written buy-sell agreements are essential to the smooth transaction of any deal involving mergers and acquisitions. So why are most written so poorly, if at all? If the agreement in any way favors one party over the other, is based on an unreliable calculation method or excludes any pertinent information, the seller can find themselves in court. So how do you avoid litigation? What steps should you take to ensure that your buy-sell agreement is as iron-clad as possible? Those are just some of the questions we ask Michael Blake, CFA and director of Valuation Services at Habif, Arogeti & Wynne LLP in Atlanta, on this edition of “Deal Talk.”
The key is to make the buy-sell agreement as detailed as possible and to write it as if you're writing an engagement for a business appraiser.
- Michael S. Blake
Jeff: To begin, in your experience, why are most buy-sell agreements flawed? Why are these things bombs? How do those flaws typically manifest themselves? What happens when those flaws become apparent?
Michael: I think buy-sell agreements are flawed for two reasons.
Number one, buy-sell agreements - if they are written at all, are typically written when the shareholders or members of the company are not really in the mood to write one. In other words, they have just created this alliance to start a new company or they are entering into a partnership together and it is human nature to not necessarily dwell upon what happens if things don't work out. Not a lot of attention is paid to the buy-sell writing. In my experience, it's even unusual just to find any buy-sell written at all. Therefore, when their written you kind of want to check off the box and move on. You don't want to think about it in too great, excruciating detail.
The second reason is I think that clients are often asking too much of attorneys to write the buy-sells for them. In other words, attorneys that write contracts are trained to write down what the client wants to accomplish and give some advice in terms of protecting clients from liability and making sure their rights are protected but, they're not necessarily trained in the mechanics of live businesses or subject interests with any business have value and so, they might pull a template or they've got language from other agreements that their law partners have used. But it's really not their area of expertise to work through the economics of a shareholder separation in tremendous detail so therefore, the buy-sell agreement often falls to the cracks and has gaping holes in it.
In my experience, it's even unusual just to find any buy-sell written at all.
Jeff: It's almost ironic, really, because they're interested obviously in protecting the rights of their clients but they may not in fact know anything about the regulations and laws concerning business and business sales which is really unusual. So, how many buy-sell agreements out of, let's say a stack of a hundred, are actually worth the result and do in fact protect the seller of the business?
Michael: I'm feeling very optimistic today so, perhaps, a third?
Jeff: A third?
Jeff: So, is it fair to say that maybe only a third of those have been put together with the help of a business appraisal in valuation service such as the type that, perhaps, you're familiar with and that you work with?
Michael: I don't know of many buy-sells that are put together with the help of a valuation adviser at all.
Jeff: Then, let's go ahead and let's talk about what happens when these things are flawed. Are there certain areas of buy-sell agreements, of course once again calling upon your experience that you have seen, were there are certain key areas that time and time again, no matter how many of these you happen to take a look at, that you see these mistakes come up over and over again?
Michael: The most common flaw that I see in buy-sell agreements is when the agreement is written such that the buy-sell price is going to be set by a predetermined price or a predetermined formula. The problems with that approach are the following:
Let's say that you have two owners of a restaurant and there's a buy-sell provision that suggest that one owner buy the other out in event of the buy-sell's triggered in the place $500,000 or one owner will buy the other out in event of a trigger for 1/3 times annual revenue plus inventory, for example. Even if that price and that formula are appropriate the day the buy-sell is written, and it's probably not, but let's say for the moment that it is, over time that price or formula is going to lead to a price that is going to differ, probably substantially, from what the market would actually bear. Certainly different from so-called fair value. And what that leads to is a scenario under which one of those partners is going to find it very much to their advantage, then, to gain the system. If they realize, for example, that that restaurant is now worth $2,000,000, however that in the event of a buy-sell trigger, they can buy their partner out for $500,000. If they can manipulate the buy-sell or the conditions of the partnership in such a way that the buy-sell will be triggered then, one of the owners will be able to buy the other out on the cheap. And so, that can very quickly set the partners at each other's throats because the buy-sell is providing an economic incentive for one of them to gain a financial advantage upon the other.
Jeff: Let's camp out here on this for a second. Using that example that you're talking about, you said it's a very common example, how can you essentially set this up to manage that risk better in the buy-sell agreement from the very beginning and prevent that sort of thing from happening?
Michael: The way to manage that is to have the price of the business set by way of an independent appraisal at the time that the buy-sell is to be triggered.
Michael: If that price is going to be set by an independent third party, we may want to talk about what independent means, because that can be a contentious thing in itself, but that price is set by an independent third party then, theoretically, there should be no advantage to either party or any shareholder that gain the system because if that appraisal process is executed properly then, the outcome is something bound to be a fair value. So, you're only going . . . you're not going to pay any more or receive any less than what that interest would receive on the open market.
