Strengthening Buy-Sell Agreements from a Business & Valuation Perspective

According to today’s Money cover story in USA Today, prenuptial agreements (or “prenups”) may be unromantic, but they may well make sense.

Buy-sell agreements definitely make sense when companies have two or more owners, and virtually all substantial corporations have such agreements.

Prenups are the result of conversations between couples regarding what happens to whose assets and income in the event that the couple divorces.  They are increasingly being used when couples marry, particularly for the second (or third) time.

“More and more, these agreements are being drafted.  It’s not just for the rich and famous any longer.  It’s for people that have assets and/or income that they want to protect,” said Marlene Eskind Moses, President of American Academy of Matrimonial Lawyers.

Buy-sell agreements are supposed to be the result of conversations among owners of businesses addressing what will happen when lots of “trigger events,” including divorce, occur.  The objectives of such agreements are to protect the interests of the company and the individual shareholders, consistent with mutual fairness.  Sometimes, however, the owners may not talk — or pay attention when others are talking — about important provisions.

I read a buy-sell agreement recently that addressed the divorce of owners.  It provided that, in the event that an owner was divorced, the company had the right to repurchase 100% of his shares.  Period.  That’s it.

Normally, divorce provisions in buy-sell agreements are there to prevent shares owned by a divorcing spouse from being split by divorce courts and awarded to non-owner-employee spouses.  Suppose that an owner of this company had a prenup agreement that protected his ownership interest from division in divorce.  Wouldn’t he be surprised when his fellow owners enforced the agreement and purchased his shares?  Suppose he did not have a prenup, and arranged things in the divorce to protect his interest in the company?  He’d still be surprised if the agreement was enforced.

I’m not saying this will happen, but it could.

What does your buy-sell agreement provide in the event that you or one of your fellow shareholders is divorced?  How would the provisions apply if another owner got divorced?  How about you?  Are any prenup agreements coordinated with the operation of the buy-sell agreement?  These are good questions to consider.

Let me suggest that you pass this post along to anyone you know that could be affected by the issues raised here.

Based on our experience, far more buy-sell agreements with valuation processes are multiple appraiser agreements than single appraiser agreements.

Multiple appraiser agreements call for the selection of two or more appraisers to engage in a process that will develop one, two, or three appraisals whose conclusions form the basis for the final prices.  If this sounds like it might be time consuming, cumbersome, and expensive, it is.  Such processes can also be divisive and foster litigation.

All of the general forms of multiple appraiser agreements either call for, or potentially call for, the selection of a third appraiser.  What is the role of the third appraiser?  The role of the third appraiser is to bring resolution to the valuation process, whether as reconciler, determiner, judge, mediator or otherwise.

In many processes, the proverbial ox is already in the ditch when the third appraiser is named – there are two appraisals with conclusions more than __% (you pick) apart.  Whether the variations relate to differing understandings or interpretations of the assignment definition, to valuation assumptions and judgments, or to actual bias, the third appraiser is expected to get the ox out of the ditch.  The third appraiser’s valuation is the tool to reconcile the differences.

What if, however, the differences are irreconcilable?  One way of addressing these issues with multiple appraiser agreements is to consider employing single appraiser agreements.

For information on the different types of multiple appraiser process agreements, see here.  For information on single appraiser process agreements, see here.

What are Rights of First Refusal?

Rights of first refusal (ROFRs) are sometimes considered to be a form of buy-sell agreement. A right of first refusal is an agreement designed, for the most part, to restrict ownership of shares by limiting their marketability. The typical right of first refusal states the conditions under which shares of a corporation can be sold. Rights of first refusal tend to work along these lines:

