As we discussed in our post on February 5, 2015, the wise investor recognizes the critical importance of a “corporate prenup” and will therefore insist on securing some form of buy-sell agreement before investing in a limited partnership, limited liability company, or closely held corporation. The buy-sell agreement is a contractual exit strategy that benefits both majority and minority owners. It provides majority owners with a contractual means to buyout the interests of minority owners and provides minority owners with the ability to cash-out of their investment. The importance of securing a buy-sell agreement became even more essential for minority owners last year, however, when the Texas Supreme Court decided in Ritchie v. Rupe to suddenly eliminate the right of minority shareholders to secure a court-ordered buyout as a remedy for oppression by the majority owners.
In the buy-sell agreement, one of the most important—and usually most difficult to negotiate—provisions is the method for determining the purchase price of a departing minority owner’s interest in the company. This post reviews several different valuation methods that are commonly used in buy-sell agreements: fixed price, book value, multiples, and engaging a third-party appraiser.
The easiest way to value a departing minority owner’s interest in the company is for the parties to provide for a fixed purchase price in the buy-sell agreement.
Unless one has a crystal ball that reveals how the business will perform in the future, however, while simple and straightforward, the fixed-purchase-price method has a number of obvious shortcomings. Depending on the success of the business, the fixed purchase price that is set for the minority owner’s interest may significantly differ from the actual fair market value of the interest when the buy-sell is exercised.
One way to mitigate the parties’ lack of clairvoyance is to insert a clause requiring the parties to periodically review and reset the buyout price. Even when a review/resetting provision is included, however, unless the buyout occurs immediately after a valuation adjustment, there is still a risk that the valuation will be stale and not reflect the company’s current financial condition. Moreover, the process of regularly requiring the buyout price to be reset may cause considerable stress and lead to conflict between the owners of the business.
Another simple valuation method is to determine the value of the minority owner’s interest by relying on the company’s stated book value or net worth: the difference between its assets and liabilities.
Though simple, as with fixed price, the book value method can be inaccurate to a significant degree because it does not account for (1) the assets and liabilities of the company that are not disclosed on its balance sheet or (2) the current fair market value of a company’s assets. Accordingly, this method would severely undervalue a company if its worth is untethered to the assets reported on its balance sheet. For example, the value of practice goodwill, which is not reported on the balance sheet, is often a service company’s most significant asset.
Moreover, this method is often inadequate even for companies that do own substantial reported assets, because book value reflects the accounting—not market—value of an asset (i.e., the original cost of the asset minus depreciation). For example, an industrial company may have purchased a factory for $2 million, which after ten years has a market value of $10 million. If the company took depreciation of $100,000 per year, however, the book value of the factory would be only $1 million (one-tenth the market value).
Using adjusted book value, which could take into account significant assets not reflected on the balance sheet and make periodic adjustments to reflect the fair market value of assets, is one way to remedy these problems.
This valuation method applies a multiplier to the amount of the company’s revenue, cash flow, or earnings per share to calculate the buyout price.
To prevent a party from cherry-picking a particularly good year in which to exit, the buy-sell agreement should use an average or weighted-average (where more weight is given to recent performance) of the company’s financial statements over a multiyear period. The agreement also should strip out one-time revenues and expenses to normalize the financials.
In addition, because the applicable multiple largely reflects a company’s financial condition and risk-profile at a given point in time, the parties may wish to include an adjustment provision in the buy-sell agreement. For example, while it might make economic sense to pay 20 times EPS for an actively growing company, that number may not be appropriate for a mature company. Including an adjustment clause would help to ensure that the valuation properly accounts for changes in a company’s financials and risk-profile as it matures.
Though expensive, to obtain the most accurate valuation of the minority owner’s interest in the business, it may be necessary to engage a third-party business appraiser. A third-party appraiser could conduct a detailed discounted cash flow analysis, as well as use other methods (e.g., analyzing comparable transactions), to value the company.
If the parties decide to go down this road, the buy-sell agreement should designate a third-party appraiser or spell out exactly how the appraiser will be chosen. The agreement should also document the specifics of the valuation—for example, whether the appraiser will calculate fair market value (applying discounts for lack of control and marketability) or fair value (the minority owner’s pro rata portion of the company’s full value).
When determining whether it makes sense to engage a third-party appraiser, the parties must balance gains in accuracy against the increased costs.
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In sum, there are two main takeaways in regard to valuing a minority interest in a private company: (1) it is essential for the owners to negotiate up front the terms of a buy-sell agreement with a clear valuation provision; and (2) there are plusses and minuses to each of the valuation methods discussed above, and the parties’ individual needs and risk tolerance, as well as the company’s financial characteristics, will help them to determine which form of buy-sell agreement best fits their needs and business objectives.