In this post, I explain why I believe that fixed price buy-sell agreements are not workable for most closely held and family businesses.  This is as true for large companies as well as much smaller companies.  However, if you, or your client if you are an adviser, insist on using a fixed pricing mechanism in a buy-sell agreement, take the steps recommended in this post to maximize the probability of success and minimize the potential for future disputes.  My text for this sermon lies in Chapters 9, 13, 14, 16 and 17 of Buy-Sell Agreements for Closely Held and Family Business Owners.

Buy-Sell Agreements

Buy-sell agreements for most closely held and family businesses are agreements between a company and its shareholders/members/partners.  These agreements dictate what will happen at future points in time when certain (usually) bad things happen – like death, firing, disability…

Importantly, they determine the price(s) and the terms under which the transactions will occur. What most business owners and many attorneys don’t really think about is that buy-sell agreements are important ownership transition agreements where owners are agreeing, in advance, on how ownership will transfer when specified trigger events happen.

There are three primary types of pricing for buy-sell agreements, fixed price agreements, formula pricing agreements, and agreements that call for an appraisal process.

So You Have to Have a Fixed Price Agreement?

This post is for those readers who believe they must have a fixed price agreement.  Perhaps they don’t want to pay for appraisals, or actually believe that they can consistently agree (at least annually) as to the value of their companies for purposes of their agreements.  Perhaps an attorney suggested that fixed price agreements were the simplest agreements.  Who knows?

Let me say, from personal experience and observation that the parties to fixed price agreements seldom, if ever, update the pricing as called for in the agreements.

• Personal experience.  I hate to admit it, but we had a fixed price agreement at Mercer Capital for about a dozen years and just never got around to updating the price. This was at a time when the value of the business was growing significantly, so the agreement was substantially undervalued for years.  We were lucky that nothing happened.  By the way, that issue was fixed immediately and the price for our agreement is now determined by independent appraisal.
• Observation.  I’ve had opportunities to review many fixed price agreements over the years.  Most of them, like ours, are just never updated.  A few of them were never priced at all.

The fact is, as time passes, the interests, ages, health, financial positions, working positions, family situations, and more change for the various parties to fixed price agreements.  It gets harder and harder to update pricing as time goes on.

An Illustrative Example of Why Not

Assume that the parties to an agreement initially set the price at $10 per share.  Over time, value may go up, and it may go down, or it may stay the same. Let’s look at two possibilities.

• Over time, value rises to $16 per share and the agreement is not updated.
• Over time, value falls to $4 per share and the agreement is not updated.

Graphically, it looks like this:

What are the implications of each of these situation, either of which is possible when an agreement is initially signed?  Consider the following:

• Value rises to $16 per share.  If there is a trigger event, the party who is bought out will lose out on value of $6 per share ($16 – $10), and the shares will be undervalued by 37%.  The party who buys, likely the company, will pay $10 per share for stock worth $16 per share, and will be beneficiaries of a significant windfall.
• Value falls to $4 per share.  If there is a trigger event, the party who buys will overpay by $6 per share ($10 – $4), and the shares will be overvalued by 250%.  The party who sells will receive a substantial windfall as result of the operation of the buy-sell agreement – i.e., if the company can afford to pay that price!

My Conclusion re Fixed Price Agreements

Fixed price buy-sell agreements are ticking time bombs and will achieve reasonable resolutions only by chance – and chance is not good enough for such important transactions for the parties.

A Bad Solution to the Problem

Some fixed price buy-sell agreements have a backup provision in the event that the price has not been updated by the parties with, say, two years.  That provision is typically very short and incomplete, but it typically calls for:

• The company to select an appraiser
• The selling owner to select another
• Both appraisers provide valuation opinions
• If their conclusions are within 10% of each other (virtually never!) the conclusion is the average of the two conclusions.
• If not, the two appraisers select a third appraiser who provides yet another appraisal.
• This third conclusion is averaged in some way with one or both of the other two to reach a conclusion for the process.

The problem is that the backup, multiple appraiser valuation process is almost certainly poorly specified.  The standard of value may not be clear and the level of value may not be clear.  The qualifications of appraisers are likely not specified. And the standard of value and level of value may be missing or unclear.  Appraisers may interpret confusing language differently and reach widely disparate conclusions.

The process is time-consuming and expensive and creates angst and anger among and between the parties.  No one knows what the result will be until after this long process is completed, likely in the midst of litigation.

And what if the company is small, with a value of $1 million or so?  This “backup” provision may well cost the parties $200-$300 thousand in appraisal and legal fees to settle.  If the company is larger and more valuable, the cost could be even higher because there’s more to fight over.

My Solution to the Problem If You Have to Have a Fixed Price Agreement

If you must have a fixed price buy-sell agreement, set the price as you must, and agree to reset the price annually as you will.

Now put in a workable backup provision.  I’ll make two suggestions for use depending on your tolerance for expense and risk.

1. Single Appraiser, Select Now and Value Now

The process I recommend goes something like this:

• Before you sign or update your agreement, the parties will all agree on a single, qualified and independent business appraiser.  This should be lots easier if there is no trigger event and the interests of the parties are reasonably aligned.
• The appraiser will be retained by the company to provide an appraisal at the financial control level of value.  This value is described in pages 137-144 of my book, Buy-Sell Agreements for Closely Held and Family Business Owners and shown conceptually in the levels of value chart (Figure 8 at page 139).
• The parties will see this appraisal in draft form and, hopefully, agree that it is reasonable, whether it is the exact price agreed to for the buy-sell agreement. The appraisal will be finalized.
• Then the parties will write into their fixed price agreement that if a trigger event occurs more than ____ months [you pick] following the last agreed upon (fixed) price for the agreement, the selected appraiser (or firm) will provide an appraisal at the financial control level to determine the price for the buy-sell agreement. The cost of the appraisal will be born by the company.

This procedure will salvage the day when you have not updated your buy-sell agreement.  The parties will have all agreed upon the appraiser and will know what his/her valuation process is and what to expect in terms of an appraisal.  The appraiser will be familiar with the company and should have credibility with all parties.  And all parties will all know what to expect and will know that resolution is forthcoming at the end of the appraisal process.

