The pricing mechanism is that part of a buy-sell agreement that defines how the price for transactions triggered under it will be determined. There are three basic types of pricing mechanisms:
Fixed price buy-sell agreements. The price at which transactions occur is set by agreement of the parties within some buy-sell agreements. The price is set and is memorialized in each fixed price agreement. Most fixed price buy-sell agreements call for the parties to reset the price each year, or at least periodically. Unfortunately, they seldom do so. Nevertheless, the words on the page that set the price, whatever they happen to be at the time of a trigger event, will determine value for purposes of a fixed price buy-sell agreement.
For example, the price may have been set at the inception of an agreement at $1,000 per share. At the time of a trigger event ten years later, the “real value” could be $500 per share or $3,000 per share. But the agreement price would nevertheless be $1,000 per share if it had not been updated in the interim. Unless, of course, one party or the other objects, and litigation ensues.
Formula buy-sell agreements. Other buy-sell agreements state a formula that is to set the price for transactions when they are triggered. The “formula” might be set at book value at a recent date, at a multiple of a defined measure of earnings, or a combination of a portion that relates to the balance sheet and another that is a multiple of an earnings measure.
I’ve said many times that there is no single formula that can reasonably set the price for transactions for a company over time given changes in the company, its industry, the general economy, and the availability of financing. Nevertheless, some buy-sell agreements do use a formula approach. And the stated formula will set the price – if it can be reasonably understood, and even if it can’t.
You see, the words on the page set the formula, which sets the price – unless one party or the other objects, and litigation ensues.
Valuation process buy-sell agreements. Many buy-sell agreements call for an appraisal process to establish the price for transactions following trigger events. These agreements may call for the company to select an appraiser and for the selling shareholder to retain another appraiser.
If the two appraisers reach conclusions within, say, 10% of each other, then their conclusions are averaged and the price is set. However, the first two appraisal conclusions are seldom within the tolerance band set in the agreements. So then, the first two appraisers must select a third appraiser whose participation will somehow bring the pricing question to resolution.
The reason that the first two appraisers’ conclusions are not close to each other, at least in part, may relate to the fact that the valuation assignment definition is not clearly specified in the buy-sell agreement. This means that there is too much room for differing interpretations of the type of value the parties were considering and too much room for misinterpretations. The bottom line is that the words on the page of valuation process buy-sell agreements are often unclear and set the stage for future appraisal disagreements and even litigation.
In the next post, we will examine this concept of “words on the page” in more detail as it relates to valuation process buy-sell agreements.
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