Three friends, including Austin, who had been in the investment business got together to start an independent firm. They took on a couple of outside investors in order to be able to start the business with some scale. Because they had outside investors, they implemented a buy-sell agreement immediately.
The business did well for going on two decades, and was growing and profitable. Austin was a key player on the team.
The shareholders got together every year and estimated the value of the business for their buy-sell agreement. They memorialized their agreement in what they called a certificate of value.
The shareholders and investors were optimistic and just knew that their business was quite valuable. They made calculations each year as a basis for their certificate of value.
One day, quite unexpectedly, Austin died in a freak accident. His wife, also his estate’s executor, was charged with determining the value of the deceased shareholder’s shares in the business for estate tax purposes and with addressing the company’s buy-sell agreement and its certificate of value.
Given her husband’s death, the executor, his wife, had some misgivings about his former partners and the certificate of value. Remember what I often say about the fact that, when one owner dies, his interests, or those of his estate, diverge from the interests of the company and remaining shareholders.
Mercer Capital was retained by the estate to determine the fairness, or reasonableness, of the current certificate of value price.
Unlike in the case of William’s father (see the previous post), where the fixed price agreement was never re-determined, Austin and his fellow owners had re-set the certificate of value price every year and had done so again just a few months before his death.
We looked at the company and its financial statements, as well as the history of its certificate of value. We looked at the industry and at available information on recent transactions. It became clear that the certificate of value price had been set at what, in valuation terms, is called a strategic value.
The value was not an appropriate value for purposes of their buy-sell agreement, but rather, what the owners hoped the company might be worth if and when they sold it to a strategic acquirer. But the certificate of value said what it said, and the agreement was operative and binding on all parties.
We quietly advised Austin’s wife, as the saying goes, to “take the money and run.” And she did. The company had some insurance on Austin’s life and paid the remainder of the certificate of value price in a long-term note.
The certificate of value price was more than fair for Austin’s wife. The shareholders had been betting, all along, that none of them would ever die, but Austin was wrong, and he won the bet. The company and the other owners substantially overpaid for his interest, and Austin’s widow fared very well. They accepted lower than normal returns on their investments for many years.
Moral of the Story
I’ve said many times that, if you are so foolish as to have a fixed price buy-sell agreement, it is necessary to reset the price on a regular basis. What I should have said is that if the price on a fixed-price buy-sell agreement is reset regularly, it is absolutely necessary that it be a price that is appropriate for all shareholders, whether they are future buyers or sellers under their agreements.
We will address the solution to this buy-sell agreement problem in a subsequent post.
Until then, be well!
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.
I’ve priced it at $2.99 so you won’t have to think about the expense. So click on the image of the book. You will be taken to Amazon. Then buy the book. Don’t be mislead by the price. It is a full length book. If you like it, as most readers have, please take a few minutes and review the book on Amazon!
Additionally, my two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers, and attorneys.