When most people think about buy-sell agreements, they think about shareholders and companies entering into agreements. However, corporations also enter into buy-sell agreements.
Many years ago, a large oil company entered into a partnership with a much smaller, private company to develop and run truck stops across the country. The private company contributed its existing truck stops at their estimated values to the partnership. The oil company contributed an equivalent amount of cash, which provided the initial growth capital for the joint venture.
The partnership was owned on a 50%-50% basis, and ran and grew successfully for many years.
Then, one day, the big oil company announced a combination with another large oil company that many market participants referred to as a merger of equals.
One or both of the joint venture partners pulled out the partnership agreement and read its Section 9.7, which said, in its entirety:
Section 9.7 Option
If the controlling interest in a Partner or an Affiliate of a Partner which controls the Partner is sold to a third party, then the other Partner shall have the option to purchase the Partnership at its appraised value as a going concern. If the parties are unable to agree on an appraiser, one shall be appointed by the American Arbitration Association. The appraisal shall be completed within 90 days from the date of appointment of the appraiser. The other Partner shall exercise its option within 30 days of the appraiser’s report. Closing shall occur within 90 days from the date such option is exercised.
Oil prices were depressed at the time, as were gasoline and diesel prices. Joint venture earnings were at a low point. The private company thought it was a good time to purchase the other 50% of the joint venture, and exercised its option under Section 9.7.
The now very large merged oil company did not want to sell its interest, since the joint venture provided a large customer for its refined products, and they were satisfied with the joint venture’s operations.
The First Arbitration
The large oil company read the first sentence of Section 9.7 and said that no change of control had occurred and therefore, the option was not triggered. The sentence stated:
If the controlling interest in a Partner or an Affiliate of a Partner which controls the Partner is sold to a third party, then the other Partner shall have the option to purchase the Partnership at its appraised value as a going concern.
The large oil company argued that there had been no change of control. Rather, they had engaged in a merger of equals, so there was no change of control. The private company disagreed. There was an arbitration on the sole issue of whether there had been a change of control.
After a process that extended well beyond a year, the arbitration panel ultimately concluded that, indeed, there had been a change of control as result of the merger of the two oil companies, and that the option of Section 9.7 had been triggered.
This led to the need to determine the Partnership’s “appraised value as a going concern.”
Other Issues to Be Resolved
I don’t recall whether the parties agreed on a business appraiser or whether there had been an arbitration on the point. My recollection is that the parties had agreed on an appraiser. So one point of contention was either avoided or had been resolved by the time I became involved.
I’ve written, in Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners, that six defining elements are required to specify the valuation process when appraisers are called for pursuant to buy-sell agreements. The elements, with brief comments, follow.
- The standard of value. The standard of value was not specified in Section 9.7. It merely called for the Partnership’s “appraised value as a going concern. The normal standard of value for buy-sell agreements, fair market value, had not been specified. However, the parties, in conjunction with the selected appraiser, agreed that the standard of value should be fair market value.
- The level of value. The level of value, like financial control or nonmarketable minority, was not specified in Section 9.7. Again, with some guidance from the selected appraiser, the level of financial control was agreed to by the parties.
- The “as of” date. Note that there is no specification of the “as of” date in Section 9.7.
- Qualifications of appraisers. Qualifications of business appraisers include, among other things, their experience, training, credentials, and specific industry experience, if applicable. Note that Section 9.7 is silent regarding experience requirements for a selected appraiser. In this case, the parties had agreed to a credentialed business appraiser holding the Accredited Senior Appraiser (ASA) designation of the American Society of Appraisers. He had some industry experience and more than a decade of appraisal experience.
- Appraisal standards to be followed. The appraisal standards to be followed were not specified in the agreement. However, because the parties agreed on an ASA-designated appraiser who was required to comply with the Uniform Standards of Professional Appraisal Practice (USPAP) and the ASA Business Valuation Standards, this defining element was met.
- The funding mechanism for transactions. There is no specification of a funding mechanism in Section 9.7. We will see that this was an important omission.
The “as of” date for the valuation was not specified. As time progressed following the precipitating merger of the two oil companies and the first arbitration to determine if a change of control had occurred, industry conditions and the profitability of the joint venture were improving.
The parties continued to operate the joint venture as before, and normal decisions regarding reinvestment and distributions were made.
