Valuation‐Related Language
Excerpted from an Actual Buy‐Sell Agreement
A. Purchase Price. The purchase price paid will be the deceased Shareholder’s proportionate
ownership interest in the Corporation multiplied by the Corporation’s Fair Market Value, as defined in Treasury Regulation §20.2031-1(b) of such shares of stock as of the Shareholder’s date of death. The Fair Market Value shall be determined by an independent appraiser with the cost of the appraisal being paid by the Corporation. In the event the deceased Shareholder’s personal representative and the Corporation are unable to agree as to such appraiser, such deceased Shareholder’s personal representative and the Corporation shall each select an appraiser, which appraisers shall agree upon a third independent appraiser, who shall then proceed to determine the Fair Market Value of such shares of stock. The value so determined shall be final and binding on the parties.
B. Payment of Purchase Price. The purchase price will be paid by delivery of a signed promissory
note from the Corporation made payable to the order of the deceased Shareholder’s estate over a period of five (5) years, together with interest at a variable rate equivalent to the Prime Rate published in the Wall Street Journal on the first business day of each calendar year. Payments of principal and interest will be made in equal consecutive quarterly installments beginning on the first day of the sixth (6th) full month
following the date of death. The Corporation will have the right of prepayment without penalty. The deceased Shareholder’s Personal Representative will execute and transfer to the Corporation his stock certificates and will execute such other documents as may be necessary to transfer and convey all the deceased Shareholder’s interest to the Corporation.
C. Failure of Corporation to Exercise Option to Purchase. In the event the Corporation fails to
Analysis of the Agreement
in light of Buy‐Sell Agreements for Closely Held and Family Business Owners
Introduction
One good way to examine buy-sell agreements is to analyze the relevant text on a phrase-by-phrase or sentence-by-sentence basis. Each of the three paragraphs quoted above is reproduced and annotated with letters, which will be discussed in the section for each paragraph. Doing this enables the analyst to focus on the “words on the pages” to facilitate understanding from business and valuation perspectives.
We refer to the language in this example buy-sell agreement as a “valuation process agreement” because an appraisal process is required to determine value (i.e., the purchase price per the agreement).
The following discussion is developed in the context of Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners, which is titled “The Defining Elements of a Valuation Process Agreement Explained.” The discussion is also enhanced by observing what the agreement says and how it could be misinterpreted by (possibly) unqualified appraisers who are asked to perform the valuation process. This process involves careful reading and the application of logic and common sense.
The Purchase Price Paragraph
A. Purchase Price. (a) The purchase price paid will be the deceased Shareholder’s proportionate ownership interest in the Corporation multiplied by the Corporation’s (b) Fair Market Value, as defined in Treasury Regulation §20.2031-1(b) of such shares of stock (c) as of the Shareholder’s date of death. The Fair Market Value shall be (d) determined by an independent appraiser (e) with the cost of the appraisal being paid by the Corporation. (f) In the event the deceased Shareholder’s personal representative and the Corporation are unable to agree as to such appraiser, (g) such deceased Shareholder’s personal representative and the Corporation shall each select an appraiser, (h) which appraisers shall agree upon a third independent appraiser, (i) who shall then proceed to determine the Fair Market Value of such shares of stock. (j) The value so determined shall be final and binding on the parties.
Some appraisers are so ingrained to develop nonmarketable minority values for minority interests that they might interpret “proportionate interest” to be the proportionate share of a nonmarketable minority level value (after perhaps applying minority interest and/or marketability discounts). And since the independent appraiser’s conclusion will be binding on all parties (j), this would be unfortunate.
b. Standard of value. The agreement specifies that Fair Market Value is the required standard of value and further provides a citation to the definition of Fair Market Value as Treasury Regulation §20.2031-1(b), which is quoted below (with emphasis added).
separately returned. Property shall not be returned at the value at which it is assessed for local tax purposes unless that value represents the fair market value as of the applicable valuation date. All relevant facts and elements of value as of the applicable valuation date shall be considered in every case. The value of items of property which were held by the decedent for sale in the course of a business generally should be reflected in the value of the business. For valuation of interests in businesses, see §20.2031–3. See §20.2031–2 and §§20.2031–4 through 20.2031–8 for further information concerning the valuation of other particular kinds of property. For certain circumstances under which the sale of an item of property at a price below its fair market value may result in a deduction for the estate, see paragraph (d)(2) of §20.2053–3.
There are at least three reasons why I think the reference to Section 2031-1(b) is not ideal. First, the definition relates to the “valuation of property in general,” and not to the valuation of business interests. Second, the definition refers to other sections of the regulations for further discussion of the valuation of interests in businesses, which can cause confusion. And third, the discussion relates to “an item of property,” which could be misinterpreted as the block of stock itself rather than the proportionate share of the value of the enterprise, as indicated in the paragraph.
I would suggest that a reference to the ASA Business Valuation Standards could be preferable [or to other standards, as appropriate for the reviewing appraiser]:
”Fair Market Value. The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”1
This would also tend to ground the valuation in the context of relevant valuation standards. Alternatively, the definition from Revenue Ruling 59-60 could be used:
”Section 2.02. Section 20.2031-1(b) of the Estate Tax Regulations….define fair market value, in effect, as the price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well-informed about the property and concerning the market for such property.”
