Tim McPoland, CPA/ABV, CVA, CFE
An Enforceable Buy-Sell Agreement Should Provide for an Up-to-Date Appraisal
Author: Tim McPoland
Closely held businesses commonly rely on buy-sell agreements to facilitate liquidity and smooth ownership transitions. But the agreements also occasionally play a part in divorce proceedings. In one such case, Wood v. Wood, a Missouri appellate court rejected a buy-sell agreement’s valuation formula as the basis for valuing the business in the divorce settlement.
The husband was an employee and part owner of a closely held corporation. At their divorce trial, he and his wife both presented expert testimony on the value of his interest in the business.
The wife’s expert applied a valuation formula included in the buy-sell agreement that her husband and the two other shareholders entered into in 2007 when they purchased the business. The formula provided that the total shares’ value equaled the last appraised value of the company, plus or minus earnings or losses, and less dividends paid or declared by its board. Using this approach, the expert calculated the total value of the business to be approximately $3.5 million, with the value of the husband’s interest being about $1 million.
The husband’s expert conducted an actual appraisal of the business and presented an opinion on the fair market value (FMV) of his interest. The expert relied on traditional measures of valuing closely held businesses, including accounting for goodwill, minority ownership and the impact of the economic recession. He calculated the FMV of the husband’s interest to be $325,000.
Finding the testimony of the wife’s expert more persuasive and credible, the trial court relied on her valuation formula’s calculation. The husband appealed.
The appeals court noted that a closely held corporation’s share value is usually reached using the earning, liquidation (or underlying asset) or comparable sale approach. It also pointed out that, in a divorce proceeding, the objective of a business valuation is to determine FMV as of the date of trial.
However, the wife’s expert’s calculation didn’t seek FMV. Moreover, the expert didn’t use a current appraisal of the business as part of the calculation of present share value. Instead, the expert used the historical value of the company in 2007 as the starting point.
The appellate court acknowledged that a trial court generally can accept the opinion of one expert on value over another and can prefer one valuation method over others based on the particular facts of the case. But it explained that, when an expert’s testimony doesn’t attempt to determine FMV, a trial court simply can’t find it more persuasive and credible than another valuation. And it can’t rely on such testimony in valuing the shares.
The trial court, therefore, had misapplied the law. The appeals court reversed and remanded for a proper determination of the value of the business as of the date of the divorce.
Easier isn’t better
The main lesson in Wood is that it’s critical to ensure that a valuation is seeking the appropriate standard of value for the matter at hand. But the case provides a secondary lesson as well: Although the valuation formula in the husband’s buy-sell agreement didn’t harm him here, it could in other situations.
Say, for example, the husband was involved in a dispute over how much he was required to pay a co-owner who was exiting the company. Using a formula like that in the Wood case, he could end up paying the co-owner about three times as much as he would if FMV were determined under traditional methods.
It may seem easier and cheaper to include a valuation formulation in a buy-sell agreement than to provide for an independent appraisal. But it’s not advisable because formulas often are overly simplified. They may rely primarily on preset multiples of historical earnings or on current book value. Such formulas often exclude subjective, but important, factors such as the company’s risk premium and future growth rate, current economic conditions, and other key factors that involve professional judgment and analysis. A full valuation by an independent appraiser can account for all critical elements.
Drafting a solid agreement
Depending on the jurisdiction, an enforceable buy-sell agreement should provide for an up-to-date appraisal. A valuation expert can work with you and your client to draft a solid agreement, as well as provide a current appraisal when needed, whether for purposes of divorce, ownership changes or other reasons.
For any questions on buy-sell agreements or any other litigation support issue, contact us here or give us a call at 716.847.2651.