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!