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Don’t Allow Your Client To Sign A Shareholder Agreement Unless You Consider These Four Items

Posted in Business Valuation, on Feb 2018, By: Mark S. Gottlieb

Shareholders with the forethought to sign buy-sell agreements help facilitate voluntary and involuntary transfers between shareholders. But when it’s time for a buyout, many shareholders discover that their agreements don’t cover all of the necessary details.

Here are four key terms to consider when drafting or reviewing a buy-sell agreement.

1. Definitions

One of the leading causes of disputes in shareholder buyouts is failure to provide valuation guidelines and define key terms. For example, buy-sell agreements often state that the buyout price is the value of an interest in the business. But “value” can mean different things in different contexts, so the agreement needs to spell out whether the price should be based on fair market value, fair value, investment value or some other standard of value.

Moreover, every valuation is effective “as of” a certain point in time, and the valuation date can have a big impact on the result. The agreement should specify whether the date used is the date of the triggering event, the last day of the company’s most recent fiscal year or some other date. Using a specific date rather than the date of the triggering event discourages owners from timing their departures to maximize the buyout price.

2. Discounts & Premiums

Even if a buy-sell agreement specifies a standard of value, the level of value – which can range from a controlling interest to a nonmarketable, minority interest – can have an enormous impact on the outcome.

Parties to buy-sell agreements often assume that value is based on their pro-rata share of the value of the business as a whole. Without further direction, a valuation specialist might adjust this value to reflect control premiums, minority interests or marketability discounts.

To avoid unintended consequences, the agreement should clearly specify which discounts or premiums, if any, apply. The parties might feel, for example, that a fair price is the fair market value of an owner’s interest, without regard to discounts or premiums. Beware: Sometimes discounts and premiums are imbedded in the valuation expert’s methodology. So consider addressing in the buy-sell agreement which types of adjustments can be made when projecting the company’s income stream.

3. Use of Valuation Experts

Other issues to consider include time limits for completing various valuation steps, appraiser qualifications and alternative dispute resolution (such as arbitration or mediation). The preferred method of resolving valuation problems inherent in buy-sell agreements is an agreement requiring shareholders to abide by independent findings if the agreement’s terms trigger a valuation.

Independent professional valuation services increasingly are favored in buy-sell agreements because shareholders must agree on a valuation firm’s qualifications and independence. The resulting valuation under the agreement will be objective and independent of any individual shareholder’s interests, making it fair to all shareholders.

4. Timeline

A final consideration, especially if using a single appraiser, is when the appraiser will be selected. Many buy-sell agreements provide that the parties will select an appraiser after a triggering event occurs. But there are two significant drawbacks to this approach. First, it may be difficult for the parties – who now have conflicting interests – to agree on someone. Second, even if both parties are comfortable with the appraiser, the outcome will be uncertain.

A more effective strategy is to select an appraiser at the time the agreement is signed. Ideally, the appraiser will perform a valuation at that time to set the initial buyout price and then revalue the business annually (or every two or three years). This allows the parties to become comfortable with the appraiser’s methods and conclusions and to get a handle on what the buyout price will be.

If a triggering event occurs, the buyout price is based on the most recent appraisal. But many agreements provide for a new appraisal if the most recent one is out of date (more than a year old, for example). In addition, a buy-sell agreement must be kept current to have any validity, so it’s critical to review the agreement regularly and amend it, including any valuation provisions, as necessary.

For more information about valuation issues affecting shareholder and their business interests please browse through our earlier blog posts.

For a specific concern, contact us by phone (see numbers above) or by email msgcpa@msgcpa.com