I have read too many buy-sell agreements to count. The typical valuation process in them (for appraisals following trigger events) range from 150 words to perhaps 300-400 words. That simply is not enough “wordage” to describe or define any valuation process, much less an appraisal. I started focusing on the seven defining elements over the years as I experienced problems with each and every one of them in troubled or litigated valuation processes where I was either an appraiser or a consultant. Do your clients’ buy-sell agreements adequately define the seven elements? Or does your company’s agreement do the same? If they are not clear in an agreement, future trouble is almost certainly lurking. Take a look or read.
Hello, Chris Mercer here at chrismercer.net and mercercapital.com.
Today’s video post is titled “The Seven Defining Elements of Valuation for Buy-Sell Agreements.”
The typical buy-sell agreement valuation process in buy-sell agreements that I read may range from 150 to 300 words, give or take a little bit, but not nearly in sufficient depth to define value for purposes of buy-sell agreements.
In order to define value, we need seven elements that are crystal clear for appraisers who are retained in a later time upon trigger events to determine value.
Those seven defining elements are number one, the standard of value. In a previous post, we talked about the standard of fair market value. Fair market value should be the standard of value in most buy-sell agreements. That is, there is a definition to it. It should be in the buy-sell agreement.
The second is the premise of value. I’ve seen a number of fights in buy-sell agreement processes over whether or not a company should be treated as a going concern. Well, a going concern premise is typically assumed in valuation, but we may as well make it crystal clear in terms of the valuation process.
The third element is the level of value and we talked about that in the previous post about the definition of fair market value. But the fair market value of what? Does the buy-sell agreement say the fair market value of the interest which might be an illiquid minority interest? Or does it say the pro-rata share of the value of the business equity as a whole, and then is crystal clear that no premiums and discounts are added to that or taken from it. Well, the level of value is very important.
The fourth one might seem problematic, but the as of date is very important in terms of disability or divorce or in terms of corporate divorces with joint ventures. The as of date might not be quite as clear as it might be for example with the death of a shareholder.
Next, the qualifications of the appraisers to be retained for purposes of the buy-sell agreement valuation process need to be stated. What are those qualifications and credentials? How many years of experience? What valuation credentials are required? Is industry experience required? And, if industry experience is required, is it also important to have valuation credentials? That should be spelled out in the buy-sell agreement.
Next, what appraisal standards will be followed by the appraisers? Every appraiser doing a valuation for purposes of a buy-sell agreement ought to agree to follow the Uniform Standards of Professional Appraisal Practice as a promulgated, I love that word, promulgated by The Appraisal Foundation. That appraiser, whether he or she, should also have to follow and will have to follow the standards of their credentialing organization. But the appraisal standards are also very important.
The last element, the seventh, is something that not many people think about, but it’s the treatment of life insurance. Because with the life insurance associated with buy-sell agreements, the life insurance for valuation purposes can be treated as a corporate asset or as a funding vehicle. Those may yield widely disparate results depending upon the assumption that’s required. So the shareholders need to agree on how that treatment will be handled because it’s not a decision that the appraiser should make.
There are seven defining elements in any valuation for purposes of a buy-sell agreement: the standard value, the premise of value going concern, the level of value, the as of date, the qualifications of the appraisers, the appraisal standards to be followed, and the life insurance treatment.
If you’d like to talk about the defining elements of your buy-sell agreement. Give me a call.
Wherever you are, I hope you’re having a great day. Be well.