One Business Appraiser that All Parties Know and Trust

Jointly retaining a single business valuation expert in disputes over value is becoming increasingly common as owners seek ways to streamline the valuation process, protect their companies and control costs. Naming one appraiser in buy-sell agreements (versus formula and select-3-appraisers-upon-trigger approaches) is also becoming more popular. In this slightly long-winded rant, I will discuss the pros and cons of using one appraiser that all parties know and trust, and explain why you should give serious consideration to this option.

Where My Thought Process Started

Exit Strategies has provided valuation services for many California companies going through involuntary dissolution processes.  Involuntary dissolution proceedings, per California Corporations Code § 1800 and § 2000, give minority shareholders who feel they have been victimized by those in control to force a liquidation or sale of the company, unless the corporation or its majority owners agree to buy them out at fair value.  CC § 2000 stipulates that, “The court shall appoint three disinterested appraisers to appraise the fair value of the shares …”. Often, the judge in these cases requires that the appraisers work together to develop a conclusion of value.

What’s interesting to me is that in every CC § 2000 case where I worked collaboratively with other competent appraisers from start to finish, we were able to reach agreement on a conclusion of value.  I’ve talked to several other BV experts who have similar experiences on such panels.

So, why do appraisers, working separately, reach different values?

I see three main reasons why Qualified (experienced and professionally accredited) valuation experts selected by opposing parties and working in isolation from each other are more likely to conclude different values for the same business:

  1. They have different facts. They ask different questions about the company, often of different people with different agendas, Then, using different information they arrive at different conclusions. Makes sense, right? Conversely, when appraisers receive the exact same inputs on a company, they are far more likely to produce similar values. If you hire multiple appraisers, be sure that they all get the exact same information.
  2. They head off in different directions.  Subtle differences in scope of work can have substantial effect on reported values.  Appraisers using different standards or levels of value are guaranteed to report different values.  It’s also common to see different valuation dates used.  Or, one appraiser reports a value of equity and another reports an undefined asset sale value. Often, the clients don’t even know this is happening.  And the appraisers don’t know because they are working in isolation. Such differences in direction are best identified and resolved in advance.
  3. Bias. Even though appraisers are supposed to be impartial, some succumb to pressure to deliver a result that favors the party that selected them or satisfies the attorney that hired or referred them. Exit Strategies’ professionals assiduously avoid letting bias creep into our valuations. (M&A advisory is a different story. There we absolutely advocate for our client.)

Now, CC § 2000 cases are fairly infrequent, and usually the parties decide how many appraisers to hire. As this point you may be thinking, “wait a minute, doesn’t each shareholder need to have their own appraiser?” Let me turn that question around…

If a panel of appraisers working together generally see eye-to-eye, why have more than one?

The main argument for having multiple appraisers (besides putting more appraisers to work!) is that it can guard against an outlier opinion or one appraiser making an honest mistake. If you are careful in selecting the appraiser, however, you can mitigate these risks.

Cost is an obvious disadvantage to having multiple appraisers. Not only do the parties have to pay for 2 or 3 valuations, but appraisers generally charge more when they know they’ll be working in an antagonistic and uncooperative environment or when they know their report is likely to be challenged in litigation. The reason; more hours of work.

One very important disadvantage of hiring multiple appraisers is the deleterious effect it can have on shareholder relationships and the company itself. The perception of having an appraiser in their corner promotes divisiveness between owners. They become suspicious of the other expert(s). And doubling or tripling the number of information requests, interviews and follow up questions increases management’s workload, distracts them from running the business, and prolongs the valuation process. As the rift between owners grows and the company drifts, value erodes for all shareholders.

This seems to be a good point to summarize the advantages of a using single, jointly-retained business valuator — lower cost, less work and distraction for management, better shareholder cooperation, reduced likelihood that information will be withheld or biased, less danger of advocacy, and scope of work clarity. Next, let’s discuss how you go about selecting and working with a joint BV expert.

