Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Philip: If I could give just one piece of advice to business owners, it would be that every business owned by two or more partners (or shareholders or members) should have a buy-sell agreement. A buy-sell agreement is to a business what a will is to an individual: a way to plan for the allocation or disposition of assets or interests in the event of the unthinkable.
A buy-sell agreement could be triggered by the death or divorce of a partner to keep the business interest out of the hands of the spouse or children of the deceased or divorcing partner. It could be triggered when a partner quits, retires, or is fired or becomes disabled and is no longer able to work. It could also be triggered in the event of the bankruptcy of a partner to keep the business out of the hands of the bankrupt partner’s creditors.
Everyone thinks they will never have a problem with their partner until the problem occurs, and by then it is probably too late to resolve it by anything other than long, drawn-out, and expensive litigation.
Buy-sell agreements can value a business interest in several different ways, and they are not all created equal. Some agreements simply provide a fixed value for the business interest. It’s quick, cheap, and easy, but it may not reflect the true value of the interest and it probably goes out of date very quickly. The business owners may agree to update the value regularly, but then fail to do so. And if they do update the value, how do they do it? Do they use one of the other approaches, or do they just pull a number out of the air?
Other buy-sell agreements may specify a formula to calculate the value of the business interest. This approach is also quick, cheap, and easy, but there is no formula that can always give the value of any business. If there were such a formula, there would be no need for business appraisers. If this approach is taken, the formula should be specified in words and in algebraic symbols, and an example should be provided in the agreement. This may help to reduce disputes later. Even so, because the formula description may be subject to different interpretations, the agreement should also specify who is to calculate the formula (i.e., the company’s attorney, the company’s CPA, etc.).
In addition to being quick, cheap, and easy to implement and calculate, the fixed value approach and the formula approach also give a fairly predictable result; i.e., the individual partners can estimate an approximate value at any time. This makes estate planning by the partners fairly easy.
Another approach to valuation sometimes seen in buy-sell agreements is what I like to call the Solomon approach. Under this approach, one party to a dispute over value would specify the value of the interest and the other would elect either to buy or to sell at that price. At first, this sounds fair, almost like the Wisdom of Solomon, but on further consideration, one can see problems. For example, if the buy-sell agreement were triggered by the death of one partner, he would be in no position to buy. Or if one partner owns 80% of a business and the other two partners each own 10%, the minority partners might not have the financial ability to buy the larger interest. In either case, the second party would realize whether the first party had to buy or sell and could adjust his own behavior to take advantage of that.
Buy-sell agreements that specify a valuation process are the most expensive to implement, but they are also better than the cheaper alternatives. There are several variations of this approach, one requiring a single appraiser and one which requires two or even three independent appraisers. Under the multiple -appraiser approach, both parties hire an independent appraiser. If their value conclusions are close to each other (say, within 10%), the value is determined to be the average of the two values. If the two values are not close to each other, then the two appraisers together may select a third independent appraiser. This third appraiser may mediate between the first two appraisers, or may choose between the two appraisals, or may conduct his own appraisal. If the third appraiser conducts his own appraisal, the final value could be the conclusion of the third appraiser, or the middle of the three values, or the average of the two closest values, or the average of the three values, or some such amount.
Besides the financial cost, the multiple-appraiser process can take months to complete, while the fixed value method, the formula method, and the Solomon method can all be completed quickly. Each side must choose an appraiser, the two appraisers must each complete their appraisal, and the appraisals must be compared. If necessary, a third appraiser must be selected and complete an appraisal. And finally, a value determination must be made. Also, the partners may have no idea what the value will be because they cannot know what the independent appraisers will conclude. This makes planning difficult or even impossible.
The best approach, the single-appraiser method, is more expensive and time consuming than the fixed-price method, the formula method, and the Solomon method, but less expensive and time consuming than the multiple-appraiser method. Under this method, a single appraiser is hired not by the two parties, but by the company. This reduces both the cost and the time to complete the process when compared to the multiple-appraiser method. To further streamline the process, the appraiser should be selected and named in the buy-sell agreement. That saves the time it would take to choose an appraiser in the event that the buy-sell agreement is triggered. If the appraiser is selected and provides a valuation based on the specific language of the agreement when the buy-sell agreement is adopted, and every year or two thereafter, the value determination would be both more current and predictable enough to allow for easy planning. In that event, the value of an interest would be the value determined in the most recent appraisal.
Business owners might object that annual or biennial appraisals can be expensive, and they are right. But they are far less expensive than litigation.