1. If a shareholder desires to sell his or her shares to a third party and the third party provides a concrete offer, the corporation retains a right of first refusal to purchase the shares at the same price and on the same terms offered to the existing shareholder by the third party. The corporation generally has a period of time, from 30 to 60 days or more, during which to match the third party offer and purchase the subject shares.
2. If the corporation does not match the offer within the specified period, many agreements provide what could be called a “right of second refusal” to the other shareholders of the corporation. Such secondary rights are normally offered to the shareholders pro rata to their existing ownership. If one or more shareholders elect not to purchase, the other shareholders can then purchase the extra shares (usually pro rata to remaining ownership). The other shareholders then have a period of time, from 30 to 60 days or more, during which to match the third party offer and purchase the subject shares.
3. In order to assure the possibility of a completed transaction, the corporation must have a “last look” opportunity to purchase the shares if the other shareholders do not. The corporation is granted some additional time, perhaps 30 to 60 days or so, to make this final decision.
4. If all of the prior rights are refused, then and only then, is the original shareholder allowed to sell his or her shares to the third party – again, at the price and terms shown to the company and other shareholders.

What Are Rights of First Refusal Designed To Do?

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While traveling from Boston to Memphis yesterday I met a gentleman who was the “vice president, strategic solutions” for a sizable business.  His company had been a $60 million services firm that had just recently been acquired by another services firm that was backed by private equity.  The market value combined entity was perhaps $200 million or so.

I was reading a new book on buy-sell agreements (that I will review later), and we struck up a conversation.  I was interested in his response to my assertion that problems with buy-sell agreements were probably limited to relatively small companies.  His thought was that larger companies, or rather, their key managers and advisers, tended to be more sophisticated financially than folks in smaller businesses, and would not have such problems.

He was surprised at my response.  What I told him was that, in my experience, company size does not matter when it comes to problems with buy-sell agreements.  Big companies are not immune to the basic problems that plague buy-sell agreements everywhere.  But fixing the problems does tend to be more expensive for larger companies than for smaller ones!

There are five things that must be in a buy-sell agreement to specify a valuation process in unambiguous terms.  There is a sixth thing that, while not defining the valuation process, can raise havoc with that process if it is also not specified.  What is important is that the participants to buy-sell agreements agree to these things.  That’s why they are called buy-sell agreements!

1. Standard of value. This element specifies the kind of value that is desired.  Most buy-sell agreements specify fair market value as the standard of value.  Fair market value is a willing buyer, willing seller concept where both buyers and sellers are acting without compulsion and with reasonable knowledge.  However, other terms are often used, including “fair value” (whatever that is), “the value,” the “going concern value” and others.  If the parties desire fair market value as the standard of value, then the agreement should specify fair market value every time value is mentioned.
2. Level of value. This element specifies the value of what is to be valued.  The question is, do the parties desire the buy-sell agreement valuation to specify the pro rata share of the value of the company, or the value of the specific interest in the company that is being purchased pursuant to the agreement?  Confusion over this issue is found in agreements for companies of all sizes.  And even if the intention was clear, the words on the pages of the agreements are often confusing.  For a conceptual look at what confusion over level of value can mean, see the levels of value charts.
3. “As of” date.  The “as of” date grounds the valuation in time, so appraisers can look at the company, the industry, the markets, the economy at that time for purposes of their valuations.
4. Qualifications of appraisers.  Very few agreements, regardless of the size of the company, specify the qualifications of appraisers to be selected when they are triggered.  In fact, the book I was reading yesterday includes these descriptions for appraisers: a certified public accountant, a professional business appraiser, the appraiser, and a disinterested appraiser. The bottom line is that with any of these descriptions of the appraiser, there are virtually no instructions to selecting parties regarding qualifications.  Most agreements are written such that “any appraiser” will do, and that is simply not true.
5. Appraisal standards to be followed. If few companies specify the qualifications of the appraiser, virtually none specify the appraisal standards to be followed.  If appraiser qualifications are specified, such as, for example, the selected appraiser shall hold the Accredited Senior Appraiser (ASA) Designation of the American Society of Appraisers,” then such appraisers must follow specific standards.  ASA appraisers must follow the ASA Business Valuation Standards and the Principles of Appraisal Practice and Code of Ethics of the American Society of Appraisers.  They must also follow the Uniform Standards of Professional Appraisal Practice. Otherwise, you can specify which standards you want to have followed by all appraisers selected for purposes of your agreement.  Appraisal standards provide comfort regarding how an appraisal will be conducted and the manner in which it will be reported.
6. Funding mechanism.  The funding mechanism is critical for the successful operation of a buy-sell agreement.  Most buy-sell agreements are triggered by life-time events.  Many, if not most, agreements provide for the company to purchase shares with a promissory note.  Most agreements do very little to specify the quality of the note.  For many, there is no specification of collateral.  For some, the interest rate is confusing.  For others, the amortization can be interpreted in multiple ways.  And for many, prepayment rights and obligations are not specified.  But that’s just one issue.  Many companies carry life insurance on the lives of their key owners.  If this life insurance is associated with a buy-sell agreement, it is critical that the agreement specify how the appraiser(s) will treat it for valuation purposes.  It can be treated as a funding mechanism and not included in the valuation, or it can be treated as a corporate asset and included in the appraisal.  These two treatments can lead to widely disparate results.

