The Dismal D’s of Buy-Sell Agreements

Al StatzWell-written Buy-Sell Agreements enable orderly share transfers upon the occurrence of certain events during the life of a business. They also prevent litigation that can quickly create a lose-lose situation for business owners. This article presents a list of 27 trigger events and common issues addressed in buy-sell agreements. For fun each item on the list begins with “D”. Buy-sell issues are unpleasant to think about; which is why owners often put off addressing them and why we call them Dismal D’s. However, it’s only good business to have a plan in place that protects company and shareholder interests when these events occur.  And they will occur.

The Buy-Sell Agreement Dismal D List

  1. Departure (quits or leaves)
  2. Disinterest (mentally but not physically leaves)
  3. Discharge (fired)
  4. Divorce
  5. Death
  6. Disagreement
  7. Deadlock (major disagreement)
  8. Disability
  9. Distress (within the business)
  10. Default (personal bankruptcy)
  11. Disqualification (licensing, regulatory, etc.)
  12. Disclose (confidentiality)
  13. Donation (donate or gift stock)
  14. Do not compete
  15. Dual entities (e.g. holding and operating)
  16. Dilution
  17. Drag-along rights
  18. Distribution policy
  19. Dividends and Distributions after a trigger
  20. Dispute resolution
  21. Death benefits (life insurance)
  22. Down payment and debt (buyout financing)
  23. Determination of value (fixed price, formula, or independent valuation)
  24. Defining elements of any valuation engagement
  25. Discounts (for minority interests)
  26. Different discounts (depending on trigger type)
  27. Dueling appraisers

Items #1-14 are common trigger events. Items #15-27 are common issues to be negotiated and addressed in the BSA. Items #22-27 are nearest and dearest to our hearts as business valuation experts. Arguably, valuation is the most important (and argued over) aspect of buy-sell transactions.

The above list is intended to be a starting point for consideration by shareholders. They should work with their partners, attorney, CPA and business appraiser to understand and address all of these issues.  “Daunting D List” may be a better description!

Not only is it critical to have a BSA (yes, many businesses don’t have one), but it’s also vital that the BSA be kept up to date. Owners come and go. Shareholders’ personal, family and financial circumstances change over time. Likewise, businesses are not static and economic and industry conditions, services offered, customers, management depth competition are in a constant state of flux – all key factors in valuation.

Click here for more information on how Exit Strategies’ helps with buy-sell agreements.


Business valuation plays a central role in buy-sell transactions and buy-sell agreements. Contact one of Exit Strategies’ senior advisors with any questions or for a no obligation, no cost and confidential consultation.

Exit Planning: A New Year’s Resolution

“Expect the best, plan for the worst, and prepare to be surprised.” – Dennis Waitley
This is the time of year when many of us decide that we need to change things or accomplish new things, and we set goals at the beginning of the New Year. Quit smoking; lose weight; make more money? How about taking a look at your business this year and begin to prepare it for your exit, which will ultimately arrive whether you’re ready or not.  Surveys have shown 75% of business owners have done little or no exit planning. Owners that do plan ahead are more likely to attract buyers and obtain a higher selling price. Here are some key steps to take this year:
1. Clean up financial records.
  • End commingling of expenses, assets & liabilities. This may result in increased tax liability, but will more than pay for itself by returning a higher sale price. Example: suppose you wanted to sell your businesses in 3 years. If the market multiple of EBITDA (Earnings Before Interest, Taxes Depreciation & Amortization) is 4, for every extra $1 of EBITDA you show on the bottom line, you receive an extra $4 in the selling price.
  • Declare all sales revenue.
  • Sensible, consistent, GAAP financial statements (from the buyer’s CPA prospective).
  • Normalize each of your financial statements. Make notes below each of your year-end statements regarding expenses that are non-recurring in nature, or one-time expenses that are not normal in your business operation.
  • Control expenses: if you have a corporation, take a look at your salary, perquisites and benefits. Decide what it would cost if you had to replace your services with someone else. A business broker/appraiser would make this adjustment to arrive at a modified level of earnings that is commensurate with market rates of compensation. If you have more than one owner working in the business, adjust the salary, perquisites and benefits for each of the owners.
  • If you personally own the building that houses your operation and the corporation or LLC pays rent to you, check to see that the rent is at a market rate. Differences between market rent and actual rent being paid will adjust EBITDA.
  • Pay all of your taxes on time; sales, personal property, payroll, etc.
  • Maintain sensible, accurate management reports.
2. Systems, policies and practices.
  • A well-documented operation pays off by adding intangible value from a buyer perspective.
  • Develop or update systems – and have detailed documentation for all processes your business performs.
  • Measure, report and act on key performance indicators
  • Develop or update employee manuals, policies and job descriptions  for each employee.
3. Personal Goodwill.
Depending upon the type of business and your role in it, take a hard look at your involvement with customers. If most of them do business with the organization because of personal relationships with you, begin to transfer these relationships to someone else or a new hire in your organization. From a value perspective, goodwill that is attached to you is more difficult to transfer to a buyer than goodwill attached to the enterprise.
4. Customer Concentration.
Take a look at your top 10 customers and the percentage of revenues and gross profits that each customer generates. A high concentration of business with a small number of customers will have a negative effect on value. One way to correct high concentration levels is to increase the size of the customer base.
For advice on exiting your company feel free to contact Bob Altieri at 916-905-5706 or boba@exitstrategiesgroup.com. 

