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!

Pent-up Demand for Deals

There are many reasons why the mergers & acquisitions markets should be heating up.  Let’s recount just a few of them in this post as we wait for what should be happening to begin to happen.

• According to PitchBook, there is a $425 billion “overhang” of private equity just waiting to be invested. Much of this equity was raised two or three years ago or more, and there is growing pressure for the private equity firms to invest the capital. For a chart illustrating this overhang, see here.
• However, there is another overhang in the private equity markets. PE firms have invested in more than 6,000 companies in the United States. Of these, some 4,000 are maturing investments in companies where the PE firms are under increasing pressure to sell in order to generate returns for their investors.
• Corporate coffers are over-flowing with cash, with more than $2.2 trillion in cash sitting on US companies’ balance sheets.
• Commercial and Industrial lending is on the upswing, primarily in banks with more than $1 billion in assets.  Smaller banks are seeing upward trends in lending, but primarily on the real estate side.  More bankers everywhere are beginning to think in terms of commercial lending.  If they got creative, perhaps they could facilitate some dividend recapitalizations and partial buyouts in successful closely held businesses that don’t want to sell in the entirety?

The Age of Aquarius?

The population of Baby Boomer business owners continues to age. I don’t have to cite a statistic for this. All I have to do is calculate the average age of business owners I meet and look at myself.  Many business owners are perhaps waiting for that elusive perfect time.

The absolute perfect time to sell a business is when the stock market is hot, when the economy is good, when industry conditions are favorable, when financing is readily available and cheap, when conditions at a company are on the upswing or perking along with good margins and growth,  when management is ready and has plans for what follows and ….  It reminds me of a song by the 5th Dimension, Age of Aquarius, which states, in part:

When the moon is in the Seventh House
And Jupiter aligns with Mars
Then peace will guide the planets
And love will steer the stars

This is the dawning of the Age of Aquarius
Age of Aquarius
Aquarius! Aquarius!

I’m not sure if the Age of Aquarius, or the perfect time to sell a business, will ever come. I wrote about this in February 2011.

A Perspective on the Baby Boomers

To touch on the Baby Boomers once again, many baby boomer business owners missed the surge in mergers & acquisitions activity that preceded the crash in 2008.  There was pent-up demand for selling businesses in 2008. Now that we are on the short side of 2012, that pent-up demand is causing unknown pressures for business owners, their families, and their employees, who are uncertain about the necessary transitions that await.  One M&A adviser tells the story this way:

What happened between 2008-2011?

The answer, from a business transition viewpoint, is very little. Businesses generally suffered a decline in revenue, profitability and cash flow, making them less valuable to buyers. It became very difficult to finance the purchase of a business as credit became tight and de-leveraging began to occur. Transactions were difficult to close. Sellers sought a return to the prices that were paid in 2005-7 which was not realistic given the reductions in value. Companies that performed well during the downturn achieved greater multiples of value as there was a shortage of supply of quality sellers.

Baby Boomer Transition Bubble just got kicked down the road?

In essence, the bubble is still there – it just got kicked down the road. Now, the backlog of sellers is bigger and the situation may become more urgent.  It is true that most business owners have adjusted their retirement expectations and it has been estimated that retirement ages have been pushed out about 3 years on average. Since very few businesses sold during the 2008-2011 timeframe, there is an enormous backlog of business owners who would sell given the right circumstances. Our best estimates are that between 1.2 million and 1.5 million business owners are in that backlog.

So What Should Business Owners be Doing?

Pent-up demand for business transactions is a fact of life.  We know from history that transactions tend to come in waves.  When will the long-awaited wave of transactions involving Baby Boomer business owners arrive?  I don’t know, but it almost has to come soon.  In terms of age, the leading edge of the Baby Boomers turns 67 this year.  The lagging edge turns 47.

Many of the Baby Boomer businesses are small firms with limited potential in the M&A markets.  However, much of successful, private corporate America is owned by and led by Boomers.  We won’t live forever.

I spoke with a business owner the other day.  He is 75 years old and still working.  His business needs to be transitioned to the next generation of owners (not his family).  And yet he waits.  The longer he waits, the less ability he will have to negotiate a favorable transition.  The situation is even more dire if he becomes disabled or dies and his family is left to handle the transition. This is, perhaps, an extreme situation, but it is not uncommon.