Either of the definitions from the ASA Business Valuation Standards or Revenue Ruling 59-60 is preferable to the reference to Section 2031-1(b) because of their focus on businesses and business interests.
c. Valuation date. The valuation date is specified as the date of death. That is crystal clear in the agreement. Without further guidance, this will leave the selection of financial statements to provide the basis for the appraisal up to the appraiser. That is not necessarily bad, but if the Corporation prepares quarterly financial statements, for example, it might be good to instruct the appraiser to consider the most current financial statements available at the valuation date.
d. Qualifications of the appraiser/Standards to be followed. The Agreement calls for the parties to attempt to agree upon an “independent appraiser,” a term not defined in the agreement. Unfortunately, that tent is so open it doesn’t have doors. Absent specific criteria describing qualifications (experience, credentials, size of firm, etc.), any accountant, business broker or college professor could qualify.
It is an excellent idea to provide a list of valuation credentials as minimum qualifications for the selection of an appraiser. I always recommend the ASA designations of the American Society of Appraisers. Members of the ASA are required to provide appraisals in accordance with the ASA
Business Valuation Standards and the Uniform Standards of Professional Appraisal Practice
(USPAP). This is important, because you definitely want your appraiser to provide a standards-compliant appraisal. [If you follow other standards, you obviously want to cite those standards in your write-ups of reviews of buy-sell agreements]
e. Cost of appraisal can be an issue. The Agreement states that the “cost of the appraisal” will be borne by the Corporation. However, this could be read as applying only to the cost of the appraiser in the case where the Corporation and the deceased’s representative agree on an appraiser. If the shareholder has to retain an appraiser to participate in an appraiser-selection process (as called for in the absence of agreement), who must pay for that appraiser? One reading would indicate the Corporation. But another reading might suggest otherwise. Also, does the Corporation pay for its appraiser if this process is required? I can tell you that all the appraisers will need this clarified, and it is pretty easy to do if the parties talk about it.
If the estate’s representative and the Corporation cannot agree. If there are no agreed
upon appraiser qualifications, it may be difficult for the parties to agree. This agreement calls for what we describe as a “Single Appraiser, Select and Value at the Trigger Event” process. The decision as to who the appraiser will be is put off until a trigger event (death of a shareholder) occurs. No one will know what kind of appraisal will be received until after a trigger event. The biggest problem with this structure for determining value is that all the decisions are put off until the worst possible time, i.e., when the interests of the parties have diverged.
There are no timeframes built into the process for selecting the appraiser and for the appraiser to deliver the appraisal. What happens too frequently is that corporations delay the process, often because it is just not given a high priority. If this happens, the shareholder’s estate has no leverage to require moving things along.
Consider how much easier it would be for the parties to talk to appraisers now, and agree on the appraiser when the agreement is put in place. Any questions regarding the standard of value of the level of value would be resolved while the appraisal was in the draft stage.
Consider how much more information everyone would have if the appraiser conducted the initial appraisal and established the initial value for the Agreement. Then, reappraisals could be done every year (or every other year) or so, depending on the economics. This is a much better structure for shareholder planning.
But the clause is, in the event that the parties cannot agree.
f. Each party selects an appraiser. The sole purpose of this procedure is for the appraisers selected by the estate’s representative and the Corporation to mutually agree on (select) a third appraiser. This is sometimes easier said than done.
g. The first two appraisers will agree on a third independent appraiser. The first two appraisers have no guidance re the qualifications of the third appraiser and, depending on their respective backgrounds, may themselves have a difficult time in reaching agreement. At this point, the estate is interested in a higher valuation and the Corporation is interested in a lower valuation. It just works that way when the interests of the parties diverge. Sometimes, the first two appraisers are unable to agree on a third appraiser. There is no provision for what happens then, or how long they will have to attempt to reach a mutual selection.
h. Who shall determine the Fair Market Value of such shares of stock? This seemingly innocuous phrase can undo what the parties may have thought was an agreement at the outset. The reference to “the Fair Market Value of such shares of stock” might be interpreted by some appraisers as relating to the particular interest being valued. If that interest is a minority interest, they might well apply valuation discounts, which, I don’t believe, is what the Agreement intends.
i. But nevertheless, the conclusion of the appraiser is binding. This is why I always suggest an initial appraisal for buy-sell agreements. If the parties agree on an appraiser at the outset, that appraiser will have to interpret the agreement’s language. If he makes a different interpretation than the parties discussed, or if the parties didn’t discuss it and find out what could happen, there is time to fix the problem. The parties at that time do not have disparate interests.