The Importance of a Credible and Competent Valuation Expert

Al StatzThe need for business valuation arises in many circumstances ranging from dispute resolution, to estate planning, to the sale of a business to name only a few.  As in all professional disciplines, it is important to hire a practitioner who is fully trained, able to discern relevant facts, and abreast of current best practices. Consider the following New York Supreme Court case.*

Adelstein v. Finest Food Distributing Co

Two brothers and their uncle each owned a one-third interest in a distribution business.  The brothers had offered to buy out the uncle. The uncle refused, the relationship deteriorated, and the case became a matter for the New York courts to decide.

The Brothers’ Expert

The expert for the brothers was a CPA lacking a business valuation credential, who had reportedly performed about 50 business valuations. His valuation report was three pages in length, based on a review of the company’s tax returns, and conversations with its accountant and its principals.  He chose an income approach, using the capitalized income method.  His rationale for using just one approach was that he couldn’t find comparable market transactions and that the company was not public. Normalizing adjustments produced an income stream of $206,000. A derived 20% capitalization rate was based upon company-specific risk factors such as customer concentration and limited management; applied a 20% discount for lack of marketability. He concluded the uncle’s one-third interest was worth $230,000.

The Uncle’s Expert

The uncle’s expert was a credentialed business appraiser.  His review included tax returns, general ledger, bank statements, and sales reports.  He found sales had doubled, gross margin declined, while officer compensation increased from $0 to $500,000. Further due diligence revealed 20% of sales were cash payments not recorded on the books. Analysis of sales reports found unrecorded sales of almost $1 million.  Additionally, he imputed industry gross margins of 35% versus 25% company reported margins.  The income approach produced a normalized income stream of $486,000, a 12% capitalization rate, a 5% discount, and a $4,050,000 value. As a sanity check, he applied a market approach using transaction data commonly accessed by professional business appraisers. In applying market multiples for sales, gross profit, and EBITDA he found a range of values between $3,990,000 and $4,191,000. He gave a 70% weight to the income derived value; 10% weight to each market derived value.  He concluded the uncle’s one-third interest was worth $1,287,000.

The Court’s Decision

The court affirmed the uncle’s expert citing his “credibility and reliability of valuation methods.”  Specifically, the court noted his qualifications, the use of more than one valuation method, and more objective and rigorous due diligence to support his conclusion.  Importantly, the uncle’s expert also demonstrated an understanding of state law on the applicability of minority discounts.

This case illustrates the wide range of business valuations and experts found out there in the real world.  More often than not, relying on a cursory review of an entity’s operations and a single method of valuation will omit key value determinants.

Accurate valuation requires an understanding of professional valuation standards and a rigorous analytical process that can be clearly explained and understood. Whatever the intended use of a business valuation, working with a trustworthy, experienced and accredited valuation professional usually provides the most accurate and defensible result.

* Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); Matter of Adelstein v. Finest Food Distributing Co., 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)


Exit Strategies’ team of accredited business valuation experts have over 100 years of combined experience.  Please contact us for a frank, confidential discussion about a potential business valuation, sale, merger or valuation need.

Why do real estate bubbles hurt more than other bubbles?

