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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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