Jeff: And by independent third party, I think you're talking about someone who is completely objective to either side and not someone who you happen to know who knows somebody else from some connection that you made at the annual Chamber of Commerce mixer down the street but rather someone who's completely objective who can provide objectivity on both parts.
Michael: Right. Now, it may be somebody that you know. Maybe appraisers and I think most do carry themselves in a way that is objective but particularly in the case of a buy-sell perception, very much equals reality.
Buy-sells are so contentious, first and foremost, because the value in that business probably represents most, if and, potentially all of the net worth of the individuals that are in the business so, the stakes or financial perspective are actually as high as they possibly can be. Even the slightest perception that the outcome may be skewed in favor of one shareholder or another leads to the collapse of the process.
What I advocate, and this is not my idea it's found in Chris Marshall's book on formulating buy-sell agreements, but I think it's a terrific idea, is that the appraiser should actually be selected jointly by the individuals in the buy-sell beforehand. So, when you sit down to that buy-sell and you determine the mechanism by which the company is going to be valued, let's say you're going to select an appraiser, then put into a list right now five appraisal firms which you're going to solicit bids at the time of the trigger and then maybe you say you're just going to automatically select the lowest bid, or you're going to select the bid that files in the median, and the firms that respond to the RFB and that firm is going to perform the appraisal. And therefore, because that process has been set well in advance and there's a mechanism that can't be manipulated or at least not easily, that gives the best chance for all parties deeming the result to be credible and reliable and, therefore, minimizes the chance that people are going to be calling their litigation attorneys as soon as the member comes out.
Even the slightest perception that the outcome may be skewed in favor of one shareholder or another leads to the collapse of the process.
Jeff: That man right there is Michael Blake. He's the Director of Business Valuation Services at H, A & W, LLP in Atlanta, Georgia and you're hearing him on the Morgan & Westfield podcast. My name is Jeff Allen. We're talking about buy-sell agreements that will keep you away from the courts.
From the very elementary level, Michael, we're talking about buy-sell agreements among two or more shareholders in a company here and I'd like to pause for a second to talk about why it's important to have a buy-sell agreement early in the going? And I believe that I saw in something that you wrote, and this is probably well-known amongst people who've been in business for a long time and who've owned businesses and sold them, but I saw something that you wrote, and it said: as soon as you know you have more than one shareholder, it becomes very critical that you have that buy-sell agreement . . . doesn't it?
Michael: Obviously, if you only have one shareholder, there's nobody to buy or sell so, it doesn't matter. But the second that there's the possibility that that pie is going to have more than one piece to it, there needs to be an agreement in terms of how that pie's going to be split or how that pie, frankly, is going to be put back together in the event that one of the party is not going to be participating in the company anymore. The longer you wait, the harder it is because the more entrenched people get, the more people don't want to focus on it, and frankly, the more people, then, will disagree about the value and the valuation process of the business. It's a classic example. An ounce of prevention is worth about 18 pounds of cure.
Jeff: Well, no doubt about that. So, the buy-sell agreement is critical. It's something that you carry with you in your “back pocket.” You file away and put it away and maybe don’t look at it for a while, but you need to have that done in advance up front as quickly as possible, after you know you will have someone else who may have an ownership interest in the business from a shareholder's perspective. So, two or more shareholders . . . certainly that's when you need to really start to put your plans together for that buy-sell agreement ASAP.
Michael, how are issues involving buy-sell agreements handled in court, if they ever get to court and they often do as you pointed out, how are they handled once they get there?
Michael: Well, in terms of how court handles, I’m approaching this from a layman’s perspective, I'm not an attorney, so I don’t want this to be interpreted into any legal advice, but generally, the court is going to rely on the agreement and whether the agreement benefits one party or not or whether it reflects economic reality that courts really don't care. The question is, then, whether or not that agreement is enforceable. The trouble that often arises is that the buy-sell trigger and pricing processes themselves are so badly written that the contract itself is un-enforceable. In certain cases, including in Georgia, that can lead to the judge taking extraordinary step to simply dissolving the company because the buy-sell simply can't be feasibly executed.
The trouble that often arises is that the buy-sell trigger and pricing processes themselves are so badly written that the contract itself is un-enforceable.
Jeff: Now, have you seen that often? Have you seen that happen?
