A buy-sell agreement is a legal agreement between owners of a business that will govern how the ownership will change if a significant event occurs to cause an owner to depart the business. Some of the more common significant events, also known as trigger events, are death, disability, divorce, retirement, termination and disputes. Every business with two or more owners should have a buy-sell agreement. We are not lawyers and the purpose of this article is not to examine all of the components of a buy-sell agreement. Our focus as accountants, business consultants and certified valuation analysts is to point out some of the pitfalls of the valuation methods included in buy-sell agreements we have experienced over more than 30 years.
A properly drafted buy-sell agreement should include a section on the method of valuing the stock or owner’s interest in the business should one of the many trigger events occur. Typically, the value is calculated in one of three ways and sometimes even a combination of the three ways: fixed price, formula and independent business appraisers.
Fixed-price method: This is when the owners agree on the value of the business at the time the buy-sell agreement is drafted. The primary advantage of this method is that the value is easy to negotiate at the inception of the business. The primary disadvantage is that the value becomes obsolete very soon after the buy-sell agreement is signed because the value of the company will change due to a variety of factors. The agreement will often call for periodic revisions to the fixed price, but that rarely occurs.
Formula method: This is when the owners agree on a formula to calculate the value of the business. Similar to the fixed-price method, the formula is easy to agree upon and understand at the time the buy-sell agreement is drafted. The most common formula is a multiple of one of a trio of key income components: revenue, EBIDTA (earnings before interest, depreciation, taxes and amortization) or net income. The problem is that a multiple is too simple and doesn’t incorporate all of the factors that can influence a specific company’s value, such as: management’s ability, age and health, key employees, competition, marketplace, economy and interest rates.
Independent Appraisers: The outcome is unpredictable and will likely surprise one or both parties. There are so many different factors to be considered in the valuation process, so it’s very likely that the value concluded by each of the appraisers will differ substantially. The agreement will require the hiring of the third appraiser to resolve the resultant disparity. This will increase the cost to the parties and business. The appraisal process can take a long time and cause significant hardship to the ongoing business operations.
A better method is to engage a single appraiser at the time the buy-sell agreement is being drafted and agree to have this designated appraiser re-appraise the company annually or at a minimum bi-annually.
Through this method the process of appraising the company is established up front and understood by all owners at the outset. The owners participate in the selection of an independent appraiser, including the method and approach that the appraiser will utilize. For example, the buy-sell agreement can establish that the company will be valued using a fair market value, and the income approach will utilize a discounted cash flow method.
While this example may appear to be technical, there are three different accepted valuation approaches and many different methods within each approach. If the buy-sell agreement is silent as to this area and requires two or three different appraisers, it’s inherently certain that each appraiser will use a different approach and method and will arrive at markedly different values.
It’s a good practice to have the appraiser prepare a draft valuation report prior to the execution of the final version of the buy-sell agreement. Each party should read the draft report and have the opportunity to ask questions and offer input into the process. An initial, agreed-upon value has been established once all of the parties are comfortable with the appraisal.
The selected appraiser should be engaged to re-value the company annually or bi-annually under the method and approach as dictated in the buy-sell agreement. Again, all parties should have the opportunity to review and comment on the current appraisal. There are two major benefits to this strategy:
1) The valuation process never gets old or obsolete.
2) If circumstances in the company or the industry or the marketplace change, the buy-sell agreement can be altered prior to a trigger event.
The cost of this suggestion is a factor to be discussed. However, you may find that it’s not a significant financial burden and should save the company substantial money, time, emotional distress and disruption to the business should one of the parties (or their heirs) feel taken advantage of by one of the three common valuation methods.
Using a single appraiser on an annual or bi-annual basis means the parties know the current value of their business, which can be helpful in their personal estate or gift planning, and can help the parties gain confidence in the valuation process. It can also provide peace of mind that this process will eliminate the uncertainties when a trigger event occurs.
This discussion is germane to the minor league baseball industry because the majority of the franchises are owned by multi-owner entities. Those familiar with the valuation process most often applied in this industry, comparable sales, may quickly conclude that many of the pitfalls of an open ended, vague buy-sell agreement would not apply. Our experience is just the opposite. Often a trigger event to a passive investor will expose the fact that the passive investor or their heirs or representatives do not understand the baseball business, minor league baseball industry and the marketplace in which the team resides, or the valuation methods. A costly contentious dispute can be avoided by implementing our recommendations.
We suggest that you review your current buy-sell agreement and discuss the valuation process with your legal advisor. A good time to have this discussion is at your annual meeting with your advisors. If you have any questions or comments, please don’t hesitate to contact either Steve Resnick, CPA, MBA at email@example.com or Gary Loewenstern, CPA, CVA at firstname.lastname@example.org.