I came across an article in the First Tuesday Journal, posted by Jeffery Marino, May 30, 2014, that I thought would be worth sharing. The author quotes two thinkers on the economics of bubble-and-bust episodes; Atif Mian, Economics Professor at Princeton and Amir Sufi, Finance Professor at the University of Chicago.
This blog title’s question is best illustrated by the comparison between the burst of the tech bubble of 2000 and the real estate bubble of 2007-2009. Why is it, the authors’ ask, that the tech bubble that burst in 2000 wreaked relatively little havoc on our economy while the housing bubble sparked a decade(s) long depression?
The answer, according to Mian and Sufi, has to do with  the distribution of losses. The tech crash only affected those holding large amounts of tech stocks. Thus the losses resulting from the downturn were distributed almost exclusively among the wealthy — those who are sufficiently insulated against such financial blows. Losses from the housing crash, on the other hand, were distributed across every income bracket, with the majority of the losses being concentrated among the poor.
Make sense—doesn’t it? The chart below says it all:
Chart courtesy FiveThirtyEight Economics
As the duo’s research shows, excessive household debt leads to foreclosures, causing individuals to spend less and save more. Less spending means less demand for goods, followed by declines in production and huge job losses. A majority of Californians and Americans are vulnerable to the shock of a housing crash, and through them, our entire economic system.
For more information on the effects of macroeconomic conditions on private capital markets, business valuations and M&A activity, Email Bob Altieri or call him at 916-905-5706.

Why do business owners hire an M&A broker?

Recent clients “Jane and John Doe” were satisfied with the market value estimate of their manufacturing business, as determined by the independent valuation we prepared.  Armed with this essential piece of information, they were ready to sell the business they had founded and grown with much effort over many years.

John thought they should try to sell the business themselves.  After all, weren’t they the best salespeople for their business? And why should they share a portion of the proceeds with a broker?  Jane was not so sure and began to research whether hiring a business transaction intermediary was warranted.

One article that Jane found contained the results of a poll conducted by Partner On-Call Network LLC in which sellers of small and medium sized businesses were asked why they hire business brokers instead of trying to sell themselves.  The poll identified 62 reasons, including these top eight, in order of frequency cited:

  1. Brokers know how to sell businesses; most sellers don’t
  2. Seller doesn’t want to be distracted from running business
  3. Confidentiality preservation and knowledge of what/when to show buyers
  4. Access broker’s database of potential buyers and investors
  5. Maximize price buyers will pay for the business
  6. Owner does not know how to find buyers
  7. Prepare owner to sell and prepare business for sale
  8. Broker understands and can depersonalize negotiations

After discussing this and other inputs that they had received, the Doe’s decided that hiring an intermediary was the prudent decision if they wanted to maximize proceeds from the sale of their business and reduce the risk of no deal or a flawed deal.

All 62 reasons can be found HERE.

For a certified business valuation or assistance with successfully exiting your California company, you can Email Jim Leonhard or call him at 916-800-2716.

Why Should I get My Business Valued?

I received a call the other day from a friend who owns a publishing company. I was telling him about the types of valuation projects I was working on, and he asked, “I’m not in the middle of selling my business or transferring it to my children; why would I want to have my business valued? Besides, I know the rules of thumb for my industry.” The answer I gave him was essentially the following.
First of all, I said, most owners have heard several rules of thumb, but those rules of thumb are usually superficial, ambiguous, full of exceptions or just plain wrong.
Like most owners, my friend didn’t know if the rules indicated a value of equity, total invested capital, only certain assets, or something else.  As in this case, there are often several rules of thumb floating around—and they can’t all be right! Few business owners are confident that they understand the value of their business. And the price expectation of those who are confident is possibly too low…more often too high. In either case, it makes sense to get those expectations right, right?
Second, I said, the stakes are too high not to know the value of your business.
For most owners of small to medium-sized businesses like my friend’s, their business represents a substantial part of their net worth. Furthermore, proceeds from a business sale are often the planned source of some or all of their retirement funds. What if your expected selling price isn’t realistic or achievable? Conversely, what if you’ve already met your target value, would you sell now? You receive a statement every month from your stock brokerage telling you the value of your securities investments, right? Why wouldn’t you want to know the true value of your business at least every year or two?
Third, I told him, wouldn’t you like to improve the value of your business?
Wouldn’t it be wonderful to have a seasoned independent expert pinpoint the drivers and detractors of value in your business today? We encourage company owners who are planning to exit in the next five years to get a confidential assessment done now. This provides the business owner with a probable selling price (a number or range) and a solid basis for making sound decisions about exit strategy and improving the value of the business. Our assessments actually go well beyond value and look at marketability, finance-ability, transferrability, due diligence survivability, and other factors that are important to a successful exit. We often spot issues that are legal, tax and financial in nature and direct our clients to competent advisers in those areas. Then, after owners make adjustments in their business, we can measure progress periodically (every year or two) by updating the assessment, and give additional recommendations for reaching the next level when appropriate.
Sooner or later, everyone exits their business. The question is, do you want to leave it to chance? Or do you want to maximize value, preserve wealth, minimize risk, and exit on your terms?
J. Roy Martinez is a Certified Valuation Analyst (CVA) and business broker/M&A adviser. He can be reached at jroymartinez@exitstrategiesgroup.com or 707-778-2040.

