Buy-Sell Considerations: Are Valuation Formulas Effective?– November 03, 2014

I see many types of buy-sell agreements in the course of my work, including stock transfer, close corporation and shareholder agreements. And, unfortunately, I also see many that contain ambiguous terms or outdated provisions. As a result, when a triggering event occurs — such as death, disability, divorce or retirement — the process, outcome or both can produce unexpected results and frustration. One area that often becomes a key issue is determining what the business or ownership interest is worth at the time of the triggering event.

Rather than agreeing upon a value annually or defining a process to determine the value upon the triggering event, many owners and their attorneys attempt to draft a formula within the buy-sell agreement that is meant to calculate the value of the business or ownership interest. The problem with this approach is that the formula is drafted at the time the agreement is written or amended, but is not actually implemented until sometime in the future — when circumstances could be much, much different. Since businesses and their industries can change over time, a predetermined formula can become outdated if owners do not amend the formula to evolve with the company and its owners.

If your buy-sell uses a pre-determined formula, below are a few considerations that may help you better understand the different formula approaches and what to consider to get the most accurate value when the time comes. For other alternatives on how to determine value, read “Do You Know How Your Buy-Sell Values Your Ownership Interest?”

Balance Sheet Approach
Frequently, a balance sheet approach is used to value the assets and liabilities of a company. Book Value represents the assets minus the liabilities of a company. It is a common term that is used since most business owners can look to their company’s financial statements and calculate the difference between the assets and liabilities. However, book value is an accounting term based upon the historical cost of the assets and liabilities as they were recorded in the company’s books and records, which is not necessarily the fair market value of the assets and liabilities.

For example, if a company owns a building, it records the historical cost to acquire the building along with the depreciation expense over time related to its use. The balance sheet reflects the net book value, which is equal to the historical cost of the building less the accumulated depreciation. The resulting net book value of the building may be materially different from the fair market value, especially if the property has appreciated in value since it was acquired.

Another example is a company that grows over time, develops a good reputation within its industry and becomes very profitable. That company may develop significant goodwill or other intangible assets. The value of the goodwill and intangible assets are generally not recorded on the company’s books and records. Therefore, the true fair market value of the company will not be reflected in the company’s book value.

There could be many other types of assets and liabilities recorded on the company’s books and records at historical amounts that are not reflective of fair market value, making the use of the company’s book value mis-representative:

  • Uncollectable accounts receivable
  • Old or obsolete inventory
  • Fully depreciated machinery and equipment
  • Unrecorded contingent liabilities

An alternative is to use the Adjusted Book Value approach in your buy-sell agreement. This approach restates all of the company’s assets and liabilities at fair market value. Land and buildings would be adjusted to fair market value based on a real estate appraisal, recent offer to purchase or comparable sales of other properties in the area. Machinery and equipment could be adjusted based upon an appraisal of these assets or recalculation of the economic deprecation using the estimated useful lives of the assets. The fair market value of goodwill and intangible assets could be determined and included in the total adjusted book value of the company.

Generally, the Adjusted Book Value approach is used in valuing real estate holding companies. It is not commonly used when valuing an operating company, unless warranted by the facts and circumstances.

Income Statement Approach
Many businesses are bought and sold using some valuation approach based upon the company’s income statement, such as a multiple of earnings. Typically, a significant amount of time is invested to determine the appropriate earnings base and the correct multiple to use at the time of the potential sale. Business owners, however, will attempt to develop a formula in their buy-sell agreement based upon an Income Statement approach and defining the earnings base and multiple to be used sometime in the future at the triggering event. The challenge arises when the company or industry changes and the formula is not updated to reflect the changes on either the earnings base or the multiple.

The earning base can be defined in several different ways, including net income, cash flow, adjusted earnings, adjusted earnings before taxes or EBITDA (earnings before interest expense, income taxes, depreciation and amortization). Each one of these earnings bases should have an appropriate multiple applied to it to arrive at the true fair market value of the company. Consulting a valuation expert or someone familiar with the industry and appropriate multiples can be beneficial.

If adjustments are to be made to the earnings, the buy-sell agreement should consider addressing what those adjustments could be and who would make that determination. Adjustments could include the following:

  • Non-recurring revenue or expenses, such as lawsuit settlements or legal expenses
  • Discretionary expenses, such as compensation and benefits to the owners
  • Non-operating income or expenses, such as rental income or gains/losses on the sale of equipment
  • Economic adjustments, such as LIFO adjustments or accelerated depreciation

Once these adjustments are determined, the time period to consider in the calculation of the earnings should be addressed. The time period could be the most recent year-end, the most current trailing 12 months, or an average from the last three or five years. This time period could be different for each company and could change over time depending upon the growth, trends and stability of the company and its earnings. As such, it proves a difficult challenge to make a static formula in a buy-sell agreement that requires the use of a specific time period if the company has changed since the agreement was drafted. For example, what time period is appropriate if the company recently sold one of its divisions? Or added a new sales force that brought in several new customers under long-term contracts? Or experienced new governmental regulations that increased the cost of its raw materials and significantly reduced the company’s profits? Valuators consider these and many other factors when determining the appropriate time period for the earnings base when valuing a business using a multiple of earnings.

The development of the appropriate multiple has similar challenges. The multiple is a representation of the rate of return that a potential owner is expecting for assuming the risks of ownership of the company, factoring in the industry, economy, competition, customer base, depth of management, etc. The greater the risks, the higher the required rate of return, or the lower the multiple. Therefore, when business owners include a specific multiple in a buy-sell agreement, they are generally documenting the current rate of return associated with the business at that time, which may be very different from the future risks of the company when the triggering event arrives. Again, periodically revisiting the buy-sell agreement, to make sure the multiple reflects the current risks and expected rate of return related to an ownership in the company, is one way to make sure a static formula evolves with the company and stays consistent with the owners’ expectations.

Valuation is one of the critical elements business owners need to get right in a buy-sell agreement. This is the one area that will essentially determine how much you may receive for your ownership interest, or how much the business may have to pay to redeem another owner’s interest sometime down the road.

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This communication is published by Cohen & Company for our clients and professional associates. Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.