The determination of the “as of” date, therefore, was important. The private company who wanted to purchase the oil company’s interest argued that the valuation date should be the date they exercised their option. The oil company argued that the appropriate valuation date should be as close to closing as possible.
Ultimately, there was a second arbitration on the sole issue of determining the appropriate “as of” or valuation date for the required appraisal.
A well-known business appraiser friend of mine had been retained as an adviser to the oil company’s counsel as they worked through the first arbitration and towards the second one. He suggested to the counsel that, because of my specific experience with buy-sell agreements and my publications on the topic, I would be a helpful addition to the team for the second arbitration. By the time I was retained, the precipitating merger was more than two years in the rearview mirror.
The private company hired a nationally known appraiser for the arbitration regarding the valuation date.
Preparation for the second arbitration took many months. Reports were issued, followed by rebuttal reports. At last, it was time for the second arbitration, which lasted about a week.
The following summarizes a lengthy and hard-fought process before a panel of experienced arbitrators.
- A couple of facts
- As noted, substantial time had passed since the precipitating merger. Industry conditions and the joint venture’s performance were improving.
- While there were no appraisals, simplistically, everyone knew that the value of the joint venture was significantly higher at the time of the second arbitration than when the private company exercised its option to purchase.
- Positions of the parties
- My client, the oil company, argued for a later valuation date. They had experienced all the risks of the business, had continued to run the business (or their role in management), had shared in distributions during the interim, and were fully invested during the entire valuation process. I wrote an extensive report that looked at all sides of the arguments and at the entire partnership agreement. I concluded that the appropriate valuation date should be as close to closing as possible.
- The private company argued very loudly that the valuation date should be the date of their option exercise. They exercised the option, and that should be the date. The other expert attempted to refute the logic of my report and concluded that the valuation date should be the option exercise date.
The Second Arbitration
- There was extensive testimony from a number of valuation experts, other experts, and company management.
- When the testimony was over, I felt that the weight of the evidence supported the position of a later valuation date.
- The arbitration panel, after some time for deliberation, reached the conclusion that the valuation date should be as close to any proposed closing of the transaction as possible.
The Valuation and the Aftermath
After the issue of the valuation date was resolved, the retained appraisal firm went through its normal appraisal processes. They issued a valuation report that concluded the joint venture was worth several hundreds of millions of dollars. I looked at the report for my oil company client, and concluded that both its approach to the valuation and its ultimate conclusion were reasonable.
The private company, which had exercised an option to buy the oil company’s 50% of the joint venture more than three years before, attempted to arrange financing for the purchase. In the final analysis, they were unable to arrange satisfactory financing and therefore were unable to close on the purchase of the oil company’s share of the joint venture.
The appraisal process, which began when the private company exercised its option under Section 9.7, ended. There was no transaction.
The joint venture continued to operate for a number of years following the end of the valuation process. The bigger oil company and the private company remained partners.
The Rest of the Story
As noted, the valuation process triggered by Section 9.7 of the partnership agreement of the joint venture lasted for more than three years. The process was disruptive for the joint venture and its management. It was certainly disruptive for the management of the private company. It was probably a minor nuisance to the bigger oil company, given its size.
Based on discussions at the time with counsel for the oil company, they estimated that legal and expert fees for the appraisal process, which did not include the cost of the actual appraisal, totaled more than $6 million.
Section 9.7 had a total of 108 words. That clearly was insufficient to specify a reasonable valuation process for the option/buy-sell agreement.
Just because companies are big does not mean that they are immune to the problems faced in buy-sell agreements everywhere.
Think how simple the process would have been if Section 9.7 had called for a Single Appraiser, Select Now and Value Now valuation process. There would have been regular appraisals during the early years of the joint venture and everyone would have known the value at the time of the merger. The issue regarding the valuation date would have been resolved by the ongoing valuation process.
The big oil company and the private company would have been better off. The joint venture would have been better off.
The only folks who would have lost out with an appropriate valuation process for Section 9.7 were the many attorneys and appraisers who worked for three years during the process.
Perhaps, since I and Mercer Capital were part of that process, I should not complain. My conclusion, however, remains the same. The Single Appraiser, Select Now and Value Now process is the best valuation process for most buy-sell agreements.
Valuation is important for business owners for many reasons. One of these reasons is for the operation of buy-sell agreements. If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.
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