No single formula set out today can provide a reasonable price or value for a company under all foreseeable future circumstances pertaining to the company, its industry, the economy, the availability of financing, and many other factors.
I’ve said those or similar words many times in the past as a way to dismiss the use of formula pricing as the basis for determining the price (or value) for buy-sell agreements following trigger events. It is just not possible to foresee all possible future circumstances when setting a formula today.
If your company or your clients’ companies have formula pricing for their buy-sell agreements, the likelihood of future problems is high.
I’ve written about this New Jersey case before in the context of fixed price agreements (Estate of Cohen v. Booth Computers, Memorandum Decision, C.A. Docket No. BER-C-135-08 (N.J. Super. Ct. Aug. 4, 2009). However, the initial Partnership Agreement, entered into in 1978, actually set a formula for pricing in Paragraph 16:
16. The purchase price of any part or all of a Partner’s interest in the Partnership shall be its value determined as follows:
(A) Each of the Partners has considered the various factors entering into the valuation of the Partnership and has considered the value of its tangible and intangible assets and the value of the goodwill which may be present. With the foregoing in mind, each of the Partners has determined that the full and true value of the Partnership is equal to its net worth plus the sum of FIFTY THOUSAND ($50,000) DOLLARS. The term “net worth” has been determined to be net book value as shown on the most recent Partnership financial statement at the end of the month ending with or immediately preceding the date of valuation; (emphasis added)
(B) The value of any interest in the Partnership which is sold and transferred under the terms of this Agreement shall be determined by multiplying the full and true value of the Partnership as above determined by that percentage of the capital of the Partnership which is being sold and purchased hereunder.
It is not clear how assets were initially transferred into the Partnership, but it would appear that they were transferred without much debt. The purpose of the Partnership was to provide income to three children who were the primary limited partners at one-third each.
For a time after the formation of the Partnership, the net worth of the Partnership plus $50,000 was likely a reasonable price. However, things change over time.
- Assume that the Partnership had income each year and that most of the income was distributed to the partners. What happens to net worth? Well, it doesn’t change much.
- What happens to the fixed sum of $50,000 to be added to net worth in the formula? It doesn’t change at all.
- Additionally, what happens to the market values of the underlying real estate assets owned by the Partnership? They increased substantially over the thirty years or so until Mrs. Cohen’s death.
What happens to the formula price over time under these assumptions? It is essentially fixed while the value of the underlying assets rises. So there is a growing discrepancy between the “formula price” and the underlying full and true value of the Partnership.
At the date of death in 2009, the relevant values (as found in court proceedings) were:
- The net book value of the Partnership was $128,000.
- The fixed addition of $50,000 was $50,000.
- Therefore, the net book value of the Partnership was $178,000.
According to Mrs. Cohen’s estate, the “true value” of the Partnership, based on then-current real estate appraisals, was $11.5 million, or 65x greater than the formula price.
There obviously was litigation, or we wouldn’t know about these numbers. The short version of the story on appeal is that the Court found that the formula in Paragraph 16 was binding. The parties could have changed it at any time over more than 30 years, but did not, thus concluding:
Disparity in price between book value and fair market value, where a buyout provision is clear, is not sufficient to “shock the judicial conscience” and to warrant application of the doctrine of unconscionability. This view is consistent with the basic principle that where the terms of the contract are clear, it is not the court’s function to make a better contract for either of the parties.
The bottom line of Cohen v. Booth Computers is that the parties to a formula pricing that does not deliver a conclusion close to “fair market value,” or a reasonable price at market values should not depend on a court to fix their problem.
For more reading on Cohen v. Booth Computers see:
- A post I wrote on this blog: Book Value Pricing for Buy-Sell Agreement Held Up in New Jersey
- Peter Mahler’s New York Business Divorce blog: Court Rejects Unconscionability Argument in Family Partnership Valuation Case, Concludes that “Full and True Value” Equals “Net Book Value” as Defined by Agreement
A Solution to the Formula Problem
The parties to buy-sell agreements with formula pricing should consider changing the pricing mechanism. My recommendation is that a Single Appraiser, Select Now and Value Now valuation process be substituted for the formula pricing.
Select the appraiser now based on the experience, qualifications, and credentialing requirements as set forth in my book, Buy-Sell Agreements for Closely Held and Family Business Owners. Have an initial appraisal performed that sets the initial price for the agreement. Eliminate problems with the definition of value like found in Cohen v. Booth Computers.
In that case, rather than specifying that the Partnership would be valued at fair market value, Paragraph 16 called for the net worth and then threw in the words “full and true value.” Those words were litigated at trial. Eliminate all of those problems on the front end.
Until next time, be well!
New Book on Buy-Sell Agreements
The drafting of a new book on buy-sell agreements is almost complete. The working title is Buy-Sell Agreement Handbook for Attorneys. I am not an attorney. As always, I write based on my experience as a businessman and valuation guy.
My previous books on buy-sell agreements have been written from the perspective of business owners as in the title of the most recent book: Buy-Sell Agreements for Closely Held and Family Business Owners. Attorneys were, thankfully, one of the bigger markets for this book.
Many times, however, attorneys have said to me, in effect, “Chris, we like the ideas in your book. Do you have some template language to help us implement them?”
Until now, unfortunately, the answer was a “Not yet.” Now, this new book will contain detailed template language for several valuation processes for buy-sell agreements. I’m excited to get it to the point of making it available to attorneys, business appraisers, financial planners and, yes, business owners.
If you want to be notified when Buy-Sell Agreement Handbook for Attorneys becomes available, give me a quick email and we will put you on the list at email@example.com.