Buy-Sell Agreements: How to determine the price of ownership shares?
by Adam Lappin
The objective when determining a buyout price is to establish a realistic fair market value of the percentage (or shares) of the business to be sold based on a variety factors both tangible and intangible. Too often a poor valuation method is in place and someone draws the short straw. Determining a good valuation method suitable for the company is an important component of a good buy-sell agreement, so I will discuss a few of the more common and basic approaches to determining the value of a company and its shares.
Fixed/Agreed Price Valuation
This approach is becoming increasing less common as people see the pitfalls. It is where owners set a fixed price for the value of the company. However a company’s growth can happen quickly, so it is imperative to add a few provisions to make this a practical method of determining value. First, you need to add a provision requiring the owners to set a new value of the company at least once per year. This is often added and rarely followed, so it is important to add a “back-up valuation” provision allowing a new valuation to be put into effect in the event the owners do not set up a new value each year. If ownership is to determine a new value once per year, the back-up valuation would be for about 18 months and would read something like this,
“If the parties have not agreed to a value within 18 months prior to a triggering event, a formula method will automatically be used to establish a value for purposes of the agreement.”
This valuation method is fairly self-explanatory. When a triggering event occurs, and independent 3rd party appraiser would determine the value of the company. While this method is fair in terms of getting an unbiased opinion and current value of the company, it is not used too much because it can be expensive and time-consuming, which could harm an operating business. Appraisal Valuation is often utilized when dealing with a company that owns a lot of real estate.
Market Comparison Approach
This approach leads private companies to be valued in comparison with public companies. If a similar public company is valued at 20-times current earnings, then that multiple can be applied to determine the value of the private company. However, this would be more of a starting point. Private companies are generally adjusted downward due to lack of liquidity. To find a comparable company you might look at a public company with similar products, markets, industry criteria, revenues, cash flow, price to book, or price to earnings.
This method is often the most preferred because you get assurances up front of how much a buyout would be so the company and partners can plan accordingly for funding a purchase. A variety of different formulas are used to determine the valuation.
a) Book Value – An easy way to determine the value of the company is by looking at a company’s financial statements and taking the difference between the corporation’s assets and liabilities (also called net worth). Many problems arise with this because it does not take into account any assets or liabilities not in the books or the fair market value of those assets compared to what is in the books. I would not recommend this method.
b) Adjusted Book Value – This helps eliminate the problems with the Book Value method. Under this method, increases and decreases are made to the book value of specific assets and other items considered in the valuation of the corporation. Some common adjustments that are made include machinery, equipment, inventory, patents, work in progress, contingent liabilities, insurance proceeds, loss of shareholder’s services to the corporation, and accounts receivable.
c) Earnings Method – Earnings (also known as profits, net profits, net earnings) is not a universally defined term, so defining it is important in a buy-sell agreement. For this formula, the earnings would be capitalized to arrive at a proper value. Some things can be overlooked when determining what earnings consist of, such as employee benefits. It is also important to note assets and liabilities that are no longer in the books that could increase growth for coming years. This method is best employed when a company does not have many assets.
These are just some of the different valuation methods. There are many more methods and formulas that are used and tailored to fit a specific business. It is important to find the right method for your company based on your industry, size of the company, liabilities and assets, and a multitude of other things.
March 19th is Client Day, so I would like to give a shout-out to all present and past clients for choosing Clements & Shackle to help you with your legal needs.