Pro’s and Con’s of Price Formulas in Buy-Sell Agreements

Exit Strategies is regularly called upon to determine the value of closely-held company shares for buy-sell transactions. Common events that trigger a transfer of shares are when a shareholder retires or resigns from employment, is fired, dies, or becomes disabled, divorced or insolvent.
There are several facets to successful buy-sell transactions, but valuation is typically the most contested issue. The pricing method prescribed in your by-laws, shareholder, buy-sell or stock restriction agreement, as the case may be, is critical to the success of your next buy-sell transaction. Chances are your agreement (if you have one) stipulates one of these pricing approaches: a) a fixed price, b) book value, c) a formula, or d) an independent business valuation by one or more appraisers.
This article discusses the pro’s and con’s of formula pricing versus an independent valuation. Fixed price and book value are almost always bad ideas, so I won’t bother with them. Valuation formulas in the Buy-Sell agreements brought to us are usually pretty simple and look something like this:
Equity Value  =  Average EBITDA in the past two years  X  a fixed Multiple
Pro’s of a Pricing Formulapick_any_two
  1. Relatively quick and easy to calculate
  2. Inexpensive to apply
If your priority is to get to a price quickly with minimum effort and expense, congratulations, job done.
Con’s of a Pricing Formula
If however you and your partners’ want to see that all participants receive and pay a fair price, a set pricing formula misses the mark more often than not. One of the basic problems is that transactions occur sometime in the future, not when the formula is fixed, and formulas become stale as business and market conditions change over time.
Also, valuation itself is a forward-looking concept, and formulas generally use historical financial metrics. In other words, an investor ultimately cares only about what his or her return will be going forward, not what it was or would have been in the past. History is important in business valuation, but should never be entirely relied upon in determining the value of a company. As experienced business appraisers we see many companies whose future prospects are significantly better or worse than their recent past performance.
Let’s go into detail on some of the problems and solutions.
Businesses change.  A static formula can’t anticipate a change in business model.  One real-life example is a company that began life as a project-based, low margin contractor/installer of security systems, and evolved over time into a monitoring company with hundreds of annual customer contracts and high margins. Since monitoring companies trade for higher multiples than construction companies, the agreed-upon valuation formula undervalued the company when one of the owners died.  Solution: Rewrite the buy-sell agreement to require an independent valuation when a trigger event occurs.
Market conditions change.  Future market conditions are unknowable, and impossible to design into a formula. Consider the example of a real medium-size photographic processing company. With the advent of digital cameras and smart phone cameras, its film processing business was in steady decline when the founding partner wanted to retire. The pricing formula, which had been set 10 years earlier, overvalued the shares at the time of the trigger event. This led to a falling out and put a heavy burden on the remaining shareholders.  Solution: Require an independent valuation, or periodically update the formula at a minimum.
Stuff happens.  Major non-recurring events that substantially alter a company’s performance can happen at any time (think major lawsuit settlement, windfall sale, plant relocation or expansion, etc.). When such events occur during the formula’s measurement period, one side or the other gets penalized. Another issue we’ve seen many times, particularly as company owners age, is that they begin to rely on fewer and fewer major customers or suppliers for most of their business, which represents a major risk factor that won’t be accounted for in a pricing formula. For many reasons, pricing formulas can be rendered obsolete when things happen.  Solution: Have an expert evaluate the entire company at the time of the transaction.
Incomplete formula.  Most valuation formulas presented to us are too simplistic. What if, for example, the above formula was used to value an asset-intensive business — let’s say a heavy construction company. If the company had been deferring capital expenditures for several years, the formula would overvalue the company. Likewise, if it had recently replaced most of its equipment, possibly to take advantage of tax incentives, the formula would likely undervalue the company.  A formula can never be comprehensive and robust enough to capture all of the unique factors that can impact a company’s value.  I could list several dozen examples of this.  Solution: Have a seasoned appraiser thoroughly evaluate the company at the time of the transaction. If you must use a formula, have a qualified business appraiser design and update it periodically.
Formula is unclear or unfair.  Some of the pricing formulas presented to us are ambiguous in one or more significant ways; others are just plain unfair to one side or the other.  Usually the owners are completely unaware of this until a real trigger event occurs, at which point they are no longer objective. Sometimes the CPA or attorney who created the formula years ago is out of the picture or doesn’t remember what they intended.  Solution: Again, an independent valuation is the best option. Having a qualified business appraiser design and update the formula is second best. At a minimum, have your existing formula reviewed by a qualified business appraiser who can spot these types of problems and recommend improvements.
In summary, a pricing formula usually yields a share price that fails to reflect true economic value at the time of transfer; which leaves at least one party very unhappy. This is why most buy-sell agreements call for a business valuation. If you must use a formula, have it designed and reviewed periodically by a professional business appraiser for the reasons discussed here. If you have business partners and don’t have a buy-sell agreement in place, I urge you to create one now, before you are faced with a trigger event.
Business valuation plays a pivotal role in internal share transfers and all business succession plans. If I can provide additional information or advice on a current situation, please don’t hesitate to call me, Al Statz, 707-778-2040 or Email alstatz@exitstrategiesgroup.com. 

