Valuation Issues in Buy/Sell Agreements Presented by: John Stark, CPA/ABV, CFF

Valuation Issues in Buy/Sell Agreements Presented by: John Stark, CPA/ABV, CFF

Valuation Assignment What is being valued? Why is the valuation being done?

Valuation Assignment What is being valued? Why is the valuation being done? Is there a Buy/Sell Agreement (or other restrictive agreement) in place?

What is the purpose? Documents a meeting of the minds Intent To be fair? To punish? Client should have an understanding of what could happen

Methods To Determine Value - Overview Readily determined & defined term i.e. book value Formula Agreed Value

Methods To Determine Value - Overview Appraisal Auction Method Combination i.e.: agreed value if recent; otherwise formula

Defined Term Example: Book Value Often used because it is easily identified

Defined Term Example: The purchase price for purposes of Section 2 hereof shall be the book value of the Company s assets and liabilities as of the preceding year end as reported on the Company s books and records, determined in accordance with generally accepted accounting principles. What is wrong with this language?

Balance Sheet (FIFO) Assets 2014 2013

Balance Sheet (FIFO) Liabilities & Equity 2014 2013 2014

Balance Sheet (LIFO) Assets 2014 2013

Balance Sheet(LIFO) Liabilities & Equity 2014 2013

Defined Term Example: Book Value Is often used because it is easily identified Usually not indicative of fair market value Adjusted Book Value might make sense for some companies, such as real estate or investment holding company

Formula Document states a specific formula Example: Net income x 5 Gross sales x 1 Use of a formula is good only if the formula is good

Formula - Example Example: The net income of the company (as determined in accordance with generally accepted accounting principles) multiplied by five. What is wrong with this language?

Formula Net Income as determined by GAAP Net income How? Before or after taxes? What if after taxes and the company elects S and then has no income tax provision? Before or after interest expense?

Formula How are certain economic /accounting items handled? Accounts receivable reserves Inventory FIFO vs. LIFO Fixed Assets - depreciation

Formula How are discretionary items, such as officer s compensation, perks for officers, etc. handled? How are nonrecurring or unusual items quantified and handled?

Formula Are historical amounts representative?

Formula Are historical amounts representative? What time period is used? If more than one, how many? Simple average or weighted average?

REBEL ALLIANCE, INC. BALANCE SHEETS 12/31/10 12/31/11 12/31/12 12/31/13 12/31/14

REBEL ALLIANCE, INC. ADJUSTED EARNINGS (2010-2014) (2010-2014)

Formula (2014) (2014) (2010 2014)

Formula Multiple can change Affected by Risk Expected growth of the earnings being capitalized Should the multiple change over time? If it changes, who determines the change and how?

Agreed Value Involves judgment from the owners Allows parties to consider items historical financials may not (future outlook vs. past performance, effect of increased/decreased management etc.)

Agreed Value Are parties on same footing or is one more likely to exercise buyout than the other (such as when an experienced business owner brings in younger talent)?

Agreed Value What happens if circumstances change after agreed value? Company loses biggest client? Company gets a big, new client? Owner/key executive dies? Is value binding? If not binding, when is it not used?

Agreed Value How long should agreed value be used for? What happens if they don t agree on a value? Do the parties have insurance?

Agreed Value - Example 4. Purchase Price. (A) The purchase price for purposes of Paragraphs 3(B) and (C) hereof shall be the fair market value of such Stock as determined by unanimous vote of the Shareholders who are signatories of the Agreement and owners of the Stock in the Corporation. Such Shareholders shall consult with the Corporation s Certified Public Accountant in making this determination of fair market value.

Agreed Value Example (cont.) (B) For purposes of Paragraph 4(A) hereof, the parties hereto agree that the fair market value of all of the issued Stock of the Corporation as of the date hereof is $10,000,000.

Agreed Value Example (cont.) Thereafter, the fair market value shall be set in writing each year on or about the anniversary date of this Agreement or such other date as the Shareholders may agree upon. In the event that the fair market value has not been set in writing, the prior written valuation shall control.

Agreed Value Example (cont.) (A) Purchase of Insurance Policies. In order to assist in the funding of this Agreement, the Corporation agrees to obtain insurance policies on the life of each Shareholder with a minimum total face value of $5,000,000 per policy;

Appraisal The process is sometimes as important as anything

Appraisal - Example (a) Upon the death of the Minority Shareholder, the Corporation shall have the option to purchase the Minority Shareholder s shares of Common Stock owned by him at the time of his death, provided however, that if the Corporation, in its sole discretion, does not elect to buy the Minority Shareholder s Common Stock, the Majority Shareholder shall deliver notice to Minority Shareholder stating the Majority Shareholder will buy all of the Minority Shareholder s Common Stock.

