Some estimates indicate that 10,000 baby boomers will reach retirement age each day until the year 2030. Many business owners approaching or reaching their retirement ages will depart their businesses and sell their ownership interests. Other non-retiring business owners may depart for any number of reasons. It is in these situations that provisions related to transfers of ownership interest contained in legal agreements such as buy-sell, shareholders’, or operating agreements come into play. They should contain well thought out provisions to guide both buyers and sellers as to how transactions will take place.
These legal agreements are crucial when it comes to determining the value and the timing of payments related to that value. The hope is that when an owner decides to exit a business, the provisions contained in the legal agreement will minimize dispute or conflict in what is an inherently adversarial process. Here some of the areas legal agreements should address to make the buyout process easier.
Having a Valuation Prepared When an Owner Departs
One might think that the inclusion of a formula or of a specific agreed-to value will eliminate controversy. The opposite is normally true. A formula rarely captures the variability of the value of a business with the multitude of factors that can influence its value. A pre-determined value might be appropriate for a specific time, but its shelf life is short. Consequently, the buyer or seller, whoever is receiving the “short end of the stick,” will be unhappy with the value and contest its applicability.
Instead, we suggest having a single, well-qualified appraiser prepare a valuation of the ownership interest using appropriate valuation methods. They should take into consideration not just the time-specific financial situation of the business, but also the qualitative factors that the appraiser’s analysis finds relevant and what persons on both sides of the transaction might bring to the appraiser’s attention. This scenario has a greater chance to lead to both sides agreeing to the value than if two appraisers were hired, one by each side in the transaction, because biases may enter into the derived values.
Making Sure Market Value is Paid and Received in an Owner Transaction
The ultimate goal of the process is to provide a fair price based on market value for the ownership interest, one which the business can afford to pay and with which the departing owner will be satisfied. Both sides of the transaction naturally want to benefit themselves. The seller wants to get as much out of the ownership interest upon his/her departure as possible while the buyer wants the lowest purchase price possible to maintain funds inside the business. It is crucial for market value to be determined and paid in the transaction.
Ultimately, the cash flows of the business will be used to purchase the interest from the departing owner. If the price is too high, the future cash flows of the business will not be able to properly support the purchase price. It could lead to an extended payback period and/or put a strain on the business or the personal finances of the buyer.
Conversely, the seller wants to maximize the sales price when departing. The seller seeks to reap the benefits of all the hard work put into the business over the years, often as a way to fund his/her retirement. Having the proper provisions in the legal agreement can increase the probability that the transaction will be consummated at market value to the benefit of both parties.
Determining the Standard of Value
For appraisers, “value” has multiple meanings depending on perspective. Hence, the creation of the concept of “standard of value.” According to the International Glossary of Business Valuation Terms, standard of value is defined as the identification of the type of value being utilized in a specific engagement. Differing types of values can result in material value differences. For example, fair market value is a value determined with reference to a hypothetical exchange between a buyer and seller. If an ownership interest has the attributes of 1) lacking the ability to control management decisions and/or 2) lacking the ability to be sold as easily as a 100% ownership interest could, valuation discounts will normally be applied based on these two attributes. However, under the standard, “fair value,” valuation discounts would not be applied in Kansas and Missouri. Because different standards of value can result in markedly different values, the type of value must be specified in the business’ legal agreement so that an appraiser will know the type of lens to use to estimate value.
The valuation specialists at MarksNelson have the expertise to consult on the transfer and other provisions in legal agreements (though we are not attorneys) and to prepare a valuation of a specific ownership interest, especially as it relates to an exiting owner. Reach out to us today.
