Recent Cases Highlight Problem Areas in Buy-Sell Agreements
by Guest Author, John Stockdale, Jr.
Permission to publish this guest article by John Stockdale, Jr., Editor, Business Valuation Resources is provided by Business Valuation Resources, Inc. www.buresources.com.
The best time to think about what happens if the business or the relationship between the business owners doesn't work out is when the business is being formed and business owners are happy. While it is difficult to anticipate all the situations that might arise that may necessitate a buy-out, accounting for the situations you can predict such as death, divorce, and disability are necessary. One important component to an effective buy-sell agreement is the valuation clause. And depending on the parties, different situations may result in the use of different valuation mechanisms. Generally, a court will follow the operating agreement's valuation where the particular situation is clearly addressed and the valuation mechanism is clear and unambiguous.
Often death triggers a buy-out of the decedent's interest in the business entity. Early buy-sell agreements used book value to calculate the purchase price of the deceased's interest. Two recent probate cases emphasize problems associated with below market valuation provisions. In both cases the provisions were upheld despite that they provided for a price below the fair market value of the interests and the federal estate tax was levied on the fair market value of the stock.
In the Matter of the Estate of Maurice F. Frink, No. 6-433 (Iowa App. October 25, 2006), the Iowa Court of Appeals considered whether a buy-sell agreement that required the redemption of the decedent's stock at "book value" was ambiguous. The beneficiaries of the decedent's estate plan claimed that "book value" actually meant "fair market value," which would result in greater value for the beneficiaries. The court determined that "book value" was not an ambiguous term. It found that various dictionaries consistently noted the difference between "book value" and "market value." Furthermore, it noted that the company had consistently utilized "book value," as defined under generally accepted accounting principles, when it made prior redemptions. Thus, despite the considerable difference between "book value" and "market value," the court enforced the buy-sell agreement.