The insertion of a backup provision like the Single Appraiser, Select Now and Value Now process will save the day in the event that your fixed price buy-sell agreement is out of date.

2. Single Appraiser, Select Now

If you simply refuse to obtain an appraisal in connection with your buy-sell agreement, then go through the process of agreeing on an appraiser now.  This appraiser will be qualified and independent.

Write the appraiser’s name/firm into your buy-sell agreement and state that in the event that the fixed price in the agreement is more than ______ months [you pick] old, then the selected appraiser will be retained by the company and on behalf of all parties provide an appraisal of the fair market value of the company at the financial control level of value, citing the same information above.  You would, of course, talk with the appraiser about his understanding of what financial control value means and why it is the appropriate level of value for the appraisal.  

The appraiser will then provide his opinion to the parties and that conclusion will set the price.

This procedure is less certain than the first, because the parties will not have experienced the appraiser’s process.  However, it provides far more certainty than having no backup provision or having a poorly specified multiple-appraiser process in place.

Wrapping Up

To be clear, I do not recommend fixed price buy-sell agreements to any clients.  I believe they are ticking time bombs waiting to explode.

Some business owners, often at the suggestion of some advisers, however, will insist on having fixed prices for their agreements.

If you do this, do not do so without a workable backup valuation provision in the (likely) event that the parties will not update the agreement each year.

My recommendation is that the backup provision be that of Single Appraiser, Select Now and Value Now, where the selected appraiser provides at least one formal appraisal at the appropriate level of value for the parties.

My next best backup provision is that of Single Appraiser, Select Now.  Get a qualified appraiser written into the document reflecting the parties’ collective agreement.  Then, if the fixed price is dated, engage the named appraiser to perform the necessary valuation to set the price.

Your fixed price buy-sell agreement will work until it doesn’t.  And when it doesn’t, it will be to late to fix.  So fix it now, before it is too late.

Set your company and your shareholders up for the smoothest possible ownership transitions when trigger events occur by fixing your fixed price buy-sell agreement.

If you have a fixed price buy-sell agreement, obtain a copy of Buy-Sell Agreements for Closely Held and Family Business Owners and read Chapters 9, 13, 14, 16 and 17.

As always, do call if you want to discuss any valuation, buy-sell agreement, or ownership and management transition issues in confidence.

In the meantime, be well!

Chris

Shortly after the turn of the century (!), I started work on my first book on buy-sell agreements. That book, Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?, was published in 2007.  That same year I gave a major presentation on the topic at the annual conference of the Business Enterprise Institute in Denver.   It was fun and I received several additional invitations to speak afterwards.

During that almost two-hour presentation, I provided two slides on an idea I called “The One Percent Solution.”  I developed the term as a vehicle to talk with clients about the value of valuation and other financial and estate planning activities conducted to manage (pre-liquid) private company wealth.  The gist of the idea is simple:

Consider a budget for managing your pre-liquid wealth (defined as your ownership interest in your private company) similar to the fees you pay to manage your liquid wealth (stocks, bonds, other liquid investments).

When thinking about investing to manage your pre-liquid wealth, consider how you likely manage your liquid wealth:

• Holders of liquid wealth, including stocks of public securities, bonds of many kinds, securitizations of assets and other assets with active or relatively active markets tend to place them “under management” with financial planners, money managers, investment advisers or other professionals who manage their wealth actively.
• Asset managers charge fees for their services. Equity managers might charge 100 basis points, or 1%, of assets under management. Bond management fees tend to be lower, say from 20 to 50 basis points or so.  And private equity, venture capital, and hedge fund fees tend to be higher, perhaps 1.5% or higher.
• If you have a million dollars in managed, liquid funds, even in your company’s profit sharing plan, you are likely paying fees of 75 to 100 basis points for the services of your asset managers.  You and I and almost everyone else with significant liquid wealth does the same thing, so on your million dollar account, you are likely paying fees of perhaps $10 thousand, or say 1% of “assets under management,” or AUM for short.

Pre-liquid assets either become liquid or facilitate the creation of liquid assets when they are sold (entire businesses or partial sales) and when they distribute cash to their owners. Do owners of privately owned companies typically thing about their pre-liquid assets as investments? Not if our experience is representative. This leads us to The One Percent Solution.

The One Percent Solution Defined

So what is The One Percent Solution?  Consider 1% of the wealth tied up in your (or your clients’) private businesses as the starting point for discussion for the budget for managing that wealth.  So if a closely held or family business is worth $20 million, the budget for managing that wealth might be about $200 thousand, or about $100 thousand if you use 50 basis points as your “management fee” percent.

The Booklet

During that speech in 2007, I said no more than what I’ve written above about The One Percent Solution.  However, a few months later, I received a call from a sales manager with National Financial Partners. I thought he was going to ask me for a repeat of my buy-sell agreement presentation.  While he found that talk very helpful, he was most interested in a one-hour presentation on, you guessed it, my two slides regarding The One Percent Solution.

I delivered that presentation and also wrote a booklet on the topic for each financial planner at the conference. That booklet is available today as a complimentary pdf download. Financial planners have purchased the book in bulk to give to their clients and I have given a number of speeches on the topic.

A New Book In New Series Is Coming

Because I am a member of the baby boomer generation and because I am a transitioning business owner, I am keenly interested in succession planning for baby boomer business owners. As such, I have begun a new series of Kindle books. The series is entitled The Baby Boomer Business Owner Transition Guides. My first book in this Kindle series was recently published: Buy-Sell Agreements for Baby Boomer Business Owners. It is my third book on the topic of buy-sell agreements. It is a condensed and generationally focused version of my 2010 print book, Buy-Sell Agreements for Closely Held and Family Business Owners.  

At the request of several financial planners and attorneys, I am in the process of revising and expanding the original The One Percent Solution (available as a complimentary pdf download).  You can follow along because I will be writing installments on the topic for the blog as the new book develops. The new book will be the second book in The Baby Boomer Business Owner Guides series.

Conclusion

If you have ideas or thoughts you would like to share about managing private wealth, please feel free to call or email me.  I’d love to hear from you and consider your ideas as the new The One Percent Solution progresses.

