One day a number of years ago, I received a call from an attorney. On that initial call, he told me about a bizarre buy-sell agreement process that was underway. The attorney represented a company. Based on a buy-sell agreement of some age, an option provided by the agreement had been triggered, and one of the companies had the right to acquire the company at its fair market value.
Overview of a Buy-Sell Agreement Process
The valuation process called for in the buy-sell agreement was well underway at the time of the call.
- My eventual client, the company, had hired an experienced and credentialed business appraiser with a nationally known firm.
- The other company had hired a well-known industry broker who had no business valuation experience and held no business appraisal credentials.
- Both had provided appraisals, and they were miles apart.
- The agreement called for the two appraisers to agree on a third appraiser. They did so. The firm was well-known and the appraiser was credentialed and experienced. The third appraiser issued an engagement letter signed both by my client company and the other company.
- Because the other company’s appraiser had no valuation credentials, my client company had required that the third appraiser agree to provide a draft appraisal that was compliant with the Uniform Standards of Professional Appraisal Practice (USPAP) and the ASA Business Valuation Standards.
- The third appraiser rendered his draft appraisal.
It turns out that the third appraiser’s opinion was of particular significance because it was to be averaged with the closest of the two other appraisals to set the price per the agreement.
I’m making up the numbers and details to provide order of magnitude background, but you will get the idea.
The company’s appraiser valued the company at $100 million. The industry broker valued the company at, say, $300 million. This provided for several possibilities:
- If the third appraiser concluded $200 million, the agreement price would be precisely $200 million
- With a conclusion of, say, $205 million, the agreement price would be $252.5 million.
- With a conclusion of, say, $195 million, the agreement price would be $147.5 million.
The third appraiser’s draft conclusion was about $205 million. The swing in agreement price based on a very small change in the third appraiser’s conclusion was huge, or more than $100 million. The appraisal battle, in this case, was based on the review of the third appraiser’s draft valuation. The other two appraisals were set and would not change.
The Appraisal Review
I received the call from the attorney because he had done some research and found that I was the chair of the Business Valuation Standards Subcommittee for the American Society of Appraisers. The attorney for the company asked me if I could review the third appraiser’s draft appraisal for its compliance with the noted standards. After some discussion, we were retained to provide the review.
We did not know it at the time, but as the engagement progressed, we learned that the other side also hired two former chairs of the same committee to review the other appraisals and my appraisal review.
The process was long and convoluted, and far too complicated for this story. We can, however, note a few points along the way.
- I issued an appraisal review report that was compliant with Standards Rule 3 of USPAP. It found that the third appraiser’s draft opinion fell short of important standards at several points. The net effect of the issues was a significant overstatement in the draft appraisal’s conclusion.
- The two opposing review appraisers issued reports saying that the third appraiser’s report was okay and compliant with relevant standards.
- At some point along the way, after receiving my draft appraisal review, the third appraiser issued a final opinion of, say, $215 million. The conclusion increased, after my review showed clear problems of overstatement.
My opinion of overstatement was supported by numerous examples of problems with standards and otherwise. However, let me mention just one of the issues.
- The third appraiser’s draft report included both a guideline public company method and a guideline transactions method. The guideline public companies had a median EBITDA multiple of about 10x. The draft appraisal noted two change of control transactions with an average control premium of perhaps 60%, which lifted the effective multiple several points.
- The guideline transaction method reflected average EBITDA multiples of about 11x. This multiple was used in the guideline transactions method.
- It now gets interesting. When we looked at the two change of control transactions used to derive the average control premium of 60%, we found that the actual EBITDA multiples for the transactions were about 11x each.
My question from a standards viewpoint was how the same transactions could be used to justify 11x multiples and then, about a 60% premium to those multiples? My answer was, they could not. And the question was never answered by the other side. There were other issues, as well that led to my conclusion, but all that’s beyond this short story.
The litigation proceeded. Depositions of all parties were taken and additional rebuttal reports were issued. The matter was headed for trial.
My client’s counsel held a mock trial. This was the first and only time I’ve been involved in one of those. I was told that the other side also held a mock trial.
As I was preparing for trial, I received a call from counsel informing me that the matter had settled. Because the settlement was deemed confidential, I don’t know exactly where things ended up. But counsel suggested that the client company was pleased with the result.
What was the real result? Both sides collectively spent millions on attorney and expert witness fees. Both sides were involved in massive and disruptive litigation that lasted for years.
I know I sound like a broken record, but all this could have been avoided if the parties had amended their buy-sell agreement somewhere along the way. If the parties had agreed on a Single Appraiser, Select Now and Value Now agreement, there would have been an appraisal that set the price. Then, there would have been subsequent appraisals to reset the price.
Everyone would have known what the price was if there was a trigger event, and there would have been no room for gamesmanship with the system.
Until next time, 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!
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