3 Keys to Success When Using a Jointly Retained Business Valuation Expert

  1. Get to know the expert. Establish trust between all parties and the appraiser at the outset. Start by requiring professional valuation credentials, several years of relevant BV experience and real-world business transaction expertise (not just financial theory). Ask around for recommendations. Jointly interview appraisers until you find one that you are all comfortable with.
  2. Correctly define the engagement, i.e. standard of value, subject interest, level of value, scope of analysis, type of report, valuation date, etc. Many buy-sell agreements and jurisdictions do not have well-defined valuation criteria. A trusted and Qualified BV expert can point out the various interpretations and work with the parties and their legal advisors to reach a consensus. Or the parties can have the appraiser produce multiple values using different interpretations, often for little extra cost.
  3. Require open communication. Set ground rules to involve all shareholders, and advisors (attorney, CPA, etc.) in some cases, in all communications with the valuation expert throughout the process. Shareholders should have access to all information requests and documents provided, be copied them on emails, be invited to fill-out and review questionnaire responses, be invited to all live interviews, presentations and meetings, and be given the opportunity to review and give feedback on a draft valuation report.

Getting to Trust an must Appraiser

Successful jointly-retained experts have integrity and strong interpersonal skills. Get a sense of who they are by looking at their website and LinkedIn profile. Are they transparent and forthcoming with information? Can they write? Are they involved in their community and do they give back to their profession? Etc. Someone from a pure litigation support firm with little or no digital footprint probably isn’t right for this job.

In our experience, when we are jointly-retained, the parties are naturally more open and honest about company strengths/weaknesses, risks and future prospects. Separate experts rarely get the full access 360-degree view that a single expert with the support of all parties gets. In turn, they do better work and trust in them grows.

I often say there’s no better way to learn if you can trust someone than to work on a project together. If you know you’ll need an appraiser to set a share price for an imminent buy-sell transaction, don’t wait for the trigger event. Select an appraiser now and go through the valuation process together while there’s less at stake. You and your stakeholders will get to know the appraiser and the quality of their work. Further, the appraiser’s knowledge of the company and its industry will grow and they can probably recommend strategies to enhance the value of your company, which benefits all shareholders and more than pays for the extra appraisal.

What Business Owners Can Do

The next time you need an accurate unbiased business valuation or are preparing shareholder agreements, think about using a single Qualified BV expert that all parties know and trust.  Feel free to call us to discuss your needs and circumstances, or ask your attorney to contact us, in total confidence. We will let you know if we think this is good option for you.

*          *          *

Al Statz is President and founder of Exit Strategies Group, Inc. which has four California offices and has been selling and appraising businesses since 2002. He is an accredited business appraiser (ASA and CBA) and a Merger & Acquisition Master Intermediary (M&AMI) and can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Four Questions Your Buy-Sell Agreement Should Answer

A buy-sell agreement is a common contract between shareholders that both restricts ownership and facilitates the transfer of shares in a closely-held company. The other shareholders or the company become the buyers (marketplace) for what would otherwise be highly illiquid stock. Every buy-sell agreement should answer four fundamental questions:

1. Who is the purchaser?

Generally, buy-sell agreements take one of three approaches to determining who the purchaser will be: Redemption, Cross-Purchase or Hybrid.

In a redemption agreement, the company buys back an owner’s shares. When there are several owners of the company, this may be the best method. In a cross-purchase agreement, the remaining owners purchase a departing shareholder’s interest. This type of agreement is often considered best when there are only two or three shareholders. The cross-purchase method becomes unwieldy when there are several owners and the agreement is funded by life insurance. Insurance policies will have to be purchased by each owner to cover every other owner, which quickly multiplies the number of policies needed. A hybrid agreement is a combination of the above two methods. Upon an owner’s withdrawal, the stock may be first offered to the other shareholders of the company. If they do not wish to buy some or all of the stock, the corporation then buys the shares.

2. What are the buy-sell trigger events?

A buy-sell agreement should be tailored so that a buy-sell is triggered if a company owner dies, becomes disabled, retires, gets divorced, becomes insolvent, has a falling out with the other shareholders or disassociates with the company for any reason. You, your partners and your attorney decide what triggers are appropriate and how shares will be valued and bought out in each case.