Payment of Purchase Price Paragraph
B. Payment of Purchase Price. (a) The purchase price will be paid by delivery of a signed promissory note from the Corporation made payable to the order of the deceased Shareholder’s estate over a period of five (5) years, together with interest at a variable rate equivalent to the Prime Rate published in the Wall Street Journal on the first business day of each calendar year. (b) Payments of principal and interest will be made in equal consecutive quarterly installments beginning on the first day of the sixth (6th) full month following the date of death. (c) The Corporation will have the right of
prepayment without penalty. The deceased Shareholder’s Personal Representative will execute and transfer to the Corporation his stock certificates and will execute such other documents as may be necessary to transfer and convey all the deceased Shareholder’s interest to the Corporation.
a. The purchase price is to be paid in the form of a promissory note of the Corporation
with a term of five years. The interest rate is to fluctuate based on Prime Rate as found in the
Wall Street Journal on the first business day of each calendar year. This could be confusing. Suppose
death occurred on November 30, 20xx. Is the rate to be set for the first six months at the Prime Rate on January 2, 20xx, or is the rate to be set at that level for one month and then change to the rate on January 2, 20xx(+1)? This may seem trivial, but it could mean significant dollars to one side or the other depending on what happened to rates in 20xx.
The description of the promissory note does not state where in the pecking order of the Company’s debt it should lie. Is it subordinated to any bank debt? Is it senior to or subordinate to any previously existing shareholder debt? Is the note unsecured? That issue is not specified. Absent specification, it is probably unsecured and subject to being weakened if the Company secures debt that is senior to the shareholder note.
b. Payments are to begin six months after death. But what happens if the appraisal process is not yet completed? This is a distinct possibility. Most often, promissory notes in buy-sell agreements call for a 20% (or so) down payment at the closing of the sale, and then for financing over a term of years, often five, and sometimes more. This process, given the time for the Corporation’s option (below) and the related other shareholder options, could easily take many months to complete. There is no provision for early liquidity for the deceased shareholder’s estate during what could be a long period of waiting, even if all parties are cooperating.
There is another issue here. Payments are to be made in “equal consecutive quarterly installments.” If the rate changes in January of each year, the amortization schedule will change. If the payments remain as they were initiated, there will be a confusing disconnect between the payment stream and the actual amortization of the promissory note. Otherwise, when the rate changes, the CFO or other designated person would recalculate the amortization schedule, provide copies to the shareholder’s estate, and adjust the payment.
The “Binding or Not” Paragraph
D. Failure of Corporation to Exercise Option to Purchase. (a) In the event the Corporation fails to exercise its option to purchase the deceased Shareholder’s stock within 90 days of the deceased Shareholder’s date of death, (b) the remaining Shareholders (the “Other Shareholders”) will each have the option to purchase their proportionate share of the deceased Shareholder’s stock pursuant to the same terms and conditions set forth in this Section 5. The Other Shareholders must exercise their option to purchase within 30 days after the expiration of the Corporation’s 90 day option period. (c) If only one of the Other Shareholders exercises his or her option to purchase his or her proportionate share of the deceased Shareholder’s stock, then such Other Shareholder will be entitled to purchase all of the deceased Shareholder’s stock by delivering written notice of such intent to the Corporation and to the deceased Shareholder’s Personal Representative and the remaining Shareholder(s) within 10 days after expiration of the Other Shareholders’ 30 day option period. (d) For purposes of this Paragraph, a Shareholder’s “proportionate share” will equal a fraction, the numerator of which is the number of shares of stock owned by such Shareholder, and the denominator of which is the aggregate shares of stock owned by the Other Shareholders. (e) (f)
a. If, for the Corporation to exercise its option, it actually purchases the shares, the 90 day exercise period may not be enough. There first has to be an appraisal process. With the agreeing upon and hiring of even one appraiser, this is problematic. With three appraisers involved, it will almost certainly take more than 90 days to obtain the appraisal.
b. If the Corporation does not exercise, then the other shareholders, individually, have the right to exercise their option to purchase. The exercise period is 30 days. No notice is apparently required if things work this way.
c. If the shareholders do not exercise pro rata, a single shareholder (or two of three) may then have another 10 days to exercise the option to purchase. They can exercise by delivering notice of intent to the Corporation, the deceased shareholder’s representative and the Other Shareholders.
d. This clause works only if all the Other Shareholders exercise the option to purchase jointly. For example, assume there are four shareholders owning 40%, 40%, 10% and 10%, respectively, and there are 100 shares. The last shareholder dies. The Other Shareholders exercise jointly. They each purchase 40/90, 40/90 and 10/90, or 100% of the 10 shares owned by deceased Shareholder. If, however, the 10% shareholder does not participate, the fraction to be purchased by the two 40% shareholders is 40/90 and 40/90 per the formula. They could only purchase 80/90 shares, leaving 11.1% of the shares unpurchased. The clause should probably read something like the following: “the numerator is the number of shares held by such Shareholder and the denominator is the number of shares held by the Other Shareholders who are participating.”
f. If neither the Corporation nor the Other Shareholders exercise their options, what is the status of the deceased shareholder’s shares? The estate is still a shareholder, and there does not appear to be an option for the estate to put the stock to the Corporation. In essence, this buy-sell agreement appears to be binding on the deceased shareholder’s estate, but not on the Corporation or the Other Shareholders. You may want to ask the Shareholders to revisit this issue to clarify their intent.
