By Jason Bogniard, ASA, CVA, EA, MBA | Principal, Business Valuation and Corporate Litigation
Most buy-sell agreements, whether structured as a cross-purchase agreement between shareholders or a corporate stock redemption, are well thought-out and memorialized from a legal and tax perspective. However, we find one of the most important aspects of a buy-sell agreement is often times the most overlooked.
What is the appropriate purchase price for the exiting shareholder’s stock?
When posing this question to a group of shareholders the answer given many times over is…..“We have a formula.” Often the “formula” is nothing more than net book value of the company. Other times, the formula consists of a multiple of prior year’s reported earnings. However the purchase price is calculated, the shareholders should carefully consider if the resulting value is representative of the actual value of the business.
The Litigation Consulting department here at Apple Growth Partners sees shareholders constantly falling into the “we have a formula” trap. We usually find these shareholders embroiled in long, distracting and costly legal battles. The reason, of course, is that the selling shareholder(s) feels they are not getting full value for their ownership interest. Alternatively, the buying shareholder may find that the formula overstates the value of Company.
It is true that a formula approach to establishing the value of shares under a buy-sell agreement can be easy to calculate, understand, and communicate. However, what a formula often lacks is a good approximation of a firm’s true value. This can occur when several years pass and a value once reasonable under a formula calculation becomes outdated due to changes in industries, the general economic climate, markets served and the business itself. When a triggering event occurs (termination of employment, retirement, or death), the interests of the shareholders become disjointed, and friction can and will occur, especially if the exiting shareholder (or their estate) feels the value established for their equity interest is too low and inherently unfair.
The “value” of a dissenting shareholder’s interest in the State of Ohio is defined by case law. Specifically, Ohio case law provides for “fair cash value” as used in the Ohio dissenter’s rights statute. Pursuant to Armstrong v. Marathon Oil Company, 32 Ohio St. 3d 357, 513 N.E.2d 776 (1987), fair cash value is defined as the following:
“The amount a willing seller, under no compulsion to sell, would be willing to accept, and a willing buyer, under no compulsion to purchase, would be willing to pay for a share of stock of the corporation…”
This definition is a close approximation to a term used in the business appraisal profession of “fair market value.” Both fair cash value and fair market value account for the size of the interest being valued (control v. noncontrol), and current pricing in the market (i.e. transactions in similar business). Under this standard, the trial court can consider any factor that a willing buyer or willing seller would consider; including the fact that the stock represented a minority interest or that it was relatively unmarketable. This can mean significant discounts from any value calculated under a formula. Additionally, the court may consider the most relevant valuation method to be used as opposed to one method dictated via a buy-sell agreement. In any event, fair market and fair cash values likely exclude book value or an arbitrary formula as an appropriate way of calculating the value of a firm’s stock.
How can you limit the legal wrangling over the purchase of an exiting shareholders’ stock?
Including language in a buy-sell agreement that provides for an independent appraisal of the stock at the time of the triggering event helps to ensure fairness in the process. The appraiser should be independent from the shareholders and the corporation and have credentials from established professional appraisal organizations. Often buy-sell agreements provide that the buying and selling shareholders agree on an appraiser in advance. If an agreement cannot be reached, each party can retain the services of an independent accredited appraiser at their cost. The appraisers in turn can attempt to reconcile any differences in their respective opinions of value outside of legal system.
Other shareholder groups prefer to go through an independent appraisal process on a more regular basis, such as every-other-year. The benefits of a more regular appraisal include improved corporate planning and shortening the cross-purchase or redemption timetable, by completing the appraisal step prior to the triggering event.
Determining the value of stock through an independent appraiser helps to ensure fairness to all parties and can help to avoid costly litigation.