Today I discuss another buy-sell agreement story where shareholders bet on the company’s value upon a trigger event. This story’s protagonist “wins;” unfortunately, the same cannot be said for the other shareholders. While the price was updated annually, incongruent contexts led to a dichotomy in the price of what should have been paid and what was actually paid per the agreement.
Three friends, including Austin, who had been in the investment business, got together to start an independent firm. They took on a couple of outside investors in order to be able to start the business with some scale. A buy-sell agreement was implemented immediately because they had outside investors.
The business did well for going on two decades, it was growing and profitable. Austin was a key player on the team.
The shareholders got together every year and estimated the value of the business for their buy-sell agreement. They memorialized their agreement in what they called a certificate of value, which, by the way, is a fairly common term for fixed-price buy-sell agreements.
The shareholders and investors were optimistic and knew that their business was quite valuable. They made calculations each year as a basis for their certificate of value.
One day, quite unexpectedly, Austin died in a freak accident. His wife, also his estate’s executor, was charged with determining the value of the deceased shareholder’s shares in the business for estate tax purposes and addressing the company’s buy-sell agreement and its certificate of value.
Given her husband’s death, Austin’s wife, the executor had some misgivings about his former partners and the certificate of value. Remember what I often say about buy-sell agreement trigger events. When one owner dies, his interests, or those of his estate, diverge from the interests of the company and remaining shareholders.
Mercer Capital was retained by the estate to determine the fairness, or reasonableness, of the current certificate of value price.
Unlike the case of William’s father, where the fixed price agreement was never pre-determined, Austin and his fellow owners had re-set the certificate of value price every year, and had done so again just a few months before his death.
We looked at the company and its financial statements, as well as the history of its certificate of value. We looked at the industry and available information on recent transactions. It became clear that the certificate of value price had been set at what, in valuation terms, is called a strategic value.
The value was not an appropriate value for purposes of their buy-sell agreement, but rather, what the owners hoped the company might be worth if and when they sold it to a strategic acquirer. However, the certificate of value said what it said, and the agreement was operative and binding on all parties.
We quietly advised Austin’s wife to, as the saying goes, “take the money and run.” She did. The company had some insurance on Austin’s life and paid the remainder of the certificate of value price in a long-term note.
The certificate of value price was more than fair for Austin’s wife. The shareholders had been betting, all along, that none of them would ever die, but Austin was wrong, and he won the bet. The company and the other owners substantially overpaid for his interest, and Austin’s widow fared very well. They accepted lower than normal returns on their investments for many years.
Moral of the Story
Austin bet, and although he died, he “won” the bet with the buy-sell agreement. The other owners bet and lost. The moral of the story is that with every bet there are winners and losers. It doesn’t have to be that way.
I’ve said many times that, if you are so foolish as to have a fixed price buy-sell agreement, it is necessary to reset the price on a regular basis. What I should have said is that if the price on a fixed-price buy-sell agreement is reset regularly, it is absolutely necessary that it be a price that is appropriate for all shareholders, whether they are future buyers or sellers under their agreements.
The solution to a fixed-price buy-sell agreement like at Austin’s company is to establish a price-setting mechanism with a single appraiser. Since the time of Austin’s death, Mercer Capital has provided many clients with annual appraisals for their buy-sell agreements.
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!
Additionally, my two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive to many business owners, appraisers, and attorneys.