By Tracey Jeffers
Principal, Valuation Consulting
I recently worked on a valuation engagement for a project management firm involving minority shareholder value in a litigation. Besides the relevant financial data, one of the first documents I look at in these cases is the buy-sell agreement. What I discovered in my review for the litigation was a document containing a formula that used the average of the three previous years’ revenue multiplied by the percentage of shares owned by each shareholder. The result was the firm’s internal valuation of its shares. My first reaction?….wow, the language in this agreement presents multiple problems.
I have read a few buy-sell agreements in my day and they have ranged from the very good to the pretty bad. In the case of the agreement for the litigation, there were several major problems with the use of the formula including 1.) it set precedent for future company transactions at an overvalued rate, 2.) there was no delineation between control and minority owners and the respective value of their shares, 3.) minority shares are usually not worth pro-rata value of a control interest, and 4.) in general, firms in the architectural, engineering and environmental consulting industry do not bring 1x revenue on a price to sales multiple at a fair market value level.
From the valuation perspective, ideally a buy-sell should be clear and concise with regard to how the shares will be valued, who will value them and the process that will be undertaken. I believe there are five major issues that should be addressed in any buy-sell agreement:
What is the standard of value? Fair market value is the standard of value used in a majority of closely-held company valuations, unless there is an impending merger or acquisition then a different standard may be more appropriate. Fair market value is defined in IRS Revenue Ruling 59-60 as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts. It is helpful to the appraiser to have the standard of value identified to eliminate any question as to intent.
Who will value the shares? Many agreements that I have read, particularly those written several years ago, do not speak to who should value the shares. Others have been specific as to a professional with a valuation designation requirement. I am certainly biased in this regard, but I believe it is in every shareholders’ best interest to hire a qualified professional with valuation expertise. You can be assured that those professionals with valuation credentials have received specific valuation education, been tested and peer reviewed. Credentials in our profession are a bit of alphabet soup but the three most common are:
- CBA – Certified Business Appraiser, Institute of Business Appraisers
- ASA – Accredited Senior Appraiser, American Society of Appraisers
- CVA – Certified Valuation Analyst, National Association of Certified Valuation Analysts
Are minority interests valued at the minority level? If an agreement is silent on this issue and minority shares are the subject interest, the shares will be valued at the minority interest level using appropriate discounts. If it is the intent that all of the shares of every shareholder are to be a pro-rata value of a 100 percent interest then it should be clearly stated in the agreement.
In the event of disagreement. I have always advised my clients who are entering into business together to tend to some of the tough issues while everyone is friendly and in an agreeable mood. It is much too late to try and negotiate when unhappy parties are at the table. In the event that one party disagrees with a share value, what happens next? I have seen some agreements that go as far as to the hiring of three appraisers in the event of disagreement. One I remember specifically outlined that dissenting shareholders would hire their own appraisers to value the shares at issue. If the values of the appraisals did not come within 10 percent of each other, then a third appraiser would be hired and the third appraiser’s opinion would be the final opinion.
The use of formulas in buy-sell agreements. If you believe that the use of a formula is most appropriate for your firm, then by all means do what you think is best. Formulas should be reviewed often for their appropriateness and fit with the evolution of the business. Should you decide to go the formula route, it is a good idea to periodically have a professional valuation done to test the results of any formula in use and make adjustments accordingly. The resulting value indication from the use of a formula is not representative of fair market value.
A buy-sell agreement is one of those legal documents that really, truly should be kept dusted off and reviewed from time to time to address any major changes in the business. This document is a binding agreement that is the “go to” when a major event happens, as it is intended to govern the “what happens when.” If you are a shareholder in an architecture, engineering or environmental consulting firm, please take it upon yourself to know what your buy-sell says. It’s too late to fix it when people are mad and it shouldn’t penalize those left behind.
Tracey D. Jeffers, MBA, CBA, CMEA is the Principal of Valuation Consulting for ZweigWhite, LLC. She has spent more than a decade valuing closely-held companies and holds the Certified Business Appraiser designation conferred by the Institute of Business Appraisers. Contact Tracey at firstname.lastname@example.org or (479) 582-5700.