Shareholder buyouts frequently occur in closely held businesses and often are costly for parties that feel that the payout is unfair – whether too high or too low.
Triggering events for buyouts happen all the time, yet as a business owner, they are often not events you spend time thinking about every day. They include:
- Retirement of a shareholder
- Shareholder seeking to exit the partnership
- Death of a shareholder
- Inability to continue working together
- Shareholder involved in a divorce
They can also be costly if the ownership interests transferred are not appropriately valued, primarily due to the time and expense of litigating shareholder disputes or resolving transactions with the Internal Revenue Service. Even when a buy-sell agreement exists, it may be prudent for the shareholders to engage the services of a trained and accredited valuation professional.
Valuation professionals help mitigate the risks associated with a shareholder buyout by preparing a supportable, well-documented valuation report based on a well-defined assignment, comprehensive data gathering, and a thorough analysis of the factors affecting the value of the business. The failure to engage a professional to work through valuation leaves the parties involved open to acrimony, drawn-out negotiations, and the potential for costly litigation.
Defining the assignment
Confusion and misunderstandings arise in shareholder buyouts when the valuation assignment is not carefully defined between the appraiser and the shareholders for which the valuation is prepared.
The most critical aspects of defining the assignment are choosing the appropriate standard of value and properly addressing the impact on the value of control and minority interests.
A common standard of value is fair market value, under which a minority interest is valued with the appropriate lack of control and lack of marketability discounts. However, shareholders in a buyout situation may prefer that 100 percent of a company be valued regardless of the ownership interest that will be transferred since they may be negotiating based on the pro-rata value of the entire corporation.
Another standard of value used in shareholder buyouts is fair value, which is commonly used in dissenting shareholder valuations and minority oppression cases. Because fair value is a statutory standard defined by state case law, the business appraiser should further clarify in the engagement letter what discounts will or will not be considered in a valuation under the fair value standard.
Gathering the data
Once we have defined the assignment’s parameters, the appraiser must gather data to include both company-specific information and industry information. Part of this process typically includes a management interview to gather data and clarify any of the information provided.
Of concern is access to reliable company data. Based on the context in which the valuation is being performed, management may have a vested interest in the valuation outcome, and their answers may be skewed.
A skilled appraiser will determine whether management’s statements make sense based on the context of the company within its industry and the market factors that drive the industry.
Analyzing the data
The next step in the appraisal process is for the appraiser to analyze the data gathered and develop valuation models. An appraiser must ordinarily consider each valuation model or method likely to apply to the subject company.
Approaches will often include the asset approach, which involves determining a value indication using the value of the business’s assets less the liabilities. Since the net asset value does not include the company’s intangible value, the asset value will often “set the floor” for any valuation.
The income approach involves ascertaining the value of the future economic benefit stream of the company in today’s dollars. The anticipated benefits are usually based either on historical income statements, adjusted to reflect the ongoing earnings of the business or forecasted income statements.
Of critical importance is making normalizing adjustments. As small businesses’ financial statements are often managed for a tax purpose, normalizing adjustments are often required to indicate the actual economic benefit of ownership. (That being said, minority owners may not always be entitled to such adjustments based on their lack of control. This is a critical point to understand when Defining the Engagement.)
Using the Market Approach, the appraiser will use actual market transactions involving either sale of entire businesses or minority interests. This can provide objective, empirical data for developing value measures that apply to the valuation. This empirical data is critical in valuations for shareholder buyouts because it supports values derived under the income approach.
Ok, so you get the idea of how the process works for a shareholder buyout. But when do you get the valuation? In our experience, shareholders often take a “wait and see” approach, letting the other party take the lead in pricing discussions. Negotiating theory tells us that this is a wrong move. But even more importantly, waiting tends to exacerbate the gap between parties – both financially and personally. More often than not, this leads to more strife, leading to more lawyers, accountants, and valuation folks driving up expense! With many years working on these matters time and again, we strongly feel that it’s best to be proactive when it comes to getting the valuation completed.
Even if a shareholder disagrees with the opinion of value, the shareholder is less likely to challenge a comprehensive, well-documented valuation report by an accredited professional.
When the shareholders involved in a transaction understand and agree with the valuation process, they are more likely to negotiate successful transactions and avoid potentially costly and lengthy litigation.
- What is the standard of value?
- Fair Market Value, Fair Value, or something else?
- What Discounts will be taken? What portion of the business will be valued?
- Involve your analyst early
- Ensure data discovery is robust
- Avoid the “wait and see” approach!