These elements are critical to the reasonable operation of your buy-sell agreement, regardless of the size of your company.  If you know owners of large or even very large companies, please feel free to share this post with them.  And of course, if you know owners of any company, please share the post, as well!

This post is a reprint of an article that originally appeared in the March 2009 issue of the Southeast Wealth Management Business.  Given the length of the article, you may choose to print and read.

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This article is a warning against the blind use of legal forms, or templates, for developing buy-sell agreements.  Parties to each and every buy-sell agreement need to take time to agree on the key business and valuation aspects of their agreements, then have a qualified attorney (who can also be involved in reaching agreement) draw up the document. 

What could be simpler?  All the parties have to do is to agree on the events that “trigger” the buy-sell agreement, on who buys stock, and on the pricing and terms of the purchase.  Also, it is helpful if the funding for the transaction is specified, as well.  The problem is, if my experience is any indication, these things are almost never agreed to at the level at which it is necessary for the shareholders to understand what will happen when their buy-sell agreements are triggered by the quitting, firing, retiring, death, disability, divorce, etc. of a shareholder.

Keep in mind that I am not a lawyer and do not draft buy-sell agreements.  I am, however, a business appraiser who has seen hundreds of buy-sell agreements as part of our normal valuation practice – too many of which after failed valuation processes when litigation has already ensued.  As such, I read and interpret buy-sell agreements from business and valuation perspectives in the normal course of my business and I can say that relatively few of them address the basic questions in unambiguous terms.  Could this be because, in part, too many people rely upon standard forms rather than doing the sometimes difficult work of sitting down together to agree to the key business and valuation issues?

Over the 2009 New Year holidays, I did some fairly unscientific research.  I googled the terms “buy-sell agreements” and “buy-sell agreement forms.”  In searching quite deep into the rankings, six forms were found that were available on-line and free.  There are numerous sites that charge for buy-sell agreement forms, and others that claim to offer templates “for free,” but require a “membership” to access them.  At another time, I’ll set a budget and go form-shopping to see if the results are different.  Of the six free templates found, I noted the following:

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When drafting your buy-sell agreement, understand that the other guy will not always be the first to die or to leave the company.  It might be you.  However, your buy-sell agreement is indifferent to timing.  It will apply to you (and the other owners) whether you will be buyers or sellers. 

If you know you will be a buyer, you will prefer to buy at the lowest possible price.  If you know you will be a seller, you will prefer to sell at the highest possible price.  If you don’t know which you will be (and you likely do not) and you act rationally, you will desire pricing in the buy-sell agreement that is reasonable regardless of future outcomes. 

Applying similar logic with the other shareholders to other aspects of your buy-sell agreement leads to workable agreements.  Failing to apply this kind of logic imbeds traps in the agreement for one side and potential advantages for the other side.