You may have thought the following about a marathon:

The marathon is a long-distance running event with an official distance of 42.195 kilometres (26 miles and 385 yards), that is usually run as a road race. The event was instituted in commemoration of the fabled run of the Greek soldier Pheidippides, a messenger from the Battle of Marathon to Athens.

Peter Mahler, writing in New York Business Divorce, suggests a new definition.  Or rather, I do after reading his recent post regarding a fixed-price buy-sell agreement.

BuySellAgreementathon.  The distance covered by all parties in a case that has lasted more than a decade and that has gone to court many times.

I am referring specifically to the fight over the value to be paid for an 18% interest in Troser Management, Inc.

Mahler writes about a long-standing matter which was published following a long line of other related decisions, including this, the fourth and final (?) appeal.  See  Sullivan v. Troser Management, Inc., 2013 NY Slip Op 01634 (4th Dept Mar. 15, 2013).

Read the Mahler post here.  The essential facts of the case are listed below.

• The plaintiff was hired by Troser Mangement, Inc. (Troser) in 1986 with an agreement that he would be entitled to 18% of the equity of Troser if he stayed employed until 1991. He did. He did not actually receive the shares of Troser, but he apparently earned the legal right to such shares.
• Perhaps there were negotiations between the parties following the plaintiff’s departure. We don’t know. However, the plaintiff filed a lawsuit in 2003 asking that his stock be issued and then bought.
• There was a buy-sell agreement dating to 1986 – a fixed-price agreement. This agreement called for the owners to agree on the value each year and set such agreement forth in its Schedule A. The agreement further stated that, in the event that the shareholders did not update Schedule A for two years, then the agreement price would be adjusted up or down based on the change in Troser’s book value from the date of the last Schedule A to the time of the trigger event.
• Schedule A was never finalized, so there was no base value from which to adjust.

Readers of my blog and books on buy-sell agreements know that I am not a fan of fixed-price buy-sell agreements. Mahler quoted me, so I’ll requote him:

In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease. However, if you have a fixed-price agreement, you must have the discipline to update the price periodically. And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.

This quote is from my 2010 book, Buy-Sell Agreements for Closely Held and Family Business Owners.  I repeat this advice in my new Kindle book, Buy-Sell Agreements for Baby Boomer Business Owners. I state further in the new Kindle book about some of the emotional and practical problems with fixed-price buy-sell agreements:

Whether consciously or not, shareholders sometimes perceive the potential for personal advantage in the current fixed price:

• Younger shareholders may perceive advantage in a dated, low (rather than a higher current value) buy-sell price if there are significant age or health differences relative to older owners.
• Older shareholders may perceive advantage in a dated price if the fortunes of the company have declined and valuations are known to be generally lower than when the agreement was signed.
• A healthy shareholder may perceive advantage if another owner is in poor health and disability or death provisions of the agreement may be triggered.
• Optimistic shareholders may perceive advantage in that they do not believe that “bad things” could happen to them.

Baby Boomers should pay attention.  I don’t want to attribute bad motives to good people. The problem with fixed-price agreements lies not with motives but with a natural divergence of interests and personal objectives over time.  Most business owners, at least in my experience, will go to extremes to avoid such discussions, which are often viewed with discomfort or as potentially antagonistic.

• If there is a controlling shareholder and the remaining shareholders hold minority interests, it can become awkward to discuss valuation.
• The minority shareholders are often thinking in terms of the value of the enterprise as a whole, and not in terms of illiquid, minority interests in the corporation.
• The controlling shareholder may consider the minority shares to be worth proportionately less than his shares.
• The end result is that all the shareholders – whether younger or older, in better or worse health, or having controlling or minority ownership – end up betting that something will happen to the other owner(s) first. And one of them will be right.  Someone will win the bet and the other one(s) will lose it.

Life is uncertain. People don’t live or die or become disabled or leave based on the expectations of others. They live or die according to a divine plan (if you are religious) or by chance, luck, or genes (if you are not).

In any event, things happen over time, and they are not always the things we expect.  The Law of Unintended Consequences is at play in our business and personal lives.  If you have younger and older shareholders, think about what would happen if a key younger shareholder died unexpectedly. What if an older owner with a substantial interest died? What about, heaven forbid, at least any time soon, you?

In my other books and the new Kindle book, Buy-Sell Agreements for Baby Boomer Business Owners, I make two recommendations for those of you with a fixed-price agreement:

• First, if you have a fixed price buy-sell agreement, for heavens sake, get the owners to agree and change it to a Single Appraiser, Select Now and Value Now agreement. Then, when the appraiser you select revalues the business each year, then you will know that your agreement is current – and you will know what the value is.
• Second, if you fail to heed my first recommendation, amend your fixed-price agreement to add a clause of agreement on what happens if there is a trigger event and the fixed price has not been updated for _____ months (you name the number). That clause is defined as part of the Single Appraiser, Select and Value at the Trigger Event process. You won’t have the certainty of my first recommendation, but you will have a dispute resolution process in place by agreement.

These recommendations address Mahler’s concluding lament with respect to establishing a methodology for valuing shares:

You’ve got to figure that after ten years of litigation, including four appeals, likely the parties collectively have spent far more in legal fees than Sullivan’s shares are worth. On top of that, the litigants have yet to establish through their prodigious litigation efforts either (1) a methodology for establishing the value of Sullivan’s shares and (2) any certainty as to the exercise of Troser’s option to purchase Sullivan’s shares.

And to think, all of this could have been avoided had the parties prepared a simple schedule or certificate of value as contemplated by the 1986 buy-sell agreement. But do not view this omission as a freak occurrence. Rather, it is symptomatic of the myriad problems afflicting fixed-price buy-sell agreements.

Whether you are a baby boomer or not, the new book, Buy-Sell Agreements for Baby Boomer Business Owners, will be helpful to you as a resource to review your buy-sell agreement and seek the professional resources you need to ensure that it will work when it is triggered. In addition, the book, initially priced at only $2.99 as a Kindle book, offers complimentary downloads of the Buy-Sell Agreement Review Checklist and the Checklist for Shareholder Promissory Notes. Get these resources and use them

Don’t be a victim of a virtually certain-to-fail fixed-price buy-sell agreement like the long-suffering plaintiff and defendants in Troser.

