Key Takeaways
The value of RIA firms has moved dramatically since many buy-sell agreements were drafted, and the gap between the number produced by the document and what the firm is actually worth is the size of the eventual dispute.
Whether the mechanism is a stated or agreed value, a formula, or an appraisal process, the failures share two commonalities: values that no longer reflect the current market, and silence on the questions that determine what the number actually is (and many agreements suffer from both at once).
Badly drafted agreements and well-drafted agreements nobody has touched in a decade end up in the same disputes for the same reasons: nobody recognized the problem until the trigger, and at that point interests diverge, and the problem is much harder to fix.
When did anyone last read your buy-sell agreement? Not skim it at closing. Actually read the part that says what happens to a partner’s interest when that partner dies or leaves, and the way of getting to the valuation, with the same level of scrutiny that it will be read when an actual transaction is on the line.
For most RIA partners, the honest answer is years ago. And values have moved a long way since then.
Large platforms have recapitalized at higher prices, minority investors have paid up, and all of that flows downstream. Firms that thought of themselves as comfortably midsized have watched peers trade at multiples that nobody would have believed when the partnership documents were signed.
A buy-sell agreement sits in a drawer, sometimes for decades, until some event triggers it, and it does exactly what it says. Whether what it says still makes sense doesn’t enter into it.
The trouble almost always shows up in the valuation provision, and it takes one of three forms.
Fixed Prices
Some agreements simply state a value, or state that the partners will agree on a value on a regular basis, often through a certificate of agreed value that the partners fully intend to update every year. Then they don’t.
We’ll admit to a selection bias here, since the agreements that work as intended don’t cross our desk. But in many cases, value simply doesn’t get updated, and the latest agreed value is years out of date, at a fraction of what the firm is worth now. Often there’s a fallback provision for exactly this situation, and the fallback decides everything. If a stale agreed value sends the parties to an appraisal, the agreement can still work as intended. The riskier case is that the agreement is silent on staleness, as silence can lead to a costly dispute.
Formulas
Formula provisions price the interest based on a multiple of revenue or earnings, set when the agreement was drafted. These can feel safer than a stated or agreed price because the inputs update themselves. That doesn’t mean the inputs are the right ones, or that their definitions are clear.
A formula provision is really a bet that the relationship between the base metric (revenue or earnings) and value, as it stood when the agreement was drafted, holds forever. But it doesn’t hold forever, and the industry over the past decade has demonstrated that the relationship is anything but static. When the formula produces one price, and the market would produce another, there are consequences in both directions. If the formula is below market, the departing partner or estate sells at a discount to what the interest is actually worth, and the remaining partners receive a windfall. If the formula runs above market, the remaining partners overpay and the firm carries the strain.
There’s a second problem: what does the multiple apply to? “Two times revenue” sounds precise until someone asks which revenue. In practice, the agreement usually specifies the time period for the metric. The harder questions are the ones it tends not to address. Gross or net of referral fees? Measured before or after the departing partner’s clients decide whether to stay? Earnings formulas introduce even more variables: normalized compensation, non-recurring expenses, discretionary spending, and the like. Each unanswered question is the silence problem again. The agreement can try to chase down the “what ifs”, but every one it addresses adds definitions and exceptions, and before long the provision has reintroduced the room for competing interpretations that the formula mechanism was chosen to avoid.
Valuation Process
The third approach calls for an appraisal when the trigger hits. This is the provision we generally favor. But it doesn’t run itself, and the drafting details decide how well it works in practice.
Does the agreement say what standard of value applies, and at what level? What is the effective date of the valuation? Who selects the appraiser, and based on what criteria? Who has input on the appraisal process once it begins, and do both sides get the same access to the appraiser and the same information? What is the resolution procedure if a party disagrees with the conclusion? All of those questions should be answered in the document. Silence on those questions is a common reason for escalating disputes.
Reviewing the Agreement
The starting point is to read the document while everyone’s interests are still aligned, and while the parties don’t know which side of the transaction they will be on, with a short list of questions in hand.
What makes the reading urgent is the repricing the industry has seen in recent years.
The further values move from the last time anyone looked, the bigger the gap the document is carrying, and whatever that gap is, that’s the size of the eventual dispute. Does the mechanism produce a value anyone would recognize today?
The disputes that end up in litigation (and we see them from that side too) come in both varieties: agreements that were badly drafted from the start and agreements that seemed reasonable when signed and were then left alone for ten years. What they share is that nobody recognized the problem until the trigger, and at that point it was too late to fix.