3. How will shares be valued?

One of three approaches is generally used to value a departing shareholder’s interest:
(a) Agreed Upon Price – Since the agreement is usually executed years before it is triggered, an agreed upon price is rarely used. The owners must make extraordinary efforts to update the value on a regular basis. In practice, the price is rarely updated.
(b) Valuation Formula – Somewhat common with very small businesses, as an attempted cost-savings measure. Can work when a business has stable management, sales, profitability and operations, and industry and economic conditions are static.
(c) Independent Valuation – This is the most accurate, robust and fair approach. An appraiser can deal with dynamic economic conditions, an emerging industry, complex capital structures, and changed business circumstances.

4. How will the buyout be financed and paid?

Often installment payments are made from the business’s operating cash flows over time, and sometimes life insurance proceeds upon an owner’s death are used. The approach taken should ensure that the business won’t be crippled with a large payout, and that heirs will have money when they need it. A lump-sum payment is available if life insurance is involved. However, if the corporation is to buy out owners during their lifetime, scheduled note payments may be necessary. If an owner retirement triggers a buy-sell, life insurance cash values can serve as a down payment. There is no assurance that a company or purchasing shareholders will have sufficient funds in the future to satisfy note payments. Getting this right requires thoughtful and early planning.

A buy-sell agreement is an important part of a closely-held business owner’s succession plan. There are many more questions to be carefully considered and answered. Exit Strategies provides business valuation and consulting services to owners and attorneys when creating and carrying out buy-sell agreements. We do not provide legal services but can connect clients with attorneys who have deep buy-sell knowledge and experience. Contact Al Statz at 707-781-8580 with any questions or to discuss a current need.

Does My Buy-Sell Agreement Establish Value for Estate Purposes?

Buy-sell agreements that contain a clause that values stock at less than fair market value can be disregarded for tax purposes. It is important to consider the requirements of Internal Revenue Code (IRC) Section 2703 when developing an estate plan involving business interests in which 50% or more of the stock is family owned.

Section 2703(a) states that a shareholder agreement (entered into after October 8, 1990) that allows for the acquisition or transfer of property at a price that is less than fair market value will be ignored for estate and gift tax purposes. With respect to buy-sell agreements, Section 2703 provides that such agreements will set the value of shares for estate tax purposes if the agreement is binding in life as well as at death and results in the shares being transferred at fair market value.

Also, the buy-sell agreement must meet these requirements:

  1. It is a bona fide business arrangement.
  2. It is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration.
  3. Its terms are comparable to similar arrangements entered into by persons in an arms­-length transaction.

A buy-sell agreement is deemed to meet the three requirements if more than 50% of the business enterprise is owned by individuals who are not members of the transferor’s family.

 A business owner’s estate plan and succession plan can be interrelated in other ways as well.  Exit Strategies does not provide tax counsel, but we connect owners with competent tax professionals.  Our accredited business valuation experts appraise privately held businesses and fractional interests for buy-sell, tax, exit planning and many other purposes.  Contact Al Statz at 707-781-8580 with any questions or to discuss a current need. 

Hidden Problems with the Price Formula in Your Buy-Sell Agreement, and Solutions

It is tempting to select a formula approach to pricing shares when business partners come and go. After all, a formula is easy for everyone to understand, and in theory at least, inexpensive to apply. If you’re satisfied with getting to a price, any price, then congratulations – job done. But the goal is to arrive at a price that is fair to all concerned. This article discusses some of the unforeseen problems with buy-sell pricing formulas that we as valuation experts encounter frequently.

As a quick introduction, buy-sell agreements usually employ one of three basic approaches to pricing shares upon buy-sell trigger events (when a shareholder retires, dies, becomes disabled, etc.):

  1. Fixed Price: Shareholders agree on a price per share and agree to periodically revisit that price.
  2. Formula: Shareholders agree on a formula to calculate share price. Examples include: book value; adjusted book value; 4 times trailing 3 years average EBITDA, etc.
  3. Independent Valuation: Shareholders agree on a professional business appraiser to determine fair market value (or another appropriate standard of value).