Miles Mason, Sr., of the Miles Mason Family Law Group, has posted a review of my new Kindle book, Buy-Sell Agreements for Baby Boomer Business Owners.  The book is a condensed and generationally focused version of my print book, Buy-Sell Agreements for Closely Held and Family Business Owners.

You can read Miles’ full post on his firm’s Family Law Blog, which can be downloaded here.  In kindly recommending the book, he states, in part:

Buy-sell agreements are not merely legal documents to be signed and forgotten. If you are a baby boomer business owner, you are either making or are set to make life and business transitions soon. Some of these transitions you will plan and execute according to that plan. Other will happen to you because life happens to all of us. Making sure your buy-sell agreement will operate as you, your family, and the other owners expect when triggered can have huge consequences for you, your family, and the business.

If you are an adviser to baby boomer business owners, this book will help you understand the many valuation and business issues related to buy-sell agreements.  In turn, you will be in a better position to assist your clients regarding this important issue – and perhaps others as well when you help them solve their buy-sell agreement problems.  Available on Kindle currently priced at $2.99 it’s a lot of valuable information.

Miles beat me to the punch in introducing the book!  I’ll have a more formal introduction on this blog shortly.  In the meantime, you can go to Amazon and purchase Buy-Sell Agreements for Baby Boomer Business Owners right now!

This is the second in a two-post series on a buy-sell agreement between giants and involving a substantial business enterprise.  The first post outlined the Definition of FMV, or presumably, fair market value of some sort, to determine price per the Amended and Restated Limited Liability Company Agreement of Morgan Stanley Smith Barney Holdings LLC (“MSSBH”) (“the LLC Agreement”) and dated May 31, 2009.

The Announcements

Morgan Stanley (MS) notified Citigroup Inc. (C) in a Form 8-K filed May 31, 2012 that it intended to exercise its option to acquire 14% of Morgan Stanley Smith Barney Holdings LLC (MSSB) of the 49% of the joint venture (JV) owned by Citigroup.

Citigroup Inc. (C) announced in a Form 8-K on July 16, 2012 that Morgan Stanley (MS) had exercised its option to acquire, over time, its 49% stake in Morgan Stanley Smith Barney Holdings LLC.

Morgan Stanley filed a Form 8-K on September 11, 2012 announcing the consummation of the buy-sell agreement process outlined in the previous post about this deal.

Citigroup filed a Form 8-K on September 11, 2012 announcing the consummation of the buy-sell agreement transaction.

The financial press announced the resolution of the pricing of the purchase in articles on September 11, 2012 (at least here and here).

These announcements describe the operation of a buy-sell agreement involving the highest market capitalization company I have yet seen in operation  and provides a fascinating glimpse into Wall Street.

Buy-sell agreements come in all shapes and sizes and, perhaps, colors, too.  I’ve held off writing about this one until it was resolved.

A Buy-Sell Agreement Gone Public

Let’s summarize a number of facts that are now known about the buy-sell agreement between Morgan Stanley and Citigroup regarding a 14% common member interest of the 49% common member interest owned by Citigroup since the formation of MSSBH in May 2009.

• Morgan Stanley exercised its option (Call Right) to purchase the 14% interest noted above effective June 1, 2012.
• Morgan Stanley hired Morgan Stanley Investment Banking (“MSIB”), its investment banking arm, to be its Appraiser (per the LLC Agreement) and to perform its initial estimate of FMV (as defined in the prior post).  Morgan Stanley Investment Banking concluded that its estimate of FMV was $9.0 billion.
• Citigroup filed a Form 8-K on July 16, 2012 and announced several things.  Its Appraiser was Citigroup Global Markets, Inc. (“CGMI”), and CGMI concluded that its estimate of FMV was $22.5 billion.  Citigroup also announced that its carrying value for its 49% interest in MSSBH was about $11 billion, implying an enterprise value of $22.5 billion, which was the approximate conclusion of CGMI.  The Citigroup announcement went on to suggest that, depending on how the appraisal process turned out, a writedown of its carrying value might be necessary.
• In accordance with the valuation process outlined in the LLC Agreement (and discussed at length in the prior post on this topic), MSIB and CGMI agreed on the selection of Perella Weinberg Partners as the third Appraiser called for therein.
• Perella Weinberg Partners (“PWP”) was described in the business press as having “wide latitude” in arriving at its determination of FMV.  The reason that the third Appraiser had such wide latitude is that their interpretation of the “words on the pages” of the LLC Agreement was going to be binding.
• PWP concluded that FMV was $13.5 billion (enterprise value), which was the conclusive pricing for Morgan Stanley’s purchase of the 14% common member interests owned by Citigroup (of its total of 49%). The price for the interest was $1.89 billion.
• Some $5 billion of deposits were transferred from Citigroup to Morgan Stanley for no consideration (i.e., no deposit premium).  That is the entire discussion in both companies’ Form 8-Ks, so I won’t speculate about what that meant.
• Interestingly, Citigroup agreed to sell its remaining 35% of MSSBH to Morgan Stanley between now and June 1, 2015 at the same enterprise value of $13.5 billion.  That is interesting and one could ask, why would Citigroup agree to such pricing?  There are several possible explanations, all of which are not necessarily consistent: (1) Citigroup is more bearish on the prospects of MSSBH than Morgan Stanley and wanted to lock in the price. (2) Citigroup was embarrassed by the public valuation process and the large implied write-down on its investment in MSSBH and wanted to avoid such a public process in the future. (3) Regardless of embarrassment, Citigroup simply wanted to get this situation behind them as soon as possible.

Interesting Insights

Let’s do a bit of math:

• The difference between the appraisals offered by Citigroup and Morgan Stanley was $13.5 billion, or, by chance, about the same as the conclusion of fair market value.  Perhaps that is irrelevant but it is nevertheless astounding.
• The 14% interest being acquired by Morgan Stanley has a value of $1.9 billion.
• At this $13.5 billion enterprise valuation, Citigroup’s 49% interest has a value of $6.6 billion, which is some $4.4 billion below its carrying value of $11 billion.  This suggests that there has been or will likely be a substantial impairment charge.

