Kashmiry v. Ellis is a recent Ohio appellate case regarding the buy-sell agreement portion of a shareholders’ agreement. The case reinforces a number of things I have been “preaching” about for years. If a buy-sell agreement has provided for an annual valuation by agreement of the parties, then the parties must reach agreement annually. If the agreement then provides for a valuation mechanism to determine the price following a trigger event, then the valuation process should be clearly defined and workable.
- I have long advocated the use of what we call the Single Appraiser, Select Now and Value Now process to replace annual agreements by owners — because they virtually never get together to agree on anything, much less the buy-sell agreement price.
- Failing that, I advocate the Single Appraiser, Select Now and Value Later mechanism, so the parties know who the appraiser will be and there can be communication regarding the kind of value.
- In either case, the definition and kind of value should be clearly specified in the agreement.
Overview of the Case
RKA was an insurance agency in Ohio. EIA was a smaller agency. The owners (Kashmiry and Ellis) agreed to merge their agencies and that Ellis would become an employee and minority shareholder of the merged RKA. The stock purchase agreement required Ellis to turn over his book of business to RKA in exchange for seven shares of RKA stock. Ellis acquired another 14.4 shares of RKA stock in consideration of a promissory note to Kashmiry in the amount of $107,838.14, or about $7,500 per share. Both parties agreed to this $7,500 per share price. The total of 21.1 shares represented about 20% of the outstanding shares of RKA common stock.
Observation: The “valuation” at the time of the merger was based on relative values of both RKA and EIA at a revenue multiple of 1.25x, so there were no discounts in the pricing at the time of the merger.
The transaction as stated or implied by the Court’s decision is summarized below.
After some five years of employment with RKA, Kashmiry, as majority shareholder, terminated the employment of Ellis. There were several aspects of the case at trial and on appeal. This post addresses only the valuation issue.
- The shareholders agreement provided that, in the event of the termination of Ellis, he would be deemed to have offered all of his stock to Kashmiry, who would have 30 days to complete a purchase of the stock.
- If Kashmiry did not purchase the stock personally, then Ellis was obligated to offer the stock back to RKA and RKA was obligated to purchase the stock based on an “agreement price.”
There were two methods for determining the agreement price.
- All the shareholders would convene and unanimously agree on the agreement price, which would be the fair market value of the shares. A certificate of valuation was to be signed. If there was no certificate of valuation for more than a year at the time of a trigger event, then a second method would be used.
- The second method, if applicable, provided that the board of directors of RKA would appoint a qualified appraiser who would determine the agreement price after considering a number of specific factors in the appraisal process. Those factors included the following: a) all relevant business valuation standards, b) Revenue Ruling 59-60, c) other factors deemed appropriate by the qualified appraiser (not defined), and d) “…giving great weight to any prior valuations of the shares of the Stock which have been agreed upon by the Stockholders.” This appraisal was to be provided within 90 days of the trigger event.
Following the termination of Ellis, RKA hired a qualified appraiser [I cannot find the appraiser based on a Google search], who provided the required appraisal, but several months after the 90-day deadline. The appraiser testified that she prepared a detailed valuation report that took into account many factors, including company background and history, general economic and industry conditions, and the financial performance of the company.
She also took into account the lack of control and lack of marketability of the 14.4 shares (about 13.6% of the shares outstanding — the other 7 shares were handled differently). She testified that she gave the original purchase price of $7,500 per share little or no weight. The appraiser valued 100% of RKA stock at $405,000.
The valuation by the appraiser appointed by RKA is summarized as stated or implied below.
The trial court concluded its valuation as follows:
When the parties first valued the shares of stock in 2009 an arbitrary multiplier [of revenue – 1.25x] was agreed upon. No discounts were made for minority shareholder, nor corporate control or marketability, et cetera. Therefore, the court finds that the value of said shares of stock [relying on language calling for giving “great weight to prior transactions] as of August 15, 2014, were at the same value as originally agreed upon by the parties, i.e., $7,500 per share.
It is likely that given the appraiser’s valuation at such a steep discount to the original transaction pricing, that the trial court was attempting to find an equitable conclusion. The appellate court made a similar observation.
The Appellate Court’s Reverses the Trial Court on Valuation
There were other issues but on the key issue of valuation, the appellate court reversed the trial court and remanded the matter to the trial court for another look at valuation. The appellate court stated:
…the trial court ignored the plain language of the parties’ agreement and, instead of determining that the 2009 agreed-upon valuation was one factor that should have been given more weight by the appraiser, substituted the 2009 purchase price arbitrarily as the 2014 valuation. Based upon the trial court’s reasoning, it appears the trial court was attempting to reach an equitable result in this matter. “It is not the responsibility or function of [the] court to rewrite the parties’ contract in order to provide for a more equitable result.” [citation omitted]
I can find no record of a revised opinion by the trial court. There is a good likelihood that the parties settled the matter after the appellate court’s decision.
Lessons to be Learned from Kashmiry v. Ellis
We can make a number of observations and point out lessons to be learned from this appellate case.
- If you (or your clients) enter into a bad buy-sell agreement, don’t expect that the courts will fix the problems for you.
- It is clear that the parties entered into the arrangement with a merger on a similar basis, i.e., merging 100% of both RKA and EIA together based on a revenue multiple and without any discounts. The buy-sell agreement should have stated this fact in unambiguous terms. It is clear from the testimony of the appraiser and the calculations above that the appraisal considered the minority nature of the block of stock and discounted its conclusion significantly.
- The definition of value in the agreement should state the standard of value (fair market value) and the level of value (financial control versus nonmarketable minority), and any other instructions the parties wanted to provide the appraiser. It should have stated the required qualifications for the appraiser.
- The appraiser could have performed a relative value analysis of her conclusion and that implied by the original transaction. It would have been clear that even at the 100% equity level, she was valuing the stock at about half the value of the original transaction ($405,000 in 2014 versus an implied $801,000 in 2014). A reconciliation of those disparate valuations should have been a portion of her appraisal. Instead, she gave that transaction little or no weight.
- The shareholders’ agreement called for setting an annual agreement price to be memorialized in a certificate of value. As so often happens, the agreed upon certificate of value was never updated. The lesson is that if you are going to depend on an agreed upon value on an annual basis, you had better update that agreement each year.
- The second way in which the agreement price could be set was with an appraisal process. However, that process was never tested, and in its debut, it showed significant flaws.
- The parties would have benefited from employing the Single Appraiser, Select Now (i.e., 2009) and Value Now (2009) valuation mechanism that I have written about in my book, Buy-Sell Agreements for Closely Held and Family Business Owners. There would have been an annual or every-other-year reappraisal in the interim, and the valuation process would have been known. An appraiser would have been selected in 2009 to provide an appraisal and it would have been clear that the appraisal should be performed on a financial control, i.e., undiscounted basis.
- In the alternative, the parties could have employed the Single Appraiser, Select Now (i.1., 2009) and Value Later (2014, following the trigger event). With the selected appraiser’s help, they would have defined fair market value appropriately and avoided the issue of the surprise (to the seller) discounting in the appraisal.
The bottom line about buy-sell agreements is that the parties and their counsel need to address issues like raised above in advance of trigger events and at the time their agreements are set in place. The next best time to accomplish this is now, with a revision of your agreements before a trigger event occurs.
Please do call me (901-579-9700) or email me (email@example.com) to discuss any valuation or buy-sell agreement issues in confidence. In the meantime, be well!