It is important to talk about the future when the interests of the parties are aligned, or at least not sufficiently misaligned to prevent discussion.  So, make time to work out important issues when drafting the agreement.  Know this for certain: When your buy-sell agreement is triggered, the interests of the parties will have diverged.

Attorney Peter Osman writes in the GreenBayPressGazette.com about important things missing in buy-sell agreements that create problems for lifetime transfers.  His advice echos mine:

The best way to prevent this impasse with your company is to address, right now, potential problems caused by a buy/sell agreement drafted years ago for a transfer event that is not the event most likely to occur.

Read what he has to say. Pass this post along to anyone you know who has a buy-sell agreement.  The advice is timely!

Not Specific to Industry or Corporate Form

Many business owners think that their industry is different than all other industries in its unique problems and issues. They also tend to think that within their industry, their company is also unique. They are at least partially right.

Buy-sell agreements, however, are used in every industry where different owners have potentially divergent desires and needs — and that includes every industry we have seen to date.

Consider the many companies in any industry with these four primary characteristics:

• Substantial value. There are many hundreds of thousands of businesses that might be categorized as "mom and pop" enterprises (with no disrespect whatsoever), and generally do not attain significant economic value.  We will focus on businesses with substantial value, or those with millions of dollars of value (as low as $2 or $3 million) and ranging upwards to many billions of value.
• Privately owned. When there is an active public market for a company’s securities, there is generally no need for buy-sell agreements.  Note that this definition does not apply to joint ventures involving one or more publicly-traded companies, where the joint ventures themselves are not publicly-traded.
• Multiple shareholders. Most businesses of substantial economic value have two or more shareholders. The number of shareholders may range from a small number of founders or initial investors, to many dozens, or even hundreds of shareholders in multi-generational and/or multi-family enterprises.
• Corporate buy-sell agreements. Many smaller companies, and even some of significant size, have what are called cross-purchase buy-sell agreements. While much of what we talk about will be helpful for companies with such agreements, we write primarily for businesses that have corporate repurchase or redemption agreements (often mixed with opportunities for cross purchases under certain circumstances). In other words, the buy-sell agreement includes the company as a party to the agreement, along with the shareholders.

If your business meets the above four characteristics, you need to focus on your buy-sell agreement.  The “you” in the previous sentence pertains regardless of whether you are the controlling shareholder, the CEO, the CFO, the general counsel, a director, a working manager-employee, or a non-working (in the business) investor.

In addition, the above applies regardless of the form of corporate organization of your business. Buy-sell agreements are necessary and/or appropriate for most corporate forms, including:

• Corporations, whether organized as S corporations or C corporations
• Limited liability companies
• Partnerships, whether between individuals or between entities such as corporate joint ventures
  
• Not-for-profit organizations, particularly those with for-profit activities
• Joint ventures between organizations (which are quite often overlooked)

Our last post was titled I Just Want What I Am Entitled To.  If you missed the short video, please take a moment and view it.  It last less than two minutes and provides a powerful message.

The story is simple. 

• A woman comes to the office of the business her husband co-owned prior to his recent death. 
• His partner welcomes her and asks about the kids. 
• What we know is that the woman has already learned what she will get for her husband’s stock based on the company’s buy-sell agreement. 
• We also know that she has three children and a mortgage.
• We learn that the agreement was signed some ten years ago. 
• We also learn that the business has been successful over the period. 
• We see that the remaining partner says that what the buy-sell agreement said is "all I can do."
• And we hear the woman say that she needs to call an attorney, because all she wants is what she’s entitled to.

If you know anyone who has a fixed price buy-sell agreement, please send this post to them.  They can link to the video here.  http://www.bit.ly/cgtCGi

Fixed price buy-sell agreements are dangerous for one primary reason.  The parties virtually never update them with the passage of time and changes in the fortunes of their businesses. 

Don’t be like the owners in the video. 

Whether they thought about it or not, they each were betting that the other guy would die first.  And one of them was right.

This video can be all too true if you are party to a fixed price agreement.  Take a look. 

Source: http://www.youtube.com/user/TomChoque