The agreement calls for Morgan Stanley to acquire the remaining 35% interest held by Citigroup by June 1, 2015 at the same $13.5 billion valuation.  Citigroup’s CEO Vikram Pandit had this to say:

I am pleased we have reached agreement on a value for our remaining stake in Morgan Stanley Smith Barney. Establishing certainty regarding the divestiture of this business is in the best interests of our shareholders

Morgan Stanley’s CEO, James Gorman had this to say:

This mutually beneficial agreement gives both parties certainty and transparency on price and timing, and is a significant milestone for Morgan Stanley in the implementation of our strategy.

These quotations are consistent with my interpretations above, or so it seems.

The LLC Agreement contained provisions found in many buy-sell agreements and provided a valuation process.  The process had a great deal of uncertainty, including uncertainty regarding where its conclusion would land, whether in the middle third (where its conclusion was binding on the parties), the lower third (where it would be averaged with the $9.0 billion conclusion of MSIB), or the upper third (where it would be averaged with the higher conclusion of CGMI.

It looks like PWP finessed the issue.  Let’s do a bit more math and see.

• MSIB’s conclusion was $9.0 billion, marking the lower bound for the valuation process (recall that PWP was required to agree with one of the two initial Appraisers, or to be within the range they established).
• CGMI’s conclusion was $22.5 billion (and all of these are close approximations), marking the higher bound.
• The difference between the first two estimates is $13.5 billion, so $4.5 billion is one-third of that.  The lower third is marked by the range of $9.0 billion to $13.5 billion, the middle third is from $13.5 billion to $18 billion, and the upper third is the range of $18 billion to $22.5 billion.
• With a conclusion at or very near the lower third boundary pricing of $13.5 billion, PWP appears to have agreed more with MSIB than with CGMI.  However, PWP was apparently not willing to drop below $13.5 billion, where its conclusion would then have been averaged with that of MGIB.  For example, of PWP had concluded that its estimate of FMV was $13 billion instead of $13.5 billion, the final result would have been $11 billion (the average of $9 billion and $13 billion).

All parties experienced substantial uncertainty with the buy-sell agreement process and the price wasn’t known until the end.  No one knew how the Appraisers would interpret the language in the LLC Agreement defining FMV, and no one knew who the third Appraiser would be until the selection of PWP was made.Until the actual appraisals become available publicly, it is not possible to know what caused the enormous $13.5 billion gap between the conclusions of Morgan Stanley and Citigroup.  One thing is certain.  Being large, even the sizes of Morgan Stanley and Citigroup, and being able to hire the largest law firms and the largest investment banking firms, does not avoid common problems with buy-sell agreements.

How Could the Result Have Been Different?

Had I been present when the LLC Agreement was being negotiated in May 2009, I would have suggested a single appraiser pricing mechanism like that outlined in my book Buy-Sell Agreements for Closely Held and Family Business Owners.  It is called the Single Appraiser, Select Now and Value Now valuation process.  The process would have gone something like this:

• The parties would have agreed on Mercer Capital (or another qualified, independent appraiser or investment banker, but I am writing this post!) to be the single appraiser for the valuation process and written this firm’s name into the LLC Agreement as the Appraiser when it was signed on May 31, 2009.
• The Appraiser would have provided an appraisal as of May 31, 2009 based on the agreed upon definition of FMV and it would have been discussed and reviewed by and accepted by Morgan Stanley and Citigroup.  This would have been much more likely at that time, since there was no Call Right that was exercisable for at least three years, and the interests of the parties were relatively aligned — else why would they have entered into the joint venture with MSSBH?
• The Appraiser would have provided an appraisal as of May 31, 2010 and May 31, 2011.  An appraisal would have been underway at the time Morgan Stanley exercised its Call Right on May 31, 2012, and its conclusion would have provided the pricing.
• The parties would have known who the Appraiser is, how the appraisal or determination of FMV would be conducted, what it should look like relative to prior appraisals based on changes at MSSBH, in the markets, the brokerage industry and the economy.  The determination of FMV as of May 31, 2012 would not have been embarrassing for Citigroup, since it would have kept its carrying value in line with the annual independent appraisal.  It would have provided certainty for all parties.

If you or a client have a buy-sell agreement with a multi-appraiser valuation process, it would be an excellent time to have your trusted advisers, including your business appraiser, review the agreement.  If results like we have just described above and in the last post can happen to Citigroup and to Morgan Stanley, they can certainly happen to you.

Help for Your Buy-Sell Agreement(s) is Available

For help, you can acquire a copy of Buy-Sell Agreements for Closely Held and Family Business Owners.  Quantity discounts are available.  Anyone buying the book now receives a complimentary copy of the companion piece, Buy-Sell Agreement Checklist, which provides a roadmap to discuss most valuation and business aspects of buy-sell agreements.

Overview of a Two Part Series

Morgan Stanley and Citigroup entered into a joint venture (JV) dated as of May 31, 2009, with Morgan Stanley owning 51% and Citigroup owning the remaining 49% of the common member interests in Morgan Stanley Smith Barney Holdings LLC (“MSSBH”).

The JV was evidenced by the Amended and Restated Limited Liability Company Agreement of MSSBH (“the LLC Agreement”). The LLC Agreement contained certain provisions providing for a series of options for Morgan Stanley to call (purchase) the 49% of the common membership interests owned by Citigroup. To learn more about LCC, articles like how to start an llc in Texas would be filled with the right information.

Morgan Stanley issued a press release on May 31, 2012 (three years from the date of the LLC Agreement to the day) announcing its intent to exercise its option to call (purchase) an additional 14% of the common member interests from Citigroup in accordance with the terms of the LLC Agreement.

This post will describe the definition of the price (i.e., the amount that Morgan Stanley will have to pay to Citigroup) for transactions pursuant to the LLC Agreement as well the previously agreed upon process (in the LLC Agreement) for determining such price.  The next post will then describe the actual process based on publicly available information.  As usual, I will comment and relate this big-time buy-sell agreement to those found in companies that our attorney friends, accountants, financial planners and business appraisers more normally deal with.

I will be quoting from the Morgan Stanley Form 8-K and making comments, as appropriate.

As usual, there are some lessons to be learned from the “big boys.”  And the big boys may have learned a lesson or two, as well.

