Usually, I like to start blogposts with the story of some legendary car remembered fondly for its contributions to the automotive community. The car photographed above, a 1990 Chrysler TC by Maserati, is not an example of that. The TC was the mutant offspring of a brief tryst between Lee Iacocca, who headed Chrysler, and Alejandro de Tomaso, who owned the Maserati brand at the time. Iacocca and de Tomaso signed an agreement to jointly produce a sport coupe, and this was the worst they could come up with: a convertible based on Chrysler’s K-car platform, powered mostly by weak Chrysler engines, but tarted up with hand-stitched leather upholstery and inexplicably manufactured in Italy. One might have expected the TC to have had Italian styling and American reliability – instead it was the other way around. None of it made sense any more than the peculiar porthole window in the hardtop. Somehow, over 7,000 were sold. May they rust in peace.
Despite talented people, carefully developed business plans, and the best of intentions, not every partnership goes well, and some of those that don’t go well don’t end well either. When a partner leaves an investment management practice, the potential for a major dispute over the buy-out usually looms. Internally, at our firm, we sometimes refer to these situations as “business divorces”, even though the consequent acrimony often exceeds that of a marital dissolution.
For the exiting partner who was either pushed out or who left in disgust, it’s usually their last shot at their adversaries. Getting paid in full, and maybe then some, becomes a way to even not only the economic score, but the emotional score as well. For the continuing partners, overpaying risks endangering the business, while a cheap buy-out might be seen as giving the ex-partner what he or she really deserve.
Usually, no one sees a business divorce coming until it’s too late to prepare. Once the negative emotions are underway, it’s too late to get the partners to sign a shareholder agreement or modify one that’s inadequately drafted. We started writing about buy-sell agreements at Mercer Capital over ten years ago with the idea that we could help firms avoid costly disputes over ownership. We have succeeded in doing some work in that area, but we are often hired as a jointed retained appraiser to try to help clean up messes after a fight broke out.
It is always dangerous to make blanket statements, but I think if we’ve learned one thing from working in the shareholder dispute arena, it’s that a poorly drafted buy-sell agreement may be worse than having none at all. The words on the page look pretty innocuous when everyone is getting along, and unclear verbiage and inadequate guidance can be dismissed (“We know what we mean…”). So, to that end, here are a few mistakes we’ve seen others make, in the hopes that you read this and don’t do the same.
Be Clear about the Valuation Date
In one extreme case in which we were involved, there was a $250 thousand hearing just to get the court to determine what the appropriate valuation date was to buy out a joint venture partner. You probably won’t have that big an issue, but the valuation date can be extraordinarily significant. If you have a large RIA with a stable customer base and placid markets, the valuation date may not matter. But what if markets are particularly volatile? What if you’re buying out a partner who left because of FINRA sanctions and now your clients are asking lots of difficult questions? What if a very successful client service partner left for another firm and is now working diligently to move his clients? What if the death of a key partner risks the loss of large mandates? We have seen some buy-sell agreements specify that the entity be valued at the fiscal year end prior to the trigger event for the action, as doing so would value the entity without regard to the issue at hand. That’s one way to handle it, and doing so often benefits the departing shareholder. We have also seen buy-sell agreements specify that the entity be valued at a certain point after the triggering event, to let the dust settle. Obviously, this treatment can be beneficial to the firm if the partner leaving is contemporaneous with some kind of firm trauma. But, more often than not, the valuation date is not clearly specified in the buy-sell agreement. Don’t let that happen to you.
Be Clear about How to Choose an Appraiser
Obviously, you want a valuation expert to handle your business divorce who is both trained and experienced in business valuation and who understands the investment management industry. Your buy-sell agreement should delineate the qualifications of the appraiser or appraisal firm to do the work. But how will he or she be chosen? We have seen agreements in which the appraiser is chosen by the company, and the obvious implication of this is that the departing or departed shareholder is suspicious of conflicts. We have also seen many situations where each party to the agreement chooses an expert who is supposed to agree on a jointly retained appraiser. This works better in theory than in practice, except in instances where the two sides propose the same third appraiser. Whatever you do, be specific about the process. We have been brought in many times after the court had to be asked to intervene on behalf of one side or the other.
Be Clear about the Standard of Value
If your buy-sell agreement doesn’t already specify fair market value as the standard and makes that clear by reference to a definition such as exists in the International Glossary of Business Valuation Terms, then that’s an easy fix. We worked on a lengthy and expensive litigation which was almost entirely related to ambiguity as to the standard of value. Absent clarity, a buy-sell agreement could be settled based on investment value to either the buyer or seller, some notion of intrinsic value, or statutory fair value – particularly since in many shareholder disputes the departing partner could argue for protection under some state fair value statute.
Be Clear about Valuation Discounts and Premiums
Usually, the subject interest in a buy-sell dispute is a minority interest in a closely held business. This would suggest that it could be valued, absent guidance to the contrary, at a non-marketable, minority interest level of value (inclusive of discounts for lack of control and lack of marketability). I think it’s safe to say that most partners think of their interest in an RIA as their pro rata participation in the enterprise. If the firm is worth, say, $10 million, and they own 20%, they expect their interest to fetch $2 million per the buy-sell. The acquiring firm has ample economic motivation to argue for discounts, and indeed the continuing partners will benefit if the selling partner is bought out for less than pro rata enterprise value. On the other hand, a well-crafted shareholder agreement will also specify what is meant by enterprise value. Is it going concern on a stand-alone basis (what might be considered a financial control level of value) or is it the value that could be achieved in a synergistic change of control? There is no perfect answer, but think about your firm and how you and your partners would want to buy or be bought out.
Best Practice is to Practice
Even with all of the above care given to your buy-sell agreement, it’s difficult to know what will happen once the trigger event has occurred unless you find out in advance. The best practice is to have an annual appraisal done pursuant to your buy-sell agreement. With an annual valuation, you and your partners will know who is doing the work, how the process will occur, and (within a range) what the result will be. It does mean some regular investment of time and money, but the typical dispute we’ve worked on would have paid for a couple of decades of annual appraisals, not to mention the immense frustration and distraction that a shareholder disagreement causes a firm. If you can’t imagine finding yourself or your firm in that situation, now is a good time to start preparing.