A buy-sell agreement provides the option for a Company (to be named shortly) to purchase the interests of certain key managers if and when they are no longer employed by the Company. Fair market value is to be determined by a valuation process involving up to three “qualified appraisers.” The valuation process is initiated by the Company by retaining a qualified appraiser whose conclusion of fair market value is offered to the departing owners.
The question is, can the Company decide to opt out of the valuation process once it has begun?
The answer is no, as seen in Walsh v. White House Post Productions, LLC, Carbon Visual Effects, LLC. By initiating the valuation process, the Company exercised its call option to purchase. Having done so, it was a breach of contract not to follow through.
The Required Appraisal Process
White House Post Productions is the majority member of Carbon VFX, a creative visual effects studio. Carbon’s LLC Agreement provides an appraisal process to determine the fair market value of Member Units if the Agreement is triggered. “In the event a Member ceases to be employed by the Company for any reason, the Company shall have the right to purchase such Member’s Units, and such Member shall be obligated to sell such units to the Company…” The process is stated as follows:
The purchase price of that Member’s Units will be determined by a qualified appraiser. The appraiser will be instructed to determine the fair market value of the Member Units… If the departing member does not agree with the results of the first appraisal then he or she may, at their own cost, retain a second appraiser to determine the fair market value of the Member’s Units. This second appraiser must be instructed to value the Company under the same conditions as [the first appraiser]. If the results of this second appraisal are within 10% of the results of the first appraisal, the fair market value of the Member’s Units shall be calculated as the average of the two appraisal results. If the results of the second appraisal are more than 10% higher than the results of Company’s appraisal, the two appraisers shall jointly choose a third appraiser. This third appraiser must be instructed to value the Company under the same conditions as [the first appraiser]. The cost of this third appraisal shall be equally split by the Company and by the Member. The results of this third appraisal shall be binding on both parties. (“the Buyout Provision”)
The omitted text outlines certain “conditions” for the first appraisal. The valuation is to include a minority interest discount of 15% and an illiquidity discount of 35%. The agreed upon total discount to the initial appraisal is therefore 45% (i.e., (1 x (1 – 15%) x (1 – 35%)). In addition, the instructions provide that the appraiser should incorporate effects of loss of business likely based on the departure of the Member and to exclude any increase in business brought on by the replacement for the departing member.
Timeline of Events
Key dates in the timeline of events are as follows:
- November 2018. Company informed the two Plaintiffs it would not be renewing their service agreements.
- November 9, 2018. In anticipation of their departure, the Company made an offer for Plaintiffs’ units
- December 13, 2018. Company obtained the first appraisal and presented to the Plaintiffs.
- April 2019. The Plaintiffs’ employment at the Company ceased.
- February 7, 2019. Plaintiffs informed Defendants that they would obtain the second appraisal called for in the Buyout Provision.
- February 11, 2019. Plaintiffs informed the Company that they had retained an appraiser. They requested information from the Company to facilitate the second appraisal.
- March 18, 2019. Company responded to the document request in part.
- March 29, 2019. Company emailed Plaintiffs indicating that had “reevaluated” and that they had decided not to exercise the Company’s right to repurchase their Member Units.
- April 19, 2019. Plaintiffs informed the Company that their second appraisal’s conclusion was more than 10% higher than that in the Company’s December notice. Plaintiffs requested that the Company engage the third appraiser contemplated by the Buyout Provision.
- No date. The Company did not respond.
- June 5, 2019. Plaintiffs commenced the litigation regarding breach of the LLC Agreement (and some other counts).
Brief Summary of Legal Analysis
The legal analysis was a bit lengthy, but it boiled down to the question of whether Carbon’s obtaining the first appraisal was a revocable offer or a binding acceptance? I thank the analysis of Peter Sluka of Farrel Fritz, writing on Peter Mahler’s New York Business Divorce Blog for help in cutting through the legal analysis. In other words:
- Was the selection of the first appraiser and obtaining his result a revocable offer on the part of the Company? Was it okay to withdraw the “offer” prior to the time that Plaintiffs had accepted it? This was the Company’s basic argument.
- Or was the selection of the first appraiser a binding acceptance of the implicit call option that the Plaintiffs had negotiated at the time of the Buyout Provision? This was the Plaintiffs’ argument.
Vice Chancellor McCormick of the Delaware Chancery Court sided with the Plaintiffs. He reasoned, according to Peter Sluka, that “the buy-sell provision was a call option, an offer by Walsh and Devlin [Plaintiffs] to sell their interests in Carbon pursuant to the price-fixing process, which offer Walsh and Devlin were required to hold open in the event their employment with Carbon was terminated.”
V.C. McCormick wrote as follows:
The Buyout Provision is a call option. It contains both elements of an option contract: an offer to enter into an underlying agreement for the sale of property and a promise to keep that offer open. The underlying agreement is the Company’s “right to purchase” a member’s units “[i]n the event [that] [m]ember ceases to be employed by the Company.” The collateral agreement is Plaintiffs’ promise to keep that offer open: “such [m]ember shall be obligated to sell” his units to the Company. In sum, when executing the LLC Agreement, the parties agreed that all of pre-negotiated buyout terms would bind the parties in the event the Company exercised its option. This is, in all practical effect, the way a call option operates.
Carbon’s acceptance of the Plaintiffs’ offer bound both parties to proceed with the process outlined in the Buyout Provision.
I have not previously seen a situation where a company began a buyout process under a buy-sell agreement and then tried to revoke the process. There is nothing in the decision to suggest why the Company changed its mind regarding its intent to purchase Plaintiffs’ units. We do not know the magnitude of the repurchase (percentage of Company or dollar magnitude) from information in the decision.
In this matter, the Buyout Provision (valuation process) provided Carbon with an option to purchase the shares of members who are no longer employed by the Company. By taking the first step to exercise that option, the Company accepted the offer of Plaintiffs’ to sell, granted with the signing of the LLC Agreement, and that acceptance was binding.
The purpose of valuation processes in buy-sell agreements, including those in LLC operating agreements, is usually to define a process that will achieve the agreed upon definition of value (usually fair market value) and provide for a completed transaction. The court’s decision was made in the context of Carbon’s motion to dismiss for failure to state a claim. As Peter Sluka observed, the court stopped short of holding the parties to the buy-sell agreement. Presumably, they will get a third appraisal and be done or else agree on a transaction price.
We conclude with Peter Sluka’s concluding sentence:
In all events, counsel would be wise to refresh themselves with the fundamentals of contract formation and options in considering precisely when parties become bound to follow through with a buy-sell agreement; it may be sooner than they think.”