Developing Appropriate Valuation Provisions: Defuse ticking time bombs in shareholder agreements before they explode

Monday, November 7, 2016 - 00:37

Shareholder agreements document the intentions of the parties in connection with, among other things, the price to be paid for an ownership interest in the event of a shareholder’s death, disability, retirement or other triggering event. There are four commonly used methods to value a company.

Book value. This is the easiest and simplest approach to value a company. Simply refer to the company’s balance sheet and use stockholders’ equity as the proxy for value. The advantage of this method is that it is easy to apply; its disadvantage is that it does not take into consideration any goodwill or differences between the depreciated cost of assets and their fair market value. Another limitation of this method is that if a company maintains its books and records on the cash basis of accounting, all of its assets (i.e., accounts receivable) and liabilities (i.e., accounts payable) may not be included in the analysis. Often, the use of a book value methodology will result in a value that is substantially less than the company’s fair market value.

Fair market value. This can be determined by an independently prepared appraisal. The advantage of this method is that it will yield a value that is reliable and accurately reflects all of the goodwill of the company. The disadvantage is that there is a cost associated with this approach and, if timing is important, the possibility of a delayed response.

Formula approach. This approach employs a simple multiplication exercise, i.e., multiplying some metric, say, revenues or income before shareholders’ compensation, by an agreed upon multiple. Like the book value approach, this is easy to employ. Its disadvantage is that facts and circumstances change, and the multiples that may be applicable at the date of the agreement may be significantly different than the appropriate multiple at a later valuation date. Hence, parties to the agreement will need to revisit this approach periodically to see if it requires revision.

Stipulated value. Some agreements provide for the annual (or other periodic) designation of a value by a company’s board, shareholders or other authoritative body. This approach is not recommended. Inevitably there will come a time when it is not performed in accordance with the requirements of the agreement or it may be improperly documented, and then there will be a problem. It also creates an opportunity for unnecessary and avoidable friction with respect to the determination of value.

Valuing the Subject Interest

There are several ways to value the subject interest.

Fair value. Multiply the value of the company (as discussed above) by the shareholder’s percentage interest. This is a simple approach that does not take into consideration the reduction in value that an investor would likely demand when purchasing a minority, nonmarketable interest. This approach is sometimes referred to as fair value, which in many states is the applicable standard of value in lawsuits involving shareholders and the company.

Fair market value. This is calculated by using fair value reduced by discounts for lack of control and lack of marketability. It more accurately reflects the amount that the subject interest could realize if it were separately sold. The applicable discounts can be (but don’t need to be) stipulated in the shareholders agreement. Fair market value is the standard of value required for federal estate and gift tax reporting purposes.

A bona fide third-party offer. Use a bona fide third-party offer for the subject interest. This may be inapplicable if no offer has been received.

For the subject interest value, use the higher or lower of the third-party offer and either fair value or fair market value.

Circumstances Matter

Different valuation approaches may be applied depending on the circumstances surrounding the transaction. For example, if a transaction is necessitated by termination of employment with cause, it may require a different methodology (resulting in a lower value) than if the transaction is caused by death or disability (a higher value).

There is no one-size-fits-all-situations solution. Moreover, priorities may shift over time depending on a number of factors, including shareholders’ ages, whether all shareholders are required to remain active in the business, the timing of entry of new shareholders, etc. The most important question that shareholders should answer is what do they want to achieve: high, low or precisely accurate value; cost savings; timeliness – or some combination thereof. Agreements that do not satisfy the needs of shareholders are like ticking time bombs that will undoubtedly explode at the most inopportune time. Gaining a clear understanding of the shareholders’ needs will enable counsel to draft an agreement that is appropriate in each circumstance. 

Eric J. Barr, CPA/ABV/CFF, CVA, CFE, is the Partner-in-Charge of Valuation Services, Financial Advisory Services group, at Marks Paneth LLP. 

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