We recommend that parties to buy-sell agreements meet with their accountants, other shareholders, corporate attorneys, corporate business consultants, and financial planners, if appropriate, to review their buy-sell agreements. These teams will enable them to discuss the business and legal aspects of your buy-sell agreement in detail. In addition, they should obtain competent advice regarding business valuation aspects of their buy-sell agreements. Business valuation experts should be able to identify issues related to the expected operation of their agreements from a business valuation viewpoint and make suggestions to modify the text to correct identified issues. The questions posted below are a sample of those that can be found in the Mercer Capital’s Buy-Sell Audit Checklist.

Potential Items to be Considered When Drafting or Reviewing a Buy-Sell Agreement

DEFINING VALUE FOR PURPOSES OF VALUATION PROCESS BUY-SELL AGREEMENTS

There are six defining elements that must be specified clearly if a process buy-sell agreement will work as expected. Each should be the subject of specific negotiation and agreement when a process buy-sell agreement is initiated or reviewed.

1. STANDARD OF VALUE. What is the standard of value for the required appraisal to determine price?

• Fair Market Value. This standard is the most frequently used standard of value for buy-sell agreements. It is a “willing buyer, willing seller” standard of value. If fair market value is the concluded standard of value, it is a good idea to either incorporate the precise definition into the buy-sell agreement or to provide a specific reference to the desired definition in the agreement.
• Fair Value. This standard of value appears in numerous buy-sell agreements. When it is used without further definition, it can give rise to confusion.

• Is statutory fair value in the state of incorporation of the company the desired standard of value? If so, the agreement should specify the appropriate statute for reference. If the statute does not define fair value, consider the agreement referring future appraisers to then-current judicial interpretations of fair value in the state, and specify a law firm to interpret the meaning of fair value for appraiser(s) in a manner they can translate into operative valuation approaches and methods. Consider specifying in the buy-sell agreement that all appraisers providing appraisals pursuant to the buy-sell agreement will use the same definition of fair value determined just above as the standard of value for their business valuations.
• Is accounting fair value is the desired standard of value? If so, the buy-sell agreement should specify the appropriate accounting rules or regulations that define the kind of value that is meant by fair value. Consider specifying in the agreement that all appraisers providing appraisals pursuant to the buy-sell agreement will use the same rules and regulations as the basis for their determinations of statutory fair value.

• Investment Value. This standard suggests a value to a unique buyer or type of buyer.

• If the agreement specifies investment value as the appropriate standard of value:
  • There should be a definition of what investment value means.
  • The specific buyer or the specific type of buyer should be defined.
  • Consider specifying in the agreement that all appraisers providing appraisals pursuant to the agreement will use the same definition of investment value and the same specified buyer(s) in their business valuations.

• Going Concern Value. Often, parties desire to specify that the business valuation shall be of the company as a “going concern.”
  • Specifications like “going concern value” or “value of the company as a going concern” are not, however, adequate to specify a workable standard of value. If it is the desire of the parties that the valuation be specified as a going concern value (as opposed to, for example, a liquidation value) this modifier should be included with another selected standard of value (see above).Note that the standard of value of fair market value of a business presumes that the business is a going concern unless the analyst determines that a liquidation value would yield a higher resulting valuation (see USPAP).]

• Other Standards. If some other standard of value than those above is selected, make certain that the standard is clearly defined and that all parties understand it. In addition, make certain that business valuation experts are able to make a similar interpretation.

2. LEVEL OF VALUE. What will be the level of value specified for purposes of the business valuation? [This specification is particularly critical and relates to whether the buy-sell price will represent a pro rata share of the value of the enterprise, or the value of a particular, perhaps minority, interest of the enterprise.]

• Strategic Control. Is the appropriate level of value for the agreement that of “strategic control?”

• This level reflects the value of the enterprise considering strategic or synergistic benefits available to certain buyers, but not generally available to the company or to its shareholders.If this level of value is deemed appropriate, the buy-sell agreement should probably specify that no discounts related to lack of marketability or lack of liquidity be considered by the appraisers. There is no market evidence of such discounts and such discounts are not considered by qualified buyers of companies.

• Financial Control / Marketable Minority. Is the appropriate level that of “financial control,” which is also considered synonymous with the “marketable minority” level of value?

• This level of value reflects the value of the enterprise based on normalized earnings of the enterprise as it operates, with existing ownership and management. In other words, value at this level would not include the benefit of expected synergies for synergistic or strategic purchasers of the business. If this level of value is deemed appropriate, the agreement should probably specify that no discounts related to lack of marketability or lack of liquidity be considered by the appraisers. There is no market evidence of such discounts and such discounts are not considered by qualified buyers of companies.

• Nonmarketable Minority. Is the appropriate level of value for the agreement that of “nonmarketable minority?”

• This level of value reflects the value of a minority interest in the company, taking into account its lack of marketability. If this level of value is deemed appropriate, the buy-sell agreement should specify that the appraiser(s) should consider minority interest and marketability discounts, to the extent appropriate in the valuation of the interest.

• General Levels of Value Issues. We recommend that buy-sell agreements specify the selected level of value. We also recommend that buy-sell agreements reference a “levels of value” chart indicating the selected level of value.

3. THE “AS OF” DATE. [The “as of” or “effective date” is the date as of which available information pertaining to a business valuation should be considered by appraisers. It should be specified. Values of companies change over time based on in such things as the national economy, interest rates or regulations, the industries in which the companies operate, regional or area economic activity, as well as changes within companies themselves. In the operation of process buy-sell agreements, it is necessary to fix the point in time at which appraisals are conducted and prices are determined. See Chapter 18.] Possible “as of” dates for consideration include:

• The exact date of the trigger event. This may be the most understandable and agreeable date in many instances, but others may be considered appropriate by the parties.

• Date determined by availability of financial statements.

• The date of the monthly financial statements immediately preceding the trigger event (which might be published after the trigger event).
• The date of the quarterly financial statements immediately preceding the trigger event.
• The date of the financial statements for the month during which the trigger event occurs.
• The date of the quarterly financial statements for the quarter during which the trigger event occurs.

• Date determined by the appraisal process.

• The date the initial appraiser(s) is (are) selected and hired.
• The date that the appraisal report(s) is (are) submitted by the appraisers. Note that any subsequent appraiser(s) would have to use this same date.

• Other date, as agreed upon by the parties.