The pricing method prescribed in your company’s operating agreement, by-laws, or shareholder, buy-sell or stock restriction agreement, as the case may be, is important to the success of your next buy-sell transaction. So, what are these hidden problems with the formula method?

Businesses evolve, and formulas are static

No single formula will consistently produce a fair market value result year in and year out. It is common, for example, for companies to move from a project-based model to a recurring revenue model over time. The latter sell for higher multiples, yet the multiple stated in the buy-sell agreement still reflects the old business model. In this scenario, the buyer wins and the seller loses. Formulas don’t capture changes in the business, and eventually become irrelevant. Shareholders usually have every intention of updating pricing formulas, but in practice buy-sell agreements get filed away and forgotten about, and their formulas become stale. As years go by and shareholders’ interests diverge (some become buyers and some become sellers), renegotiating a formula to bring it in line with market value becomes increasingly difficult.

Value is forward looking, and formulas aren’t

One of the central tenets of valuation is that the value of an operating business is based on expected future financial returns, considering risk and market conditions at a point in time. Valuation is therefore a forward-looking concept. Past performance may be a strong indicator of what to expect going forward, or it may not. Let’s say a manufacturing company has invested heavily in new product development for the past three years or has just added significant equipment to increase production capacity. A multiple of earnings formula would grossly under-value the shares in this case. In our work testing buy-sell formulas and providing benchmark valuations, we find that prices determined by formulas often bear little resemblance to fair market value.

Formulas are seldom 100% replicable

I’ve seen three reasonable financial experts apply the same price formula to a company and arrive at three different answers because there were at least three ways to interpret the formula. Rarely do we see pricing formulas that are totally unambiguous. When the formula was created, no one was sweating the details. Years later, when buyers and sellers emerge, a formula that leaves room for interpretation will almost certainly result in a dispute. While seemingly straightforward, a pricing formula that is not designed by a seasoned valuation professional is very likely not 100% replicable.

Formulas can create the wrong incentives

An earnings formula creates a disincentive for a managing shareholder to invest in operations toward the end of his or her reign. If he or she expects to be paid a multiple of EBIT, they might hold back from making investments that fuel growth or allow the company to remain competitive. The exiting shareholder receive more per share, while reducing future cash flows, which reduces actual value. Conversely, an unscrupulous controlling shareholder who knows that other shareholders are nearing retirement, could overspend for a few years to reduce EBITDA and therefore the buyout price. It does happen.

Bottom line; pricing formulas often yield results that are not true economic values. They produce winners and losers, which leads to hard feelings, disputes, and sometimes litigation, which becomes shockingly expensive, time-consuming and disruptive; and destroys shareholder value for all concerned.

All of the above shortcomings can be overcome by having a valuation-based buy-sell agreement and appointing a qualified and experienced business appraiser. However, if you insist on using a formula, I recommend that you at least hire a valuation expert to do a benchmark valuation of your company and design a formula that is more accurate, more replicable, and more robust. Then have that appraiser update the valuation and test and revisit the formula every three years or so.

If you would like to have your buy-sell agreement objectively reviewed from valuation, economic, fairness and practical business perspectives, please give us a call. Al Statz, ASA, CBA, can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Twenty Reasons to Know the Value of Your Company

Company owners and shareholders seek independent business valuations at various times for various reasons. Here are twenty situations in which you may want a business valuation:

