This story dates back to the early years of Mercer Capital during the late 1980s. I had, at that point, been involved in a handful of buy-sell agreement matters and had testified in a couple of trials regarding buy-sell agreements.
An Agreement is Signed
Four men got together in the early 1980s to form a company to process catfish for sale to restaurants and institutional food preparers. I don’t remember the details, but one gentleman provided substantial funding, was a non-working owner, and owned 25% of the stock. The other three owners each held 25% of the shares.
There was a stock purchase agreement to memorialize their respective investments and ownership of the business. The initial investment totaled about $1 million. The stock purchase agreement was clear that the respective contributions of the owners were equal and were valued at $250 thousand each.
The parties signed a buy-sell agreement at the time of formation. The agreement stated that in the event of a trigger event, like the death of an owner, the price to be paid for a departed owner’s shares would be determined by an appraisal prepared by Mercer Capital.
A few years passed by…
The Agreement is Triggered
I had no idea that we had been named in the buy-sell agreement until I was contacted following the non-working owner’s unexpected death. As it turned out, I had known one of the owners and the company’s attorney before the formation. I guess they were satisfied with our reputation, and all parties agreed to our inclusion.
When we were retained, I read the buy-sell agreement to determine how we were instructed to consider the valuation. The agreement said that the appraiser would determine “the fair market value of the interest.” Ordinarily, that definition would call for the appraiser to determine value at the nonmarketable minority level of value, or at the lowest conceptual level in the “levels of value” chart below.
However, the buy-sell agreement referenced the shareholders’ agreement and other start-up documents that indicated that if anything happened in the future, all owners were to be treated equally in terms of value.
Normally, appraisers are bound by what I call “the words on the pages” of the buy-sell agreement to interpret the kind of value called for by the agreement. In this case, the words on the pages in the agreement suggested that the appraiser should render his conclusion at the nonmarketable minority level of value. However, related documents that were referenced in the buy-sell agreement were clear that the conclusion should be at an undiscounted level, or the financial control/marketable minority level of value.
The conceptual difference in these two levels is obvious in the chart above. A marketability discount, if applied, might have been in the 30% to 40% range.
I called a meeting with the company and the executor of the deceased owner’s estate and informed them of the issue. I told them that I would not make the decision regarding the level of value to be determined.
Their resolution was asking me to provide an opinion of fair market value of the company (undiscounted) and also provide “the fair market value of the interest,” which would include an appropriate marketability discount applicable to the interest. They indicated that Mercer Capital’s obligation would be fulfilled if we provided both conclusions, and so we did.
The company and the estate negotiated a price for the purchase of the deceased owner’s 25% interest, and the matter was resolved. I never knew exactly what conclusion was reached, but the parties seemed satisfied with the result.
Moral of the Story
I learned two primary lessons from the experience with the catfish company.
- It is critical that the pricing mechanism in a valuation process buy-sell agreement be specified without any ambiguity. When the parties signed the buy-sell agreement in the early 1980s, they were thinking of a valuation reflecting a pro rata share of the value of the business, or an undiscounted value. However, the actual language suggested otherwise.
- It is a great idea to agree on the business appraiser on the front end before a trigger event occurs. With the start-up company, Mercer Capital was the agreed-upon appraiser at the outset. Once the buy-sell agreement was triggered, there was no argument over our selection.
What the attorney for the company had crafted in the early 1980s was what I later came to call a “Single Appraiser, Select Now and Value Now” valuation process. It was a good idea then to name the appraiser at the outset when the interests of the parties are reasonably aligned. It remains a great idea more than 40 years later.
As noted in my “Single Appraiser, Select Now and Value Now” process, it is an even better idea to have the named appraiser value the business and to let that conclusion become the price for the buy-sell agreement. Then, the appraiser should revalue the business each year (or two at most).
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 firstname.lastname@example.org.