In the first post in this series, we described the unfortunate scenario where a company’s buy-sell agreement did not address certain key questions that will allow for the clear and efficient execution of the agreement at the applicable time. In this post, we talk about value estimates. The first of these five key questions are:
What type of value estimate is required by the agreement?
While this may seem like a straight-forward, common-sense-type question, the differences in the definitions (or “standards”) of value can produce material differences in the resulting values. Some of the more common standards of value that exist in different areas are:
• Fair market value • Book value
• Fair value • Historical value
• Investment value • Agreed-upon value
Differences in Standards of Value
What may seem like subtle differences in the definitions of the various standards can, in the end, produce significant differences in the concluded value estimate. For example, Fair Market Value is typically defined to be from the perspective of a hypothetical pool of buyers who are motivated by financial (or economic) interests only. Investment Value, in contrast, narrows the pool of buyers to those with a strategic or synergistic interest. The implication is that a strategic buyer may pay a premium to what a financial buyer would pay, all else being equal. Based on acquisition premiums observed in the marketplace, the resulting values could differ by 30% or more.
Agreed-Upon Value – Simple, but Relevant?
Many of the decision points regarding provisions in a buy-sell agreement involve a trade-off between simplicity and relevance. In other words, provisions may be simple to understand, but not dynamic enough to be relevant in all situations. More complex provisions can be used, but the parties’ understanding of the agreement may suffer. One such option is a fixed value, where the parties to the agreement assign a static value to be used for future transactions. The benefit of a fixed value is it takes the guesswork out of planning for a triggering event and the resulting buyout of an owner’s interest. But just as business is dynamic, business value is also dynamic. While simple, a fixed price probably misstates the value (higher or lower) at any given point in the future.
The best standard of value to use is the one that best fits the situation and is agreed upon by the parties involved. The most important steps, then, are to 1) decide which standard of value to use, 2) state the relevant standard in the agreement, and 3) consider inclusion of a definition of that standard so as to reduce any ambiguity in the future.
In our next post, we will address the timing of valuation and relevant considerations as the effective date of an appraisal.
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