Appraisal Example (cont.) (b) The purchase price to be paid by the Corporation or the Majority Shareholder, as the case may be, shall be determined as follows: number of shares of Common Stock purchased divided by total number of issued shares of Common Stock multiplied by the Fair Market Value of the Corporation as determined in Section 7 hereof.

Appraisal Example (cont.) 7. Fair Value of the Corporation. Unless determined by the Shareholders unanimously at their annual meetings which determination shall be binding on the Shareholders and the Corporation for a period of one year therefrom, or, if made sooner, the next determination, Fair Value of the Corporation shall be determined by the Corporation s accountants. In the event that a Shareholder objects to the determination by the accountants, which objection must be communicated by written notice within fourteen (14) days of such determination, the Fair Value of the Corporation shall be determined by an independent valuation company selected by mutual agreement of the Shareholders and the Corporation, and the cost of such valuation shall be borne equally by the Corporation and the Shareholder requesting such valuation.

Appraisal One appraiser? Or, each party select one and two, in turn, select the third? If more than one appraiser do a majority need to agree on a value? is an average of more than one taken? are the highest and lowest thrown out and use remaining amounts?

Appraisal What qualifications should there be on determining appraiser(s), if any? What if other outside appraisers are needed (real estate or equipment appraiser)?

Auction Method Process is important! Who, what, where, when and how? Sealed bids? Right to raise amounts? Highest wins. Dutch Auction - one party names price and terms and the other decides to buy or sell.

Combination Method Every case is unique and a combination may make sense for a particular situation Example: Agreed Value - if within parameters, if not, then appraisal.

Discussion of Discounts

Consideration of Discounts Executed (and unexecuted) documents can help support valuation discounts What are the terms of the document? Are the terms being followed?

Consideration of Discounts Discount for lack of marketability Restrictions on transfer Right of first refusal to the company and/or other shareholder(s) Put option

Consideration of Discounts - Example (a) Upon the death of a Shareholder or upon termination of a Shareholder s employment with the Corporation (a Termination ) on account of Disability (as defined in Section 2(d) below), retirement, voluntary termination or discharge for any reason, the remaining Shareholders shall purchase all of the Terminated Shares, upon the terms and subject to the conditions hereinafter provided. (emphasis added)

Consideration of Discounts Example (cont.) (b) If the remaining Shareholders are unable to or do not purchase all of the Terminated Shares of the terminated Shareholder, then such unpurchased Terminated Shares shall be purchased by the Corporation, at the price per Share determined as provided in Section 3 hereof. (emphasis added)

Consideration of Discounts Discount for lack of control Elements of Control Determine management compensation Declare or pay dividends Hire or appoint management and key employees (including related parties) Set policy and change the course of business Ability to change restrictive agreement Acquire or liquidate assets

Consideration of Discounts Example 2 Upon a Member s termination of employment with the Company by reason of such Member s death or retirement after age fifty (50), the Company shall have the option to purchase, and to the extent not exercised timely, the other Members shall purchase, and the terminated Member or his or her estate shall sell, all of the Company s Membership Units owned by the terminated Member or his or her estate, at the price determined in accordance with Article 7 below. (emphasis added)

Consideration of Discounts Example 2 (cont.) Subject to the provisions of Section 7.2 below, the purchase price of the Membership Units required to be purchased and sold pursuant to Article 6 shall be the fair market value thereof (as of the date of the event giving rise to a purchase and sale of Membership Units hereunder), without reduction or discount for lack of marketability or minority position, as determined by one or more professional appraisers or independent certified public accountants qualified by experience and ability to appraise the Membership Units in the Company (a Qualified Appraiser ), selected as hereinafter provided. (emphasis added)

Consideration of Discounts Example 3 The Agreed Value of Member s Membership Interest at all times shall be equal to (i) the fair market value of the Company multiplied by (ii) the value of the Departing Member s then-current Membership Interest, determined as of the last business day of the month preceding the month in which the contingency giving rise to the desired Transfer occurs and multiplied by (iii) the Departing Member s equitable interest determined in accordance with the following vesting schedule: 0% vesting within first 3 years of becoming a Member; 30% vesting after 3 years of becoming a Member; 60% vesting after 4 years of becoming a Member; 80% vesting after 5 years of becoming a Member; 90% vesting after 6 years of becoming a Member; 100% vesting after 7 years of becoming a Member.

What is the Purpose? Businesses and owners situation change over time Buy/Sell Agreements (and other restrictive agreement) should change also Does a company have a Buy/Sell Agreement? If NO If YES owners? GET ONE NOW! Is it up-to-date and does it address the current needs of the

QUESTIONS?