  1. An owner has passed away and a valuation is required to settle the estate per IRS regulations.
  2. An owner is getting divorced and needs to have the company or their fractional interest valued to settle the marital estate.
  3. An owner wants to gift shares to his or her heirs.
  4. Business acquisition financing.
  5. Owners need an independent opinion of value to comply with provisions of the company’s shareholder agreement.
  6. A management buyout – either on behalf of the current owners, or management or both.
  7. You are considering selling the company, merging with another company, or acquiring a company – an objective opinion of value can play an important role in setting expectations and having a successful negotiation.
  8. One or more owners are developing a retirement plan and need to establish a preliminary value of their shares.
  9. Your business is the largest asset in your investment portfolio – understanding its true value is essential to any good personal financial plan.
  10. The owner(s) wants to enhance business value – a current valuation establishes a baseline and identifies opportunities for value enhancement.
  11. Owners are creating a buy-sell agreement or purchasing life insurance.
  12. Owners want to part ways and need an independent valuation to determine the share price, because they can’t agree on price or their buy-sell agreement requires it.
  13. The company is recapitalizing.
  14. The company is converting from a C corporation to an S corporation.
  15. The company (public or private) has acquired another company and needs to allocate the purchase price to all the tangible and intangible assets for financial reporting purposes in accordance with ASC 805.
  16. The company has an employee stock ownership plan (ESOP) or incentive stock options.
  17. The company has goodwill on its balance sheet and needs to test it for impairment in accordance with Generally Accepted Accounting Principles (GAAP).
  18. The company has stock-based compensation and needs to comply with IRC 409A and ASC 718.
  19. The court, or one or more owners needs an independent valuation in support of litigation, or to avoid litigation.
  20. The owners decide a capital call is required and one of the owners has become insolvent, triggering a buy-sell.

Click here for more information on the use of business valuations in different situations.

Contact one of Exit Strategies’ business valuation experts to discuss a possible business valuation need, confidentially and at no cost.

Buried in the Corporate Archives …

A lot of our valuation work is done for the purpose of internal share transfers of private businesses, or buy-sell transactions. In doing this work, we often see that owners have overlooked or neglected to keep important documents up to date. One such document is the buy-sell agreement, which articulates important legal, tax, valuation and financing issues that are important to ensuring smooth share transfers and business continuity.

I recently evaluated a holding company with a fair market value of approximately $40 million dollars. Two shareholders each owned a 50% interest in the company, a C Corporation, and one wanted to sell their stake to the other. The client said during our initial conversations that there was no buy-sell agreement in place, so we proceeded with developing a Fair Market Value opinion of a 50% interest. Just to be safe I requested a copy of “any agreements governing  or restricting the sale of shares”, as I always do.

Guess what? Just as I was wrapping up the valuation, the client came across a type-written copy of the corporate buy-sell agreement executed in 1982. The owners and officers had been unaware of its existence. Hence, it hadn’t been updated and they certainly weren’t aware of its terms and provisions. As I reviewed the agreement, I found that it prescribed that any transfer of company shares would be at book value. In this case, book value was less than $1 million dollars.

TAKE NOTE: A buy-sell agreement is a legally enforceable contract. In the 2011 New Jersey Appellate Court case of Estate of Cohen v. Booth Computers, the partnership (buy-sell) agreement stated that value would be “net book value, plus $50,000, on the most recent financial statement.” When Cohen passed away this formula generated a value of $178k. Cohen’s heirs had the business appraised for $11.5 million. The Court upheld the $178k value based on the terms of the partnership agreement!

For my client, this was a nightmare waiting to happen. In my case, imagine what would have happened had my clients not had a great relationship — the seller could have received less than $1 million for a $40-million-dollar asset! Fortunately, the owners were committed to a fair deal and they agreed to set aside the buy-sell agreement.

To assure that your company shares will transfer for an appropriate price when your buy-sell agreement is triggered or to put a buy-sell agreement in place, contact a business appraiser who is experienced in valuing company shares for buy-sell transactions. When you bring in a seasoned business valuation expert early on to interpret the pricing mechanism and other terms of your existing buy-sell agreement, they can recommend changes that will ensure that the agreement operates as the shareholders intended. And the sooner the better. It’s an easy discussion while the shareholders interests are still aligned. Later on, when shareholders becomes buyers and sellers, their interests diverge and making any changes to these agreements become far more difficult in most cases.

For further information on buy-sell agreement business valuation or to discuss a current need, please contact Jerry Matecun, CBA, at jerry@exitstrategiesgroup.com, or call (949) 287-8397.

