$11 Million or $178 Thousand? New Jersey Appellate Court Upholds Book Value in Buy-Sell Agreement
Booth Computers, a New Jersey family partnership (“Booth”), was created in 1976. In 1978, a related partnership, HCMJ Realty Ltd. was formed, of which Booth was a limited partner. Interests in Booth were given to James, Michael and Claudia Cohen by their father, Robert. The partnership acquired substantial assets over a period of more than 30 years, when Claudia Cohen died.
A 2011 case from the New Jersey Superior Court Appellate Division [Estate of Claudia L. Cohen, by its Executor Ronald O. Perelman v. Booth Computers and James S. Cohen, Docket No. A-0319-09T2], tells the story of how the Cohen children obtained their interests, and how Booth and at least one related partnership of which Booth was a limited partner, acquired substantial assets.
Claudia Dies and Paragraph 16 is Invoked
The story is somewhat long and complicated, but we’ll shorten it to focus on the relevant issue for this article, which is the Booth Computers partnership agreement and the buy-sell agreement therein.
- Claudia Cohen died on June 15, 2007.
- In July 2007, an attorney sent a letter on James’ behalf to Claudia’s estate implementing the buyout of Claudia’s partnership interest for an amount of $177,808.50.
- Claudia’s estate objected to the buyout, suggesting that the true value of the partnership, $11,526,162, vastly exceeded its book value.
- The trial court concluded that the buyout price of net book value (with a small adjustment), as called for in the partnership agreement, was the price that the parties had agreed to and was appropriate in the matter.
- Claudia’s estate appealed.
The death of a partner was a trigger event for purposes of the partnership’s buy-sell agreement. The agreement stated the pricing mechanism at its Paragraph 16:
16. The purchase price of any part or all of a Partner’s interest in the Partnership shall be its value determined as follows:
(A) Each of the Partners has considered the various factors entering into the valuation of the Partnership and has considered the value of its tangible and intangible assets and the value of the goodwill which may be present. With the foregoing in mind, each of the Partners has determined that the full and true value of the Partnership is equal to its net worth plus the sum of FIFTY THOUSAND ($50,000) DOLLARS. The term “net worth” has been determined to be net book value as shown on the most recent Partnership financial statement at the end of the month ending with or immediately preceding the date of valuation;
(B) The value of any interest in the Partnership which is sold and transferred under the terms of this Agreement shall be determined by multiplying the full and true value of the Partnership as above determined by that percentage of the capital of the Partnership which is being sold and purchased hereunder.
The partnership agreement is clear that book value plus $50,000 is the price at which partnership interests would trade hands under the agreement. We learn in the case that Michael Cohen, brother to James and Claudia, died in June 1997. James and Claudia invoked the partnership agreement and “Michael’s estate was paid $34,503.08 for his one-third interest in Booth based on the formula in paragraph sixteen of the partnership agreement.”
The Appellate Court Rules
The New Jersey Appellate Division noted the following:
We recognize the disparity between net book value and fair market value, yet the controlling factor as to which buyout method is applicable is the language of the partnership agreement. [going on to quote a treatise]…
…The trial judge’s determination that Claudia’s shares should be bought out at book value, rather than at fair market value, was supported by both substantial credible evidence and the applicable law. The judge did not err in holding that defendants established their entitlement to specific performance of the buyout provision as a matter of law.
Claudia’s estate argued, among other things that the trial judge erred because he should have determined that the buyout price was unconscionable given the “gross disparity” between net asset value and fair market value. Basically, the estate argued that the result of the judgment was that James obtained sole ownership, through Booth, of an asset worth vastly more than the price received by the estate.
The Appellate Court concluded:
Disparity in price between book value and fair market value, where a buyout provision is clear, is not sufficient to “shock the judicial conscience” and to warrant application of the doctrine of unconscionability. This view is consistent with the basic principle that where the terms of the contract are clear, it is not the court’s function to make a better contract for either of the parties.
Fair Warning to All
Estate of Claudia L. Cohen should be a wake-up call to every business owner who has a buy-sell agreement with a formula or fixed price pricing mechanism. While stated as a “formula,” the Booth partnership agreement essentially called for a fixed price of book value. The formula in this case was book value, an historical cost concept. Book value does not get adjusted as the market values of properties in a partnership rise. The formula in this case created a value that was only a small fraction of the fair market value of Booth’s underlying assets.
If any partner wanted to obtain fair market value in a transaction, Booth’s Paragraph 16 was, indeed, a ticking time bomb.
We have said for years that formulas and fixed prices are not good pricing mechanisms for most buy-sell agreements. Two short quotes from Buy-Sell Agreements for Closely Held and Family Business Owners state the conclusion succinctly:
Re Formulas (at p. 85)…My experience suggests that no formula selected at a given point in time can consistently provide reasonable and realistic valuations over time. This is true because of the myriad of changes that occur within individual companies, local or regional economies, the national economy, and within industries. Formulas simply cannot take into account these many factors in a meaningful and consistent manner.
Re Fixed Prices (at p. 80)…In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease. However, if you have a fixed-price agreement, you must have the discipline to update the price periodically. And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.
The Court’s Final Words
Does the result in this case seem unfair? Does it seem unreasonable? Does it offend your sense of how family members should treat each other? Does this case raise questions in your mind? If so, now is the time to take a look at your buy-sell agreement. If you are an adviser to business owners, now is the time to take a look at their agreements.
Our suggestion is that, for most successful companies and partnerships, the best buy-sell agreement pricing mechanism calls for the parties to:
- Select a single business appraiser, agreeing on his/her qualifications and the standards under which appraisals will be rendered.
- Have that business appraiser provide a valuation for purposes of the agreement. If there are problems or issues with the kind of value that the parties desire, they can be fleshed out while the valuation is in the draft stage. Make sure there is agreement between the standard and type of value called for in the agreement and that obtained in the draft appraisal.
- When the details above are clear, finalize the appraisal, which becomes the price for the agreement for the next period (year most likely).
- Each year (or two), have the selected appraiser reappraise the company to reestablish the purchase price for the agreement.
Claudia’s estate, as well as Michael’s estate, would have preferred this type of pricing mechanism rather than being stuck with Booth’s Paragraph 16.
The court concluded:
We reiterate what is critical about this agreement and its terms. This was a family partnership created by and funded (except for modest contributions by the children) by Robert [the father] for the benefit of his children according to his terms. He intended the beneficiaries to be family members and understood that the buyouts would require the children to provide funds to the other children. The possibility or even the probability that a surviving child would be the ultimate beneficiary of the assets of the partnership was apparent on the face of the agreement. Judge Contillo did not abuse his discretion by finding that the buyout provision was not unconscionable.
To assure that the pricing mechanism in your or your client’s buy-sell agreement will work as intended, contact appropriate legal counsel and a business appraiser who is experienced valuing buy-sell agreements.
To discuss your or your client’s buy-sell agreement in confidence, contact us.
Buy-Sell Agreements for Closely Held and Family Business Owners
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Recommended Valuation Process for Buy-Sell Agreements: Single Appraiser – Select Now, Value Now