Michael: I've not seen a court dissolve a company because the courts really don't want to do that but I have seen the buy-sells get mired in a litigation process because you literally have to have trials within a trial to resolve what the buy-sell agreement actually says. For example, I was involved in a buy-sell agreement where the buy-sell called for dueling appraiser method, in other words, one shareholder got their appraiser, the other appraiser got their appraiser and then by some mechanism, their appraisers were supposed to agree. If they didn't agree, right out of the chute, and we didn't agree. And one of the key areas in which we didn't agree was that the buy-sell agreement called for the valuation to be performed into the standard of fair market value. And fair market value, as a term of our own, has a specific meaning and has a meaning according to Revenue Ruling 59-60 for tax purposes. Fair market value does not have any meaning necessarily in Georgia law. The standard of value that's applied for shareholder descent and dissolution cases is a standard called fair value. So, in this particular case, the sellers were arguing that even though the agreement sent fair market value which calls for consideration of discounts for lack of market ability and minority interests, they argue that the contract should be in effect be voided by Georgia law because Georgia law suggest in those cases fair market applies. Even though they wrote fair market value, they didn't mean fair market value. Whereas, the other side, and I won’t articulate which side I happened to be on, but the other side said, "Well, this contract says fair market value. You signed it. It was duly executed. It was notarized so, you follow the law. If you didn't know what you were signing, that's not our problem and that's not the court's problem". And so, that very issue wound up going to arbitration before you could even get the trial back on track.
Jeff: Wow, so . . .
Michael: Knowing how much time and fees that ran up so, for the appraisers and attorneys, it was great. For the clients, it was an absolute catastrophe.
Jeff: A complete nightmare, really. Yes, it just sounds unbelievable…well, with that all being said now, I know that there are probably dozens more horror stories that you can tell us, Michael. We want to try to avoid those. So, how can I reduce the risk, as a business owner, of ending up in court over my buy-sell agreement? Let's talk about some of the things that we can really do starting with…first thing's first. What should we do?
Michael: So, the key is to make the buy-sell agreement as detailed as possible and to write it as if you're writing an engagement for a business appraiser. We talked a little bit about selecting…the selection process for your appraiser. Put up five appraisal firms in there and have some automated mechanism by which you select one of those five. And I would add to that that the appraiser must agree to not do business with any of the parties for a minimum period of two years after the appraisal so that…I think that helps ensure independence.
For example, if I were an appraiser and I work performing the buy-sell agreement, I might have an incentive to make sure that the buyer, in other words the remainder of the company, were made happy by my value because I'd like to do business with them afterwards especially as an accounting firm. I could sell them tax services, audit services, whatever if they were grateful for the assistance I gave them for helping them resolve that issue. If I'm the other party in that transaction, I wouldn't feel very good about that. I wouldn't feel very good about all of sudden becoming the company's accounting services provider and I would certainly question whether or not the appraiser had acted in a truly independent way. I think that's perfectly understandable. So, I often write into my own engagement letter for resolving buy-sells as we recuse ourselves from doing business with you or party for a number of years just that each party is comfortable that this is a one-and-done-kind of exercise and there's no implicit promise or prospect of some kind of back-end reward after the fact.
And then after that, I think I would go down the line to write it just like a valuation engagement letter. So, a valuation engagement letter, if you look up in the Uniform Standards of Professional Appraisal Practice or other valuation standards, will specify what will be the effect of date of the valuation? What standard of value is going to be applied? Is the premise of value going to be a going concern or liquidation preference? Is the level of value going to be equity value or enterprise value?
In defining those parameters then, you leave very little leeway for argument because you're using terms of ours…and then it's very easy for the appraiser to just go down and let's say, "yes, okay, we understand what value means and we have all the parties have agreed to it. You know what the effect of date is going to be and so forth" and that level of specificity is going to lead to a lot fewer surprises.
In my experience, what lands people in court is when one party is surprised. People can handle getting bad news but when they get bad news that's out of the blue that is totally different from what they're expecting, again, the first instinct is to run to a lawyer and to assume that you've been defrauded somehow.
In my experience, what lands people in court is when one party is surprised.
Jeff: You have down here, Michael, a list that I'm looking right in front of me here. The need to select not one, not two, not three but five appraisal firms in advance. Select them in advance. Why do we need five that we need to go to later on in order to solicit bids?
Michael: There's nothing magical about the number "5" with the exception that with an odd number, if you choose to have a mechanism where the median bid is selected then you have a midpoint that you can select from as opposed to even number where you wouldn't have that ability, but a larger number I think is better than a lesser number because if the business partnership lasts a long time, let's say last 25-30 years, some of those appraisal firms may go out of business or they may be acquired or people retire. One or two of them may actually merge. You'll never know a generation is a long time. We'd like to make sure that by the time that the buy-sell is actually triggered, that at least some of those appraisal firms are still around to actually execute.
Jeff: You talk about, nevertheless, the need for real experience in this area. That's really credible, isn't it?
