The default valuation mechanism for many buy-sell agreements calls for the use of three appraisers to determine the price following trigger events. Such agreements have a variety of forms, but the goal of the three appraiser process is to reach a conclusion of the price for each transaction.
When Is the Third Appraiser Selected?
The third appraiser is typically selected at the end of what can be a protracted valuation process following a trigger event, e.g., at the retirement or death of an owner. The following diagram provides an example of the steps involved in a typical three appraiser valuation process to illustrate where in the process the third appraiser comes into the picture.
The trigger event occurs at the “NOW” arrow at the top of the diagram. At that point, the company and the selling shareholder (or estate) are often given 30 days or so to agree on the price for the transaction. They virtually never do, because at that point, their economic and perhaps personal interests have diverged. What this period provides is plenty of time for the parties to get really irritated with each other.
When the time for mutual agreement is passed, the parties must each select an appraiser. Hopefully, the buy-sell agreement provides appropriate qualifications for the selection process, but often they do not. Once the first two appraisers are selected, they will undergo their respective valuation processes, that can range from 60-90 days and more. Often, if the situation is contentious or litigation has emerged, the initial valuation processes can be quite lengthy.
When the two appraisers have reached their respective conclusions, they are compared. Most agreements call for averaging the two conclusions if they are within 10% of each other. They almost never are.
It is at this point that the first two appraisers are called upon to select a third appraiser. Their clients are likely mad at each other. The appraisers may be mad at each other. And the appraisers (and their clients, of course) must agree on a third appraiser. That can take considerable time. But a third appraiser is finally selected.
There is a variation of the three appraiser process that can shorten the timeline somewhat. In this variation, the first two appraisers do not provide appraisals. Their purpose is to agree on a third appraiser who will provide the sole appraisal for the process. The first two appraisers also typically advise their clients and may provide input to the selected third appraiser. In processes like this, the third appraiser’s conclusion is usually binding on all parties.
I’ll make this point now. Under any variation, no one knows what the price will be following a trigger event for a long period of time that is filled with considerable uncertainty. Quite often there is litigation or the threat of litigation. Most often, there is considerable angst. Almost always, the two sides are mildly or wildly mad at each other. Management’s attention is distracted from the operation of the business. And the selling shareholder (or the estate) is unable to move on with life pending the outcome of the appraisal process.
What Does the Third Appraiser Do?
In most cases, the third appraiser will provide an appraisal that will resolve the price question. This is true when the third appraiser provides the only appraisal, as in the first case above. When there are already two appraisals, the third appraiser will bring resolution in one of a few ways.
- Judge. In some instances, the third appraiser is not called on to provide an appraisal, but to pick the conclusion of one of the first two appraisers. As you might imagine, this can be a pretty dicey situation for all concerned, including the third appraiser.
- Reconciler. The most common use of the third appraiser is to provide an appraisal conclusion which is averaged with one or both of the first two appraisal conclusions, thereby setting the price. Sometimes, the third appraiser’s conclusion is averaged with the nearest of the first two conclusions. In these situations, there is often a provision saying that if the third appraisers conclusion is outside the bounds of the first two conclusions, the nearest conclusion of the first two appraisals will be determinative of price. To add spice to the process, some agreements call for averaging with the lower of the first two if the third conclusion is below the midpoint, that the third conclusion is determinative if at the midpoint, and then averaging with the higher of the first two if the third conclusion is above the midpoint. The potential value swing, up or down, is then enormous if just above or just below the midpoint. I wrote about one highly public situation involving Citigroup and Morgan Stanley here and here.
- Determiner. On occasion, the third appraisal provides the binding conclusion, and the first two conclusions are simply ignored. This form of price determination can also be a little dicey for the third appraiser and for the parties to the buy-sell agreement.
- Sole Determiner. In cases where the first two appraisers do not provide appraisals, the third appraiser is the sole determiner of price for the buy-sell agreement.
The purpose of a three appraiser valuation process in a buy-sell agreement is to determine the price upon the occurrence of a trigger event. Most often, the price is not determined by the actions of the first two appraisers. In fact, I’ve only seen one instance over the last thirty-plus years where the first two appraisals were within 10% of each other and were averaged to determine the price.
This means that in three appraiser processes, the third appraiser will almost certainly be called upon to bring resolution to the valuation process and determine the price for any trigger event.
How is the Third Appraiser Typically Selected?
For reasons including that I have been writing and speaking about buy-sell agreements from business and valuation perspectives for a long time and that I am reasonably well-known among appraisers nationally, I have been selected as the third appraiser in three appraiser valuation processes on numerous occasions. In the next post on the third appraiser, I’ll address several ways that I have been selected as third appraiser (and not!), and will discuss some of the lessons I’ve learned.