In this third part of our series on buy-sell agreements, we discuss another key question that will allow for the clear and efficient execution of the agreement (see the second post in the series by clicking here):
When should the value be measured (or what should be the applicable effective date for the valuation)?
Because business value is dynamic, the “as of” date of valuation can be an important consideration. A drastic illustration of this point would be the difference in business value that could be observed in the days leading up to (and the days following) a catastrophic event such as 9/11. The difference of one day can, on the surface, make a massive difference in the value conclusion.
Date of the Triggering Event
The logical answer to this question is to value the company or the applicable ownership interest as of the date of the triggering event (e.g., date of death, date of termination, etc.) While this makes logical sense, the practicalities of using a specific date can make this answer challenging. For example, if the date of a triggering event falls in the middle of an accounting period, the collection of source data for the valuation could be cumbersome.
What about the prior month-end preceding the date of the triggering event? Or prior year-end? This answer might be easier in terms of the availability of source data but could introduce other complications. For example, the interim year financial statements for a business with natural seasonality may present a distorted view of performance as compared to the expectations for the full year period.
Subsequent Events: To Adjust or Not to Adjust?
The common practice in valuation is to use information that was “known or knowable” as of the effective date. When a valuation is being conducted retrospectively, the parties involved may have the benefit of knowing about a material subsequent event that, if not taken into consideration, might produce an unfair result. Examples of subsequent events include:
- Loss (or gain) of a key customer
- Unusual event (fire, flood, etc.)
- Regulatory changes
It is important for the parties to agree on the “spirit” of the agreement. Is it the intention of the parties to create a document with language to be interpreted strictly? If so, the parties must understand the advantages and disadvantages of such an approach. If the intention is to produce a “fair” result, the language may need to somehow allow for the consideration of material facts that may not have been known as of the effective date. Whatever the parties’ intentions are, the language in the agreement should communicate those intentions as clearly as possible for the benefit of those who will be charged with carrying out those intentions at a later date.
In our next post, we will address the potential differences in the value of a company as a whole versus the value of a specific ownership interest.
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