Why Should I Bother Valuing My Business?

ForbesA new article at Forbes.com addresses a question in the minds of many small business owners, “Why Should I Bother Valuing My Business?” 
The author explains several of the common reasons small business owners have their businesses appraised by an independent business valuation expert, as they prepare for a sale, buy-out, contingencies, retirement, or passing the business on to children.

Want a successful merger or acquisitions? Put an M&A advisor on your board.

Companies planning a merger or acquisition would do well to have an investment banker (M&A advisor) on their board of directors.

A new study from the University of Iowa found that firms with an investment banker on their boards of directors pursue mergers and acquisitions more often. Moreover, those firms perform better after the acquisition has been completed than firms that don’t have investment bankers on their boards.

Read the full article.

Transaction brokers create competition. Why is this so important?

The critical first step in selling a business is to properly analyze and value it to establish a price. In the case of an undervaluation, when the business is sold the result is obvious; the owner receives less. Conversely, businesses that are overvalued and overpriced usually do not sell. The reason for this is because of the principle of alternative investments, which states that rational buyers will act on some alternative business investment where they expect to earn a higher return on their invested capital. Setting a reasonable price is critical to a successful deal. Buyers won’t spend time pursuing overpriced opportunities.

All business valuations are based upon the expectation of future economic benefit. An investor, appraiser and transaction broker (investment banker, M&A advisors, et al) looks at historic earnings or cash flows (usually 5-years or more if available) along with other factors such as the current economic environment and outlook, industry trends and outlook, and internal business factors. From this analysis, when the earnings stream is expected to grow at a fairly constant rate over time, the valuator estimates the next year’s earnings stream, which is then converted into value using a risk-adjusted rate of return; as a devisor (capitalization rate) or multiple (1/capitalization rate) derived from market sources for similar investments. Note that the earnings stream is forecasted in harmony with the basic premise of value — the “future expectation of economic benefit.”

In addition to this critical valuation piece, the transaction broker creates competition in the market, or at least the perception thereof.

There are two categories of buyers: Financial Buyers, which include the typical individual owner-operator or investor group who usually pay fair market value (FMV); and Strategic Buyers, which is a company that has a specific business reason to purchase and has synergies with that business. Because strategic buyers get more earnings and therefore value out of an acquisition than the FMV of the target company, they may be willing to pay a premium price.

The existence of competition in the market, among financial or strategic buyers, usually results in the ultimate price paid being higher than if no competition exists.

In my 20 years of M&A experience, I have found that getting strategic buyers to pay more than FMV when there is no competition is difficult. When a business is marketed by a transaction broker, competition normally drives the purchase price upward, much like an auction environment.