Pricing Methodologies in Buy-Sell Agreements

When it comes to valuing a business for tax filings, M&A transactions, ESOP’s and most other purposes, business appraisers are usually free to use all of the methodologies in their arsenal.  But, when it comes to Buy-Sell Agreements that govern the sale or exchange of interests among closely-held business owners, many of these agreements specify a fixed amount or formula to price equity interests. Recently our firm analyzed the valuation and funding-related provisions used in thirteen buy-sell agreements that we encountered over the past several months.

Here’s a summary of the pricing approach taken in those agreements:

• 6 called for one or more independent valuations to determine share price (46%)
• 6 contained a predetermined price formula (46%)
• 1 used a fixed price (8%)

Despite the small sample, our findings were remarkably similar to a survey by forensics and valuation services firm Dixon Hughes Goodman LLP, which asked attorney’s what their preferred method was for valuations in BSA’s:

• 43% prefer a valuation
• 39% prefer to prescribe a formula
• 17% default to using a fixed price

Using a valuation process in a buy-sell agreement normally produces a value that is most fair to all parties, that stands up to scrutiny, is less likely to result in a dispute, and is less likely to be challenged by tax authorities.  On the other hand, the use of formulas and fixed prices introduces potential landmines that should be avoided under most circumstances.
 
JimL113x150.jpgProper business valuation is one of the keys to making buy-sell transactions occur smoothly and cost-effectively. Jim Leonhard works out of Exit Strategies’ Roseville, California office. For more information feel free to Email Jim or call him at 916-800-2716. 
– See more at: http://webcache.googleusercontent.com/search?q=cache:XzbYrHENcFIJ:www.exitstrategiesgroup.com/blog.html%3Fbpid%3D4326+&cd=1&hl=en&ct=clnk&gl=us#sthash.fIysArzp.dpuf

Funding Your Buy-Sell Agreement

A properly structured Buy-Sell Agreement (BSA) ensures a market for owners’ equity when they leave the business, restricts the transfer of shares to unwanted parties, and lays out a set of rules and processes that mitigate the overall risk of uncertainty when a trigger event occurs. However, when adequate funding mechanism(s) aren’t in place, this well-intentioned agreement may not work as intended.  I will briefly outline three common funding mechanisms that we see in our review of buy-sell agreements for business valuation purposes.

Life insurance is the safest bet in case of death. The proceeds are paid out promptly, and if any additional payment is required one of the other methods can be used to facilitate full payment. Several tax and administrative issues need to be considered depending on whether the shareholders or the corporation owns the policies. The type of policy – term, variable, or whole life is also a consideration. The premiums for whole are substantially higher than for term, but it builds cash value that can be used even if a death doesn’t occur. The BSA should also be specific in how life insurance proceeds are to be treated for business valuation purposes.
Seller financing is often used in BSA’s. Price and terms of the note should be clearly spelled out: full payment upon a trigger event? Or a down payment, term, and rate? Some agreements adjust the rate annually to reflect market rates, where others leave the rate fixed or pegged to a benchmark rate as of the buy-sell date. What about protection in case of default? My point is that there is no prescribed way. Obviously financing is a negotiation that can be as creative or as simple as the participants deem practical.
Corporate cash or a loan that provides funding is another funding alternative. However, cash isn’t always an option for small, closely held firms who lack large cash reserves. A loan is a possibility however, it may be a challenge to obtain bank financing to buy out an owner, especially when a firm has just lost a key executive.
As an aside, we occasionally see management partner with a private equity group to complete the buyout of a departing shareholder and gain access to new capital to support future growth. This type of funding is usually opportunistic and is not a viable option for most small closely-held businesses.
It’s important to point out that these funding options are not mutually exclusive and often one or more are used in tandem to fund the buyout of a departing shareholder.  We recommend that not only should a buy-sell agreement and the valuation be updated every year or two, but also that funding options be evaluated. A company’s financial position and current valuation both impact funding needs and options. Therefore, financing alternatives need to be adjusted along with changes that occur in the company.
Exit Strategies brings independence and well over fifty years of cumulative valuation and transactional expertise to every engagement. For a free confidential consult, email Jerry Matecun or call him at (949) 287-8397.