Owners should, as always, be running their businesses as if they were in the market to sell. I have said many times that a business that is ready for sale is, well, ready for sale.  It is also a whole lot more fun to work in than one that is not!

So business owners should be preparing themselves and their businesses for the next transactional wave.  Business advisers should be encouraging their clients to get ready, as well.

The tsunami is coming.  We may not see the Age of Aquarius, but we will see more deals in the foreseeable future.  Will you be ready?  Will your clients be ready?

If you need help with valuation or transaction issues, give me a call.

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.

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Customer concentrations are a risk for any business having them. Public companies must disclose any customer relationships which account for more than 10% of their revenues.  Public investors are interested in them and in being able to assess the degree of those risks.  Two recent announcements by sizable public entities highlight the importance of customer concentrations.

FedEx and the U.S. Postal Service

FedEx Corp. announced on July 17th that its contract with the U.S. Postal Service expires in September 2012. According to a Reuters article:

•  FedEx is the Postal Service’s largest contractor
• The Fedex contract, which has been in force since 2000 with extensions, is set to expire in September and will be up for rebid
• The contract accounts for $1.5 billion, or over 4%, of FedEx’s $43 billion in sales
• United Parcel Service (UPS) is the logical competitive bidder
• FedEx will definitely attempt to retain the contract, but likely on less favorable terms if it succeeds, which some think is likely
• The contract renewal will cast an overhang on FedEx shares until the issue is resolved

FedEx shares fell 1% during the day of announcement.  With a market capitalization of some $29 billion, this represented a decline of $290 million in market value.

SAIC and Lockheed Martin

SAIC, Inc. recently announced that it lost its largest government contract to Lockheed Martin Corp.  In a Bloomberg release and from SAIC we learn:

• Revenues for SAIC are about $11 billion
• The contract was estimated to provide “base revenue” of $1.9 billion over three years, so on an annual basis, it provided about 6% of revenues
• One investment bank lowered its 2014 EPS estimate for SAIC from $1.38 per share to $1.26 per share
• SAIC plans to protest the contract loss and there is some chance that it could be regained

SAIC shares fell as much as 5.2% during the day of announcement and closed down 3.1% for the day. With a market capitalization of some $4 billion, the closing price represented a decline of $120 million in market value.

Business Valuation Implications

The fact that a company has customer concentrations is important.  That’s why business appraisers always ask for an analysis of revenues (and profitability in many instances) by customer.  Customer concentrations definitely create risk and must be considered in business valuations.

Many years ago, Mercer Capital valued a distribution company on an annual basis.  The company was profitable and growing.  Management was always a bit dissatisfied with the relatively low multiple we placed on their earnings. Remember the basic valuation equation:

We considered the risk of the customer relationship in the discount rate, r, which was utilized in the appraisal.  Obviously, if r is increased, (1 / (r – g)) decreases, and value is decreased as a result.  With FedEx and SAIC and their recent announcements, the fact of the potential losses caused a laser focus by the markets, if only for a short while, and value was affected.

More background on this client company from years ago:

• The company’s largest customer accounted for about 60% of sales
• Growth at the business was fueled by rapid geographic expansion of the largest customer
• The relationships between company management and the management of the largest customer were excellent
• Obviously, we asked about this relationship every year at appraisal time
• According to management, there was “no chance” that they would lose this customer relationship

But something changed.  One Friday afternoon, the largest customer was acquired.  On Monday, the contract between our client company and the largest customer, which was only verbal after many years, was terminated.  Within two weeks, all business had been diverted to the favorite suppliers of the acquiring company.

Our client company did survive.  Fortunately, they had retained some earnings, responded quickly to the loss, and hunkered down.  It took a number of years for them to return to reasonable levels of profitability, but they did.  Their next annual appraisal reflected a sharp decline in value, but not nearly so much as would have been the case had we not made specific consideration of the concentration risk.

Lesson Learned

The lesson I learned there and elsewhere is this:

Every customer relationship has a beginning, a duration, and an end.

What the markets are saying in the examples of FedEx and SAIC is that the loss of a customer is a time to reevaluate not only that relationship, but other customer relationships as well.

Business appraisers must focus on the risk of customer concentration, as well as other forms of concentrations (suppliers, products, geography, etc.).

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.