Beware of fixed-value provisions and other business valuation faux pas in buy-sell agreements
Buy-sell agreements are a critical tool for closely held businesses and professional practices. The valuation provisions of these agreements play a significant role when buyouts happen. Unfortunately, shareholders in a New York law firm recently learned a hard lesson: While a fixed-value provision has the benefit of simplicity, failure to tie that formula to the business’s current fair market value can prove costly.
In Laurilliard v. McNamee Lochner, P.C. (No. 904245-22, N.Y. Supr. Ct. June 29, 2023), a New York trial court forced two law firm shareholders, who had practiced with the firm for decades, to surrender their shares for only $100 each. The court denied the terminated shareholders’ claim, which alleged their old firm and nine of its shareholders had anticipatorily breached the shareholders’ agreement by stating that the firm would be “ceasing the practice of law in the near future.”
The court ruled that the shareholders’ agreement didn’t prevent the firm from ceasing operations. In fact, the agreement didn’t speak to dissolution, liquidation, winding down or the distribution of assets to members upon dissolution. The firm’s only obligation under the shareholders’ agreement was to pay the plaintiffs the $100 purchase price for an offered share within six months — which was equal to the “book value” of the shares.
Book value is an accounting term that refers to a shareholder’s pro rata share of equity as reported on the company’s balance sheet (that is, the difference between assets and liabilities). For accounting purposes, tangible assets — such as receivables and equipment — generally are reported at the lower of cost or market value. And intangible assets — such as customer lists, brands and goodwill — aren’t reported on a company’s balance sheet unless they’re acquired from a third party. On the other hand, liabilities are typically reported at fair market value. As a result, the book value of a shareholder’s interest tends to be significantly less than its fair market value.
In addition, the court found that the plaintiffs were in breach because they refused to deliver their shares in a timely manner. So they lacked the standing necessary to maintain a claim for an equitable accounting.
Avoid other value-related missteps
In hindsight, the terminated shareholders in Laurilliard may regret not giving more thought to the buyout language in their shareholders’ agreement. In addition to using fixed valuation formulas that aren’t tied to fair market value, here are five other valuation-related pitfalls to consider when drafting or updating a buy-sell agreement:
1. Providing for a negotiated price. Some agreements call for the parties to negotiate the buyout price when an owner retires or another triggering event occurs. But the parties almost always have conflicting interests: The buyer wants to pay the lowest possible price, and the seller wants to receive the highest possible price.
2. Failing to establish qualifications for experts. It’s critical for experts to possess credentials from a reputable business valuation organization and to be independent of the company and its owners.
3. Neglecting to specify the standard and level of value. Always define the term “value” in a buy-sell agreement and address the issue of valuation discounts. Typically, fair market value is the appropriate standard of value. But if left undefined, the meaning may be uncertain and lead to disputes.
4. Overlooking the valuation date. Generally, it’s easiest to use a valuation date that coincides with the end of an accounting period. However, a company’s value can change dramatically over time — or after an event (such as a merger) triggers the buy-sell agreement.
5. Setting unreasonable time limits. Valuators need ample time to gather and analyze financial data, conduct management interviews and site visits, and write the valuation report.
Get it right
The purpose of a buy-sell agreement is to ensure a smooth transfer of ownership and avoid disputes over the buyout price when an owner dies or otherwise leaves the business. But a poorly written buy-sell can have the opposite effect: Ambiguity, missing terms or poorly conceived valuation mechanisms increase the likelihood of disputes when a triggering event occurs. Contact us for help drafting a buy-sell agreement that covers all the value-related bases.