How a Covenant not to Compete Affects Value in Buy-Sell Agreements

When someone sells a privately-held company, the buyer usually insists that the seller sign a covenant not to compete. In fact, in over 20 years of business sales and acquisitions, I have yet to see a purchase agreement without a covenant-not-to-compete (CNTC) provision. Now let’s say that your Company or its shareholders purchase all of a departing 50% shareholder’s interest for fair market value; is it reasonable to expect that the selling shareholder would not compete with the Company? I think so.
Yet, many buy-sell agreements (BSA’s) are silent on the non-compete issue, allowing the departing shareholder to receive full value for their shares AND start, join or back a competing business. I briefly surveyed the last 10 buy-sell agreements that I’ve reviewed for valuation purposes, and found that fully half of them were missing a non-compete provision!
A covenant-not-to-compete provision in a BSA usually restricts the selling shareholder from soliciting customers and employees, and otherwise competing with the Company for a specified length of time within a specified geographic area. A CNTC is considered an intangible asset of the Company and may have significant value. Stated differently, the Company’s shares, post transaction, may have significantly less value without a covenant not to compete from the selling shareholder. CNTC’s have value because they protect the future revenue and profitability of the Company.
How does the absence of a covenant not to compete affect share value?
One common approach to valuing a CNTC is called the differential valuation approach; where the business is valued under two scenarios. The first valuation scenario assumes that a CNTC is in place, and the second scenario assumes that it is not. Another approach involves determining the present value of the potential future economic damages that would occur as a result of competition. In either case, the valuation expert’s job is to determine the net impact on revenue, margins and future cash flows arising from potential competition by the selling shareholder. The difference in company value for each scenario is the value of the CNTC.
To project cash flows, the business appraiser will have in-depth discussions with company management to understand and develop assumptions regarding:
  1. Seller’s business expertise in the industry and general ability to compete
  2. Seller’s intent to compete
  3. Seller’s economic resources
  4. Seller’s contacts and relationships with customers, suppliers, and other business contacts
  5. Seller’s age and health
  6. Seller’s intent to reside in the geographic area
  7. Barriers to entry that would limit the seller’s ability to compete
  8. Probability and timing of seller competing
  9. Probability that competition will harm the company
  10. Potential damage to the company due to the seller’s competition
  11. Ability of the company to prevent a customer from leaving
  12. Buyer’s interest in eliminating competition
  13. Duration and geographic scope of the (typical) CNTC
  14. Enforceability of the CNTC under State law
If valuing a CNTC sounds time consuming, subjective, speculative and expensive, it is.  You could be faced with a situation like this if your buy-sell agreement doesn’t prohibit competition. Or someone could be buying shares at a premium someday.
What does your buy-sell agreement say?
The main objective of a buy-sell agreement is to provide for the orderly and reasonable transfer of shares in the event an owner dies or leaves your Company. Yet many BSA’s don’t accomplish this because terms are ambiguous or incomplete, leading to contentious disputes and litigation when a trigger event occurs. Exit Strategies regularly appraises businesses for buy-sell events, and in doing this work we get to read lots of buy-sell agreements (and other corporate documents governing the transfer of shares), and witness firsthand how they don’t operate as originally intended by the parties.
As a business valuation expert, I recommend that you: a) have a buy-sell agreement, b) understand what it says, c) are convinced that it accurately reflects the intentions of your shareholders, and d) have great legal, tax, financial and valuation advisors to help you get it right. Otherwise you may have a time bomb ticking away in your file cabinet.
If you have any questions regarding non-compete or other buy-sell agreement provisions that affect valuation, Email Al Statz or call him at 707-778-2040.

Your Buy-Sell Agreement: Disaster Waiting to Happen? Needs a Tune Up? Or in Good Shape?

