What Happens if a Formula Buy-Sell Agreement Yields a $ Zero Result?

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Fixed price buy-sell agreements are not good.  I’ve written about two fixed price agreements that went to litigation.  Namerow v. PediatriCare Associates, LLC and Estate of Cohen v. Booth Computers, Memorandum Decision, C.A. Docket No. BER-C-135-08 (N.J. Super. Ct. Aug. 4, 2009

Actually, both “fixed price” cases involved something of a formula that basically set the price at a fixed amount.  The cases did not go well for either of the plaintiffs who sought court assistance in “fixing” fixed price agreements that yielded “unfair” results.

I’ve said many times that no formula agreement can be written that will provide reasonable valuation calculations over time under all circumstances involving a company, its industry, the national economy, conditions in the financial markets, and more.

Thanks to Paul Hood for identifying a true formula case to make the point.  We have the case, Roth v. United States, 511 F. Supp. 653 (E.D. Mo. 1981) and the appeal, St. Louis County Bank, Executor of the Estate of Lee J.sloan, Deceased, Appellee, v. United States of America, Appellant, 674 F.2d 1207 (8th Cir. 1982).  The case is obviously dated, but the point of this post should be clear.

The Original Case

Prior to gifts made in 1956, Lee J. Sloan owned all but one of the 466 shares outstanding of Sloan Moving & Storage Company. At that time, he made gifts of 36 shares each to five children and related parties.

In 1964, all of the shareholders entered into a shareholders’ agreement that called for the company or the other owners to purchase the shares of any owner in the event of death.  The formula price for any buyout was a multiple of 10 times the average of the last five years’ net earnings per share.  At the time, the company had been profitable for many years and the formula yielded a positive amount.

The company continued its profitable business until 1972 when it sold all of its operating assets and changed its name to L.J.S. Investment Company.  It used the proceeds of the sale of assets to invest primarily in real estate assets.

Prior to the sale, the highest formula price had been $1,061.15 per share in 1966, and the low price was $597.00 per share in 1970.  With the company’s change of business, its real estate assets generated depreciation and other expenses, and the company recorded net losses.  The formula value fell to $0 per share in 1971.

At the time of the Lee J. Sloan’s death in 1976, the formula price was zero.  For federal estate tax purposes, the estate valued his shares at $850 per share (their book value at the time), paying estate taxes of $36,383.06.

At a later time and in reliance upon the formula, Sloan’s estate filed a suit in Federal District Court seeking a refund of the estate taxes paid with the filing of the estate return.  In the cited decision, the Government is seeking partial summary judgment.

Based on the facts that were presented, the District Court appeared to believe that the original formula was entered into for valid business reasons, and yielded reasonable results at that time.  It was binding on the parties in life or death.

In a short Memorandum decision, the District Court denied partial summary judgment, effectively validating the formula and its zero value.

The Case on Appeal

The Government appealed the case.  The appellate court seemed to agree with much of the facts of the case as noted in the District Court’s decision.  However, there were facts that, per the appellate decision, were subject to differing interpretations.  On this basis, the District Court’s decision was reversed and remanded for further proceedings, requiring the trier of fact to decide which interpretation of historical facts was more persuasive.

There is no record of any decisions in this matter, so perhaps it settled on some basis between the estate and the Government.

Conclusion

In this matter, a long-standing formula, i.e., 10 times the average net earnings of the last five years, was essentially affirmed by the District Court.  As noted, the formula yielded a zero value at the time of Mr. Sloan’s death at a time when book value, an alternative measure of value, was substantially positive.

What would happen today if a formula that yielded an apparently unreasonable result was tested in a court?

I don’t know, but if the agreement containing the formula was reasonably entered into and it at least made sense at that time, I’m guessing that courts would be reluctant to change it, just as the two courts in the fixed price cases noted at the outset were so reluctant.

What should attorneys and business owners do?  Once again, I mention what I call the Single Appraiser, Select Now and Value Now valuation process.  It’s better to substitute a workable process for one that almost certainly won’t work consistently in the future.

My new book contains a detailed discussion of this process as well as draft template language to facilitate its use in buy-sell agreements.

Email me at mercerc@mercercapital.com to be included in notifications regarding its publication (hopefully by the end of first quarter 2019!)

In the meantime, be well!

Chris

Please note: I reserve the right to delete comments that are offensive or off-topic.

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