Recently, I was involved, for a moment, in a buy-sell agreement valuation process that was doomed to fail unless the parties agreed to a change in the process. A key executive in a company was terminated. He owned about 15% of a profitable operating company, and his firing triggered the company’s buy-sell agreement provisions in its operating agreement.
The company hired one “qualified independent appraiser,” and the selling shareholder hired another. Both appraisers were experienced and qualified. They each provided valuation reports within the 45 days required by the operating agreement, which stated that if the two conclusions were within 10% of each other, they would be averaged. They were not. So the two appraisers had to select a third qualified independent appraiser.
I turned up on the short list for the third appraiser slot, having been recommended by the appraiser for the selling owner. Prior to being “interviewed” by the two appraisers, I asked to see a copy of the company’s operating agreement, which had been signed more than a decade ago. I noted a couple of things:
- In one section, the agreement stated that the parties should initially agree (unanimously) on the fair market value of the company, which value would be an Agreed Value, a term used in many fixed price agreements. Fair market value was an undefined term in the agreement. After the initial agreement, the parties were to update their Agreed Value each year. It was my understanding that they never reached an agreement over a number of years.
- As of the triggering event, there was no Agreed Value. The first step called for the parties to agree on a qualified independent appraiser, which they did not do. Then, the parties hired their respective appraisers. The agreement stated that the appraisers would have 45 days to do their appraisals and to agree upon the Agreed Value. Going back to the first bullet, the Agreed Value should be the fair market value of the company. Arguably, that value would be a financial control value of the company. However, fair market value was not a defined term in the agreement, and there was no specification of the level of value.
- A following section then states that the appraisers should follow some principles in reaching Agreed Value, including:
Appraisers are free to apply appropriate valuation methodologies that reflect the value of the company as a whole, but employing appropriate discounts for lack of marketability and control. This guidance is confusing at best. How, if an appraiser is to value the company as a whole, or to determine the fair market value of the company, would a discount for lack of control be applicable? By way of full disclosure, I told the two appraisers that I had a long-standing position that there is no such thing as a marketability discount for a controlling interest.
Another principle was that the appraiser’s conclusion should reflect the fact that interests are not publicly traded. Typically, that could mean the non-marketable minority level of value.
- The conceptual difference between the financial control and non-marketable minority levels is shown in the chart below. They are two different types of value.
- The bottom line was that language in the operating agreement pointed both to a financial control level of value and to a non-marketable minority level of value. We did not discuss value at all in my interview, but it was fairly clear that the appraiser for the selling shareholder interpreted the agreement as calling for a financial control value, and that the appraiser for the company interpreted it as calling for a non-marketable minority level of value. These are two different conceptual levels and differing interpretations. Even if both appraisers reached identical conclusions at the financial control level, it virtually precludes reaching the 10% threshold for averaging to get Agreed Value.
Given my position on marketability discounts pertaining to controlling interests (they don’t), it is not surprising that I was not selected as the third appraiser. Another appraiser was selected. According to the agreement, the third appraiser has 30 days, which is far too short a timeline, in which to provide his report. I informed the appraisers in my interview that if selected, I would ask the company and the selling shareholder to agree on a more reasonable timeline.
The selected third appraiser must, within 30 days, reach a conclusion within 10% of one of the two appraisers for the process to be completed. That means that he or she will need to agree with one of the appraisers regarding the level of value and then, will have to have a virtually identical financial control level conclusion with the selling shareholder’s appraiser. On the other hand, if the third appraiser agrees with the company’s appraiser that a non-marketable minority level of value is called for, the net of his undiscounted value and any discount(s) must fall with 10% of the latter’s conclusion.
The odds of that happening, unless the third appraiser feels significant pressure to agree with one or the other of the first two appraisers, are low. He or she will feel pressure because of this next feature. If the third appraiser’s conclusion doesn’t converge with one of the first two appraisers’ conclusions, the valuation process outlined above will continue, presumably with a second set of appraisers, until the Agreed Value has been determined per the agreement. And if there is no agreement then…
This is a buy-sell agreement that is virtually destined to fail. Issues with this agreement include:
- While the agreement said that qualified independent appraisers will be used, there is no definition of what that means, and selected appraisers might not be as qualified as the two selected in this process.
- The agreement uses the term fair market value in the description of Agreed Value; however, fair market value is not defined, and it is not used at all in the sections describing the valuation process.
- There is conflicting information regarding whether the value per the agreement should be a financial control value or a non-marketable minority value. This type of conflict virtually assures a substantial difference in value conclusions.
- There is no pre-determined Agreed Value from an earlier date, either by agreement of the parties or from an appraiser, to relate to the language in the agreement.
- The appraisal timelines in the agreement, i.e., 45 days for the first two appraisers and 30 days for the third appraiser, are unrealistic and create unnecessary pressures on all parties and increase the probability for errors or for unclear thinking.
This time during the pandemic is a good time to check in with clients and to review their buy-sell agreements.
Be safe and be well,