An Ounce of Prevention is Worth a Pound of Cure

I can’t tell you how many times I’ve heard from business owners and their spouses that a key person became disabled or died and left an operating closely-held business in turmoil. What, no Buy-Sell Agreement? Ask anyone who has been selling and appraising business for a number of years and they will tell you this sort of thing is common. All businesses with more than one shareholder should have a Buy-Sell Agreement (“BSA”) in place. Even when companies have BSAs, they are poorly written, causing divisive and expensive issues down the road. All multi-owner businesses need a well-written BSA to transfer shares in a fair and efficient manner when a shareholder dies, becomes incapacitated, is involved in a marital dissolution, quits or is fired, retires, or the company enters bankruptcy (aka,”Trigger Events”).

Exit Strategies’ accredited appraisers perform numerous business valuations each year, and because this work requires us to review corporate documents, we can say with some authority that many privately-held companies have problematic Buy-Sell Agreements from business, funding and valuation perspectives. When we come across B-S Agreements (pun intended), most often the owners didn’t want to invest the money to do it properly, or they just didn’t understand how import it was to have a viable BSA in place at the outset. Unfortunately, those who experience costly litigation, internal disputes, business erosion and family problems learn a painful lesson later on.

Shareholders have three choices when deciding on how shares will be priced when one of the aforementioned trigger events occurs:

  1. Fixed Price: Shareholders agree on a set price. Unfortunately, the price is likely years out of date and the shareholders usually have not agreed on a way to update the price.
  2. Price Formula: Shareholders agree on a formula to calculate future pricing. Chances are, no one has calculated it lately and because of changes in the company, economic and industry conditions over time, the formula price may be higher or lower than fair market value at the time of the trigger event. Also, it’s often seen where the shareholders haven’t agreed on ways to make necessary/appropriate adjustments to the formula.
  3. Valuation Process: Shareholders agree on a process employing one or more appraisers to determine the value of shares using guidelines specified in the BSA. There are two types of process BSAa: Multiple Appraiser and Single Appraiser. Multiple appraiser agreements call for the selection of two or more appraisers to develop one, two, or three appraisals whose conclusions form the basis for the final price. If that process sounds time consuming, cumbersome and expensive, IT IS!! It can also be divisive. Single appraiser agreements call for the selection of one appraiser whose valuation sets the final price. The choices are to a) select the appraiser and value upon a trigger event; b) select the single appraiser now and value at the trigger event; or c) select the single appraiser now, value now, and of course value again when a trigger event occurs.

Our Recommendation is to SELECT ONE APPRAISER NOW and VALUE NOW

  • Select Now – If the shareholders creating the buy-sell agreement name the appraiser at the time of the agreement, all parties have a voice and can sign off on the selection. Early on, when everyone’s interests are aligned, this is a relatively easy decision to make. Doing it after a trigger event, when interests have diverged, is very difficult.
  • Value Now – Once selected, the chosen appraiser provides a baseline valuation, which is a fantastic way to put all shareholders on the same (price) page. We often provide a draft report, and give everyone time to provide comments for consideration before the report is finalized.

Reasons why selecting a single appraiser now and appraising now is the best choice for closely-held companies when creating a Buy-Sell Agreement:

  • The selected appraiser is viewed  as independent by everyone
  • Because the appraiser must interpret the BSA language related to valuation when conducting the initial appraisal, any issues regarding lack of clarity or inconsistency with the owners’ intentions can be resolved up front
  • The valuation process is observed by all shareholders at the outset, so they all know what will happen when a trigger event occurs (no surprises)
  • The concluded value establishes a baseline price (no surprises)
  • The selected appraiser maintains independence with respect to process and renders future valuations consistent with the BSA terms and prior reports
  • Subsequent appraisals, either annually or at trigger events, should be less time consuming and less expensive
  • Parties will likely gain confidence in the process
  • Parties will always know the current value for the Buy-Sell agreement, which is helpful for personal or estate planning purposes
  • The initial valuation gives the shareholders a roadmap to increasing value if that is their objective.
  • The appraiser’s knowledge of the company and industry grows over time, enhancing confidence for all parties
  • Creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares


Valuation is a key piece of any shareholder buy-sell agreement. If you need help with the business valuation provisions of your buy-sell agreement, or need a valuation for a trigger event, feel free to Email Bob Altieri or call him at 916-905-5706.