Michael: I think it really depends on what you want from the buy-sell appraisal provider. I think a lot of clients right now, not just in the buy-sell arena, but in valuation generally, believe that having industry expertise, having performed those kinds of appraisals before have a significant bearing on how credible that appraisal conclusion's going to be. And we're seeing the field becoming more specialized. We're seeing a number of firms, for example, specialized in healthcare and doctor's practices. We're specializing much more in software technology companies and professional services firms. Others are very good at food service. Clients, I think, gain a little bit more comfort that that judgment is going to be just, if you will, if the appraiser goes in with a lot of knowledge about the industry and a good instinct about how businesses are actually fought and solved in the world of that industry as opposed to more academic exercise.
Jeff: One thing that I understand may be important when it comes to buy-sell agreements is you're putting in maybe discounts or premiums based on the reason for shareholder exit. Tell us a little bit about that and why those are important.
Michael: Yes. So, one of the things that makes buy-sells very contentious is one shareholder can feel the buy-sell execution is disproportionately benefiting another even in the case of an appraisal. For example, I was once brought in to perform an appraisal in a buy-sell context where one of the shareholders had been sentenced to jail. The shareholders really wanted to get him out but they didn't want to pay him a lot because he was unable to be in the company because of his own darn fault. He committed crimes. He was sentenced to a long prison term. And it really grated the shareholders than to pay him based on his full 25 percent value of the company. But the reality is that was a buy-sell because there was nothing into the buy-sell that indicate any kind of punitive measures for being bought out because of the maleficence of that particular individual. Then, they just had to live with the higher price. In that case, the bad guy kind of wanted it.
It doesn't have to be as extreme an example as that. You could be a shareholder that causes the company to be sued. You could be shareholder that does something dumb and accept bad press for the company. You could be a shareholder that fails to report to work on a daily basis. That happens quite a bit. In that case, I think a lot of shareholders would like to have the flexibility to make the other shareholders financially accountable. And again…because the second people feel that a buy-sell is being gained to somebody's advantage, the faith in the process declines rapidly. Again, that's when the likelihood of going to a litigation scenario escalates sharply.
Jeff: You're listening to the Morgan & Westfield podcast today talking about buy-sell agreements that will keep you out of the courts. My guest is Michael Blake, Director of Business Valuation Services at H, A and W LLP in Atlanta, Georgia. My name is Jeff Allen.
We really have just a couple more minutes left in the program today, Michael. Fill us in on any other important things that really we need to remember when it comes to putting together buy-sell agreements that work that keep us out of litigation. What are some other things that we need here as we get ready to round out today's program?
Michael: One area we didn't cover is what should the buy-sell appraisal product look like? Even though, I guess I sound a little self-serving, but I'm actually a big fan of the buy-sell work product taking the form of the long form, appraiser report as it is called, or a detailed report as it's called under SSVS 1. Because again, the more information that's provided that leads the reader from point A to point B in terms of information providing methodologies applied and the conclusion's reached, the more likely it is that the reader's going find the result credible, that that report is going to be accepted if not loved and that will escape a nasty business divorce.
The other element that doesn't get covered enough is discussing how the buy-sell agreement will actually be financed. The buy-sell agreement doesn't matter a whole lot if there's no mechanism that provides some sort of assurance that the money will be there to actually execute the purchase of someone's shares so, there should be some thought and verbiage on the contract given …will there be a sinking fund to establish or will there be some kind of insurance fund or insurance policy taken out or would the buyout be financed by a seller note, say over a five or seven-year period at some rate of interest? There are things of that nature that many attorneys know how to do very well because they write those kinds of terms in a garden variety M&A deal. But that part must not be overlooked. If you can afford to execute the buy-sell then, it's really not going to do your hold out of it.
The buy-sell agreement doesn't matter a whole lot if there's no mechanism that provides some sort of assurance that the money will be there to actually execute the purchase of someone's shares
Jeff: Michael, we have just seconds really before we have to end this time and we want to have you back on so we can continue this discussion and talk about some other things that you're involved with to or that can help out with.
What if people have questions? They would like to talk to you about something that they've heard on this particular podcast and they have questions about their buy-sell agreements or maybe they've got other questions about business valuations and what they need to look for, questions that they need to ask, who should they contact? How can they get in touch with you?
Michael: I'm not hard to find because I'm all over the internet but good old-fashioned email still works so, email@example.com and you can follow my Twitter handle @unblakeable --- spells just like it sounds. My personal website as well, I talk about things like this --- unblakeable.com.
Jeff: There you go. Michael Blake. He's the Director of Business Valuation Services at H, A and W LLP in Atlanta. Thank you so much for joining us, Michael. We appreciate it.
Michael: Thanks, Jeff.
Jeff: You've been listening to the Morgan & Westfield podcast presented by Morgan & Westfield, a nationwide leader in business sales and appraisals.
If you'd like more information about buying or selling a business, call Morgan & Westfield at 888-693-7834. Or of course, you can visit morganandwestfield.com. Until next time! My name is Jeff Allen. I'll see you again.