The Price Morgan Stanley Will Pay Described

The price is described in the LLC Agreement  beginning with the Definition of FMV.  Presumably, FMV is some concept of fair market value, which is described in the ASA Business Valuation Standards as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Compare this definition of fair market value with that of “FMV” in the LLC Agreement, which is defined as the product of:

the aggregate common equity market value of MSSBH on the Notice Date as if, on the Notice Date, MSSBH had been converted into a domestic corporation or a new domestic corporation had been formed to own all the Membership Interests or assets of MSSBH (and assuming that the preferred membership interests of MSSBH had been converted to preferred stock of such corporation with the same amount of liquidation preference and having substantially the same terms as the preferred membership interests of MSSBH, subject to any modifications as may be mutually agreed by the MSSBH members in order to permit the exchange of preferred membership interests for preferred stock to be treated as a tax-free transaction for U.S. federal income tax purposes), and the common shares of such corporation (“the Publicly Traded JV Company”) were traded on the New York Stock Exchange or NASDAQ on a Fully Distributed Basis (as defined below); and the percentage of outstanding Membership Interests subject to the Call Right.

It sounds like Morgan Stanley and Citigroup wanted any appraisers to treat MSSBH as a domestic, publicly traded corporation with its (hypothetical) shares being traded on the New York Stock Exchange (“NYSE”).  And it appears that any preferred interests owned by the parties are not subject to any Call Right and remain in place following any transaction.

This is all well and good, but since the hypothetical shares of MSSBH are not actually traded on the NYSE, the parties wanted to provide any appraisers (described below) with certain instructions.  We begin with the definition of Fully Distributing Basis, which:

means assuming 100% of the common shares of the Publicly Traded JV Company were publicly traded at such time and no one person or group of persons beneficially owned more than 1% of such shares.

This definition precludes any appraiser from making assumptions regarding control or other assumptions regarding the exercise of corporate power which might influence price.  But we are not through with the definition of price.  The next ponderous paragraph states that “Under the LLC Agreement, FMV will:” (with my numbering system replacing that in the LLC Agreement and with [my comments in brackets] and with any emphasis being mine) :

1. not include any control premium [this reemphasizes the guidance in the definition of Fully Distributing Basis above]
2. not include any discount due to the illiquid nature of the Membership Interests or any discount relating to the fact that MSSBH is not a public company [i.e., there will be no marketability discounts for lack of marketability, even though it has already been made clear that the hypothetical MSSBH is publicly traded on the NYSE.  Someone just wanted to be sure that no one tried to insert a DLOM of any kind for any reason.]
3. take into account trading values of comparable companies (A) the prospects of MSSBH [how any appraiser could fail to consider the prospects of MSSBH or any company being valued is beyond me], (B) the value of the estimated future earnings of MSSBH [so the appraisers are required to use the discounted cash flow or future earnings method], (C) the size of MSSBH [with more than 16,000 brokers, it is a pretty good-sized business], (D) the public market trading values of comparable companies [so the instructions require the use of the guideline public company method], (E) the business mix of MSSBH relative to comparable companies [appraisers, be sure that the “comparable” companies are comparable!], and (F) such other factors as the Appraisers (as defined below) deem relevant
4. be based on (A) the valuation of MSSBH and its subsidiaries taken as a whole [appraisers, value MSSBH and not something else?], (B) an assumption that MSSBH will remain independent and have the continued ownership of its subsidiaries [no sneaking in a control premium Appraisers, get it?] and (C) an assumption that the then existing contractual relationships among Morgan Stanley, Citigroup and MSSBH and their respective controlled affiliates shall remain in full force and effect and continue in accordance with their terms (other than certain transaction documents that terminate in accordance with their terms) [This reminds me of a buy-sell agreement dispute where an investment banker from then Salomon Brothers was appraising for his “buying” client.  He wanted to argue that his client would cease supplying the joint venture and its value was therefore diminished by the operation of the buy-sell agreement!  It didn’t work.]
5. take into account whether or not any items are non-recurring and [this virtually universal appraisal practice is made specifically clear.]
6. assume that all funding contribution obligations and obligations to make any delayed contributions of certain businesses to MSSBH have been satisfied or made and all delayed distributions of certain businesses from MSSBH to Morgan Stanley and Citigroup have been effected.  FMV will also take into account the tax attributes of the Publicly Traded JV Company, including an assumption that the Publicly Traded JV Company had received the benefit of a tax basis step-up for income tax purposes(if then available under applicable law) arising by reason of the purchase of  (A) Citigroup’s entire Membership Interest in MSSBH (i.e., a 49% percentage interest) at FMV as of the Notice Date and (b) all preferred membership interests of MSSBH then held by Citigroup and/or its affiliates at their liquidation preference. [From the financial press, there was a substantial disagreement regarding tax treatment in the valuation process]As of March 31, 2012, there was an aggregate face amount of approximately $7.5 billion of preferred membership interests of MSSBH outstanding, of which approximately $5.5 billion was held by Morgan Stanley and $2 billion was held by Citigroup.  The determination of FMV will assume only a single level of corporate income tax imposed on the Publicly Traded JV Company

Lawyers and perhaps some consulting investment bankers must have worked hard on this, trying as best they could to define away all possible sources of potential future dispute.

Interestingly, while the LLC Agreement prohibits the application of a control premium, it does not prohibit (nor does it mention) the use of multiples from guideline transactions involving the sale of comparable companies.  This could have been a back-door way for someone to attempt to sneak in an implicit control premium without ever mentioning the word.  I don’t know if this happened or not. The point is, the longer and more refined the list of instructions becomes in a buy-sell agreement, almost the easier for an advocative appraiser to slip in methods or techniques inconsistent with the instructions.

If I had to summarize the Definition of FMV from the LLC Agreement, it would appear that the parties were attempting to agree on a value that I would describe as “fair market value at the marketable minority level of value.”  Defining FMV in this fashion might have been clearer than all of the convoluted instructions to the appraisers.  Or, having provided specific instructions, the LLC Agreement could have concluded by noting that “the above instructions are tantamount to defining FMV as being determined at the marketable minority level of value, including all the institutional-specific assumptions provided.”  But they didn’t ask me.

The “words on the pages” of the LLC Agreement are the only words that matter once a buy-sell agreement has been triggered, including the triggering of the Call Right in the LLC Agreement by Morgan Stanley.

