There is substantial focus in almost all buy-sell agreement valuation processes on the fair market values of the interests subject to the agreements, i.e., to the interests that have been “triggered.”

While many buy-sell agreements call for the issuance of promissory notes for at least partial funding of purchases, there is no corollary consideration of the fair market values of the promissory notes to be issued.  A previous post discussed promissory notes in terms of rates and terms.  This post examines the concept of the fair market value of promissory notes issued in connection with buy-sell agreements.

The Valuation Process Leads to a Conclusion

The valuation process involved three business appraisers.

• The appraiser retained by the Corporation developed a conclusion of fair market value for the 10% interest subject to the buy-sell agreement process of $5.0 million.
• The appraiser retained by the selling shareholder concluded the fair market value of the interest was $11.0 million.
• The third appraiser, selected by the first two appraisers, reached a conclusion of fair market value of $9.0 million for the interest.
• The agreement called for the conclusion of the process to be the average of the conclusions of the closest two appraisals, so the concluded fair market value was $10.0 million.

The figure below summarizes the implied summary of the valuation based on the three appraisals noted above.

The buy-sell agreement calls for a down payment of 20%, or $2.0 million, and the issuance of a promissory note by the Corporation for the remaining balance of $8.0 million.

So, all is done and fair market value has been achieved.  Right?  Well, not quite.  Let’s look at the rest of the story.

Fair Market Value of Stock is $10.0 Million

Assume that the valuation process of a buy-sell agreement is concluded and the purchase price is determined.  The fair market value of the interest per the conclusions of the three appraisers involved in the valuation process is $10.0 million, as summarized below.

The example shows the summary of the valuation process leading to a $10.0 million fair market value conclusion for the interest we are discussing.  The instructions in the buy-sell agreement following the receipt of the appraised fair market value of the interest are as follows:

The corporation will issue a promissory note…the note will have a term of ten years and will provide for equal annual amortization payments at a rate of 2.0%…

So all is done, right?  Well, not quite, as we will see.

What About the Promissory Note?

We saw the summary of the fair market value determination of the company and the equity interest just above.  Now, we want to estimate the fair market value of the $8.0 million promissory note to be issued to the selling shareholder in the principal amount of $8.0 million.

The note is a ten-year note with an annual interest rate of 2.0%.  The note is payable annually for ten years.  Given the rate and term, the annual payment is $890.6 thousand.  The promissory note is unsecured, and all existing debt of the corporation is subordinate to it.  There are no provisions in the note to protect the holder in the event that the corporation does not make payments.

Given the terms of the note, the annual (equal) payment is $890.6 thousand.  So we know the term (10 years), the interest rate (2.0%), and the annual payment from the Corporation to the selling shareholder.

What is the Fair Market Value of the Promissory Note?

Given all the circumstances regarding the note, the corporation, and the market for illiquid promissory notes, an appraiser determined (hypothetically, for illustration only) that the appropriate market rate of interest for a similar note would be 6.0% under our assumptions (and it certainly could be higher).  The question is, what is the fair market value of the $8.0 million note?  We estimate that value in the table below.

The fair market value of the $8.0 million promissory note is calculated by discounting the ten years of annual payments based on a 2.0% interest rate to the present.  The appropriate discount rate is 6.0%, so the present value of the $8.0 million note is $6.55 million.  This present value represents an 18.1% discount from its face amount.  That’s a fairly hefty discount and amounts to $1.45 million relative to the face amount.

If we add in the undiscounted $2.0 million cash down payment, the selling shareholder received consideration with a fair market value of $8.55 million, or a 14.5% overall discount to the $10 million fair market value of the interest.

As it turns out, we (or, actually, the selling shareholders) weren’t quite done when the fair market value of the 20% interest was determined.

In our example, the valuation process determined a fair market value of $10.0 million for the 10% interest.  As we have just seen, the terms of the promissory note provided for in the buy‑sell agreement discounted that fair market value determination by 14.5%.

Conclusion

The bottom line is that the terms of promissory notes issued in buy-sell agreement transactions matter a great deal.  This often overlooked aspect of buy-sell agreements deserves discussion by the parties when buy-sell agreements are negotiated.

In the meantime, be well!

Chris

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  mercerc@mercercapital.com.