Buy-Sell Agreements: Beware - L. Wallace Behrenz
I recently testified in a dispute regarding the valuation of a business and the business interests of the
warring equity holders. The dispute could have been resolved easily and without the extensive legal
and professional fees had the buy-sell provisions of the operating agreement been drafted more
carefully. This discussion encompasses operating agreements for LLC’s, shareholder agreements
for corporations and partnership agreements. The issue: careful wording of how to value the equity
interest of the exiting owner.
Frequently, I encounter equity agreements dealing with buy-sell issues that either fail or incorrectly
define how the equity interest of a departing owner is to be valued. The standard verbiage that many
drafters have used over the years, and continue to use, is “fair market value.”
This phrase does not always result in the desired end goal and can have unintended consequences.
The recognized definition of fair market value emanates from the 1959 IRS Revenue Ruling 59-60. It
identifies a “willing buyer” and a “willing seller” where neither is under any compulsion to buy or sell,
and both parties have reasonable knowledge of the relevant facts. When determining fair market
value of a business or a business interest, the business valuator must assume a hypothetical buyer
and seller situation in applying that standard of value. Many times there is no willing buyer or seller,
or a willing buyer and an unwilling seller.
Business valuation theory and methodology is complex; not cookie cutter approaches by any stretch
of the imagination. Over the past 20 years, the technical and theoretical aspects of business
valuation have grown exponentially. The old standby “fair market value” phrase may very well not be
the best standard of value for either buyer or seller in a business dispute or amicable equity transfer.
Inherent in that definition is the application of discounts that can reduce the amount the seller
receives. One common discount is for a minority, or lack-of-control, interest. Another is the
marketability, or illiquidity, discount. Other premiums and discounts are also considered, such as
when put scenario is present.
This premium can occur when buy-sell agreements require an equity
interest be redeemed by the business entity. The application of these discounts is many times not
contemplated when agreements are drafted and end up causing litigation when their application is
discovered. This was one of the issues involved in the dispute I referred to at the beginning of this
article. The departing equity holder felt he was being cheated by artificial reduction (discounts) of
what he believed was the value of the equity interest being surrendered. On the other hand, the
remaining equity holders were thrilled that they could retire the departing equity holder’s interest at a
reduced value.
Attorneys drafting equity holder agreements with buy-sell components should consider other
standards of value for describing how a departing equity holder’s interest should be valued. What is
the true intent of the equity holders for retiring a departing member’s interest? Jointly owning a
business is much like a marriage. Disagreements happen, and frequently they end up in divorce.
Each equity holder must understand that he/she could be either the acquiring or departing
shareholder in the event of a dispute. Rather than the fair market value concept, perhaps drafters of
these documents might want to consider using a “fair value” description. Fair value is a standard of
value representing the price that would be paid to sell or transfer an asset. It typically does not
include discounts for marketability or minority interests, yet determines value using the customary
valuation concepts and techniques. Fair value establishes the amount to compensate an owner who
will be deprived of the ownership of the equity interest without reductions for discounts. When there
is a situation of an involuntary departure from an entity that will continue as a going concern, the
exiting owner receives a more equitable price for the equity interest being surrendered. The “willing
buyer” and “willing seller” assumption are not presumed in a fair value analysis, which is why it may
be more appropriate to use in buy-sell agreements.
When drafting exit provisions, attorneys should consult with an experienced business valuation
professional to ensure proper descriptions and standard of value are utilized. This can save much
cost down the road in the event a non-harmonious divestiture occurs between business partners by
eliminating litigation costs over unintended reductions in amounts believed due from redemption of
equity interests.
As Published in The Writ, November 2009.
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