The Valuation Process Described

With everything crystal clear about price and the definition of FMV, we proceed to the valuation process described in the LLC Agreement, which provides a specific process for determining FMV as follows:

Two Appraisers Start the Valuation Process

Without attempting to quote directly, we can summarize the the valuation process first, as beginning with two appraisers and then becoming a three appraiser process.  The first two appraisers are selected and operate as described.

1. Within 10 days, each of Morgan Stanley and Citigroup “will engage one investment bank or financial advisory firm of national standing and with experience in the valuation of securities of financial services for purposes of estimating FMV.” Each is an “Appraiser” per the LLC Agreement.  The parties are respectively responsible for the fees of their selected Appraisers.
2. This next aspect is quite interesting and insures great potential for disagreement (i.e., advocacy) between the Appraisers. “Either or both of the first two Appraisers may be an affiliate of the party engaging such an Appraiser.”  Morgan Stanley selected Morgan Stanley Investment Banking as its appraiser and Citigroup selected Citigroup Global Markets, Inc.
3. Each Appraiser is instructed to determine FMV in “good faith” and to provide estimates in accordance with the Definition of FMV we just described and within 45 days.
4. Finally, if the higher of the two estimates of FMV (Citigroup is selling.  Care to guess which one was higher?) is more than 110% of the lower, the final determination of FMV will be the average of the conclusions of the first two Appraisers.  In the next post we will learn just how much more than 110% the higher can be over the lower.

The Third Appraiser

If the first two Appraisers’ conclusions are more than 110% apart (higher to lower), then the first two Appraisers are required to select a third Appraiser who is independent of all parties.  There is a further process for selecting a third Appraiser if the first two Appraisers cannot agree.   Since that didn’t happen here, we’ll save a few words.  Fees of the third Appraisers are shared equally by Morgan Stanley and Citigroup.  The third Appraiser is to be selected by the 60th day following the Notice Date.

Once selected (it was Perella Weinberg Partners), the third Appraiser is to render its estimate within an additional 30 days.  An interesting restriction is placed on the third Appraiser, indicating “the estimate of the third appraiser must be equal to one of, or be within the range between, the estimates of the first two Appraisers.”

It is always the role of the third Appraisers to, hopefully, resolve the valuation process.  How that resolution occurs, however, is up to the parties.  The third appraiser’s conclusion can, for example, be binding in and of itself.  Alternatively, the third conclusion can be averaged with the closest conclusion of the first two.  Other resolving processes can be described.  The LLC provides an interesting twist on the resolution process:

If the FMV estimated by the third Appraiser is in the middle third of the range of the FMVs estimated by the other two Appraisers, the FMV of the third Appraiser will be the final FMV.  If the FMV estimated by the third Appraiser is in the top third of the range, the final FMV will be the average of the FMV estimated by the third Appraiser and the higher FMV of the first two Appraisers.  If the FMV estimated by the third Appraiser is in the bottom third of the range, the final FMV will be the average of the FMV estimated by the third Appraiser and the lower FMV of the first two Appraisers.

This clause provide for potential enormous movement of the concluded FMV based on very small differences in the third Appraiser’s conclusion.  Assume for a moment that the lower appraisal of FMV is at $3 billion and the higher estimate is at $12 billion.  The bottom third is defined by the range of $3 billion to $6 billion.

• Assume that the third Appraiser concludes that FMV is $5.9 billion.  The average of $5.9 billion and $3 billion is $4.45 billion.
• Assume that the third Appraiser concludes that FMV is $6.1 billion, this conclusion is within the middle third range and would be binding.
• A $200 million ($0.2 billion) swing in the third Appraiser’s estimate, say from $6.1 billion (within the middle third range and therefore binding) to $5.9 billion, would cause an averaging with the $3.0 billion low result. The price would fall from $6.1 billion to $4.45 billion, which would be a swing in favor of the purchaser of $1.55 billion, and a reduction of some 27% in proceeds to the seller.  The buy-sell agreement in the LLC Agreement would provide a mirror swing for conclusions around $9 million, which is the boundary between the middle third and the top third.

We will see how it all worked out in the next post, which will look at the dynamics of the process.

Observations

Several comments were made along the way.  As we conclude this discussion of the definition of price and the overview of the valuation process for a whopping buy-sell agreement, let me make the following observations.

1. The parties went to great lengths to define FMV.  However, the length of the definition likely introduced as many areas for potential dispute between advocative appraisers as it eliminated.  As noted above, the more intensively parties try to define value or price, the easier, in some respects, it is to find an exception to the “rules” laid out in an agreement.
2. This process was set up to be advocative.  Morgan Stanley hired its investment banking arm.  Citigroup hired its brokerage and securities arm.
3. There is pressure for the third Appraiser to reach a conclusion within the middle third range between the FMV estimates of the first two Appraisers.  The investment banker reaching a conclusion creating a swing like described above might be unpopular with a powerful enemy, and perhaps popular and with a powerful friend at the same time.
4. The process described in the LLC Agreement is a three appraiser agreement where the third Appraiser is the Determiner, as described in my book, Buy-Sell Agreements for Closely Held and Family Business Owners.
5. When this process was initiated on May 31, 2012 by Morgan Stanley, it was bound to be public and potentially embarrassing for one or both of the parties.  With captive Appraisers allowed and selected, the process was bound to create a third Appraiser requirement.  The confusion created by the minute descriptions in the definition of FMV provided almost certain room for varying interpretations by the two captive appraisers.

The conclusion will be interesting for those who haven’t read about the result.  Even if you have, the description of the workings of the process should be fascinating, as well.

In the July 26, 2012 issue of NACVA‘s Quick Read Industry Buzz newsletter, the article “How to Set Up Buy-Sell Agreements: Recommended Valuation Process for Buy-Sell Agreements – The Single Appraiser” was featured.

The article, excerpted from my book Buy-Sell Agreements for Closely Held and Family Business Owners, explains the Single Appraiser: Select Now, Value Now valuation process. The advantages of this valuation process are:

The Single Appraiser, Select Now and Value Now process provides several distinct advantages relative to other process agreements, including:

• The structure and process, in addition to being defined in the agreement, will be known to all parties to the agreement in advance.
• The selected appraiser will be viewed as independent with respect to the process; otherwise, he or she would not have been named. At the very least, the suspicion of bias is minimized.
• The appraiser’s valuation approaches and methodologies are seen first hand by the parties before any triggering event occurs.
• The appraiser’s valuation conclusion is known at the outset of the agreement by all parties and becomes the agreement’s price until the next appraisal, or until a trigger event between recurring appraisals occurs.
• The process is observed at the outset; therefore, all parties know what will happen when a trigger event happens.
• The appraiser must interpret the valuation terms of the agreement in conducting the initial appraisal. Any lack of clarity in the valuation-defining terms (“the words on the pages”) will be revealed and can be corrected to the parties’ mutual satisfaction.
• Having provided an initial valuation opinion, the appraiser must maintain independence with respect to the process and render future valuations consistent with the instructions in the agreement.
• Because the appraisal process is exercised at least once, or on a recurring basis, it should go smoothly when employed at trigger events and be less time-consuming and less expensive than other alternatives.

One further element can improve the Single Appraiser, Select Now and Value Now option even more – regular reappraisals. In my opinion, most companies with substantial value (beginning at $2 to $3 million of value) should have an annual revaluation for their agreements. For most such companies, the cost of the appraisal process is insignificant relative to the certainty provided by maintaining the pricing provisions on a current basis. Owners who view the cost of an annual reappraisal as excessive should have the reappraisals every other year.

To get your copy of Buy-Sell Agreements for Closely Held and Family Business Owners, click here.

Q:  Isn’t a valuation process agreement just a fixed price buy-sell agreement that is updated every year?

Answer:

The question is a good one.  And the answer is “no” and “yes.”

“No.”  A buy-sell valuation process agreement specifies just that – a valuation process to determine value.  The price is determined by appraisal. It is the appraisal process that establishes value on a regular basis or at trigger events, and not agreement of the parties in the context of setting price. So a valuation process agreement is not just a fixed-price agreement that is updated each year.

“Yes.”  A valuation process agreement does set a price which, for a time, is fixed.  In that context, it is a “fixed-price” agreement.  However, unlike with an actual fixed-price agreement, which calls upon the parties to reset the price each year (and they seldom, if ever, do), the valuation process agreement specifies a process for “fixing” the price that is, once underway, outside the hands of any party.

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For more information on this topic and other topics related to buy-sell agreements, check out Buy-Sell Agreements for Closely Held and Family Business Owners.

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This series, “Ask Chris Mercer,” is derived from the Q&A session of the May 16, 2012 webinar, “Buy-Sell Agreements” sponsored by WealthCounsel and attended by over 600.  

If you have a question for Chris, feel free to email him directly here.

DeMatteo Salvage Company, Inc. is a Long Island based, family-owned business since the 1920s, designing and installing machinery and equipment for scrap paper and solid waste customers.  The company had multiple owners who, in this case, were brothers.   DeMatteo Salvage also had a buy-sell agreement which dated back to 1966.  It was a fixed-price agreement, which read, in part:

The last value established preceding the death of a Stockholder shall be the value of his stock for purposes of this agreement. This provision shall not be altered by the fact that the Corporation and the Stockholders for any reason have failed to redetermine such value at any time or from time to time. All redeterminations of value shall be endorsed upon Schedule A hereof, dated and signed by the Corporation and the Stockholders.

Readers of this blog know that I do not like fixed-price buy-sell agreements.  I have said for years that formulas and fixed prices are not good pricing mechanisms for most buy-sell agreements.  A short quote from Buy-Sell Agreements for Closely Held and Family Business Owners state the conclusion succinctly:

Re Fixed Prices (at p. 80)…In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease.  However, if you have a fixed-price agreement, you must have the discipline to update the price periodically.  And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.

See also my post, Book Value Pricing [i.e, essentially a fixed price] for Buy-Sell Agreement Upheld in New Jersey.

DeMatteo Salvage Co. and the DeMatteo families who owned it, were mired in litigation regarding their buy-sell agreement for nearly a decade.  It is amazing that someone or anyone was able to mind the family store.  The case recently came to a head (again, I guess) with a decision in New York:  DeMatteo v. DeMatteo Salvage Co., 2011 NY Slip Op 09586 (2d Dept Dec. 27, 2011).  This was a decision of the Supreme Court of the State of New York Appellate Division, Second Department.

I could review the case in depth, but Peter Mahler has already done so on his New York Business Divorce Blog.

Peter titles his review of the case as “An Ill-Fated Solution to an Ill-Fated Buy-Sell Agreement.”

Please do read Peter’s post if you have a fixed-price buy-sell agreement.  Please read this post if you have clients that have a fixed-price buy-sell agreement.  Please share this post with anyone you know who might be shocked into action to fix a potentially disastrous problem before it explodes.

You can get started with Peter’s conclusion regarding the DeMatteo matter:

Between the first buy-out litigation following the eldest brother Joseph’s death, and the second lawsuit started by Gloria after Edward’s death, the DeMatteo family has been warring in the courts over the value of the companies’ shares for more than a decade. Whatever one thinks of the outcome, what’s absolutely clear is that the buy-sell agreement failed miserably, both in its design and its implementation, in its intended purpose to ensure family control of the businesses while providing the shareholders’ heirs with a measure of financial security based on a consensual, non-litigated, fair valuation of the companies’ equity.

• It was a mistake to design the buy-sell agreement without requiring periodic updates.
• It was a mistake to design the buy-sell agreement without providing an alternative valuation method when a buy-out event occurs more than a year or two after the last agreed valuation.
• It was a mistake for the shareholders to come up with their own valuations over the years without seeking the guidance of a professional appraiser.
• It was a mistake for the shareholders to agree to rescind the prior valuations in favor of obtaining a professional appraisal, and then not  following through by having the professional perform the appraisal until long after the death of a shareholder, when the financial interests of the surviving shareholders and the deceased shareholder’s estate became antagonistic.

Business appraiser and author Z. Christopher Mercer, a leading authority on buy-sell agreements, has described fixed pricing in a buy-sell agreement as a “ticking time bomb”. The DeMatteo case is a powerful demonstration of the accuracy of Chris’s warning.

Now that you know the punchline, take a couple of minutes to read the entire Mahler post regarding DeMatteo.