A fellow Mercer Capitalist recently purchased this beauty, a 1976 VEB Trabant or “Trabi,” at a car auction in Chicago. Ironically labeled as “the car that gave communism a bad name,” the Trabi was the most common vehicle in East Germany during the Soviet Bloc era and even made the Los Angeles Time’s prestigious “50 Worst Cars of All Time” list. If these rankings culminated in a March Madness style bracket pool, the Trabi would definitely deserve a #1 seed given its two-stroke pollution generator (that maxed out at 18 hp) and lack of basic amenities like turn signals and brake lights. The body was made of a fiberglass-like Duroplast (reinforced with recycled fibers of cotton and wood) and even had some parts manufactured from papier-mâché when the VEB production plant ran low on steel. As the Berlin Wall fell in 1989, thousands of East Germans drove their Trabis across the border as a sign of automotive liberation from the Communist Bloc.
Like the Trabant, business divorces can be liberating, but are mostly just ugly and ill-conceived. This is especially true for RIA firms where the founding principals typically serve as Chief Investment Officers or portfolio managers for the larger accounts. As a result, these shareholders (and the RIA itself) have the most to lose when corporate disputes or partner buy-outs arise. Many times, these conflicts are unavoidable and are the natural bi-product of ownership transition and firm evolution. In these instances, a carefully crafted buy-sell agreement (“BSA”) can resolve these disputes in a fair and equitable manner (from a financial point of view) if the valuation process avoids these common pitfalls:
- Employing a fixed or formulaic valuation methodology. The most commonly used rule of thumb for valuing asset managers is price (or enterprise value) to AUM, which is fraught with all sorts of issues covered by a previous blog post. Even worse are formulas that call for a departing shareholder to be bought out at a pro rata percentage of book value or his/her capital contribution. Such metrics make little sense for RIAs, which often have minimal capital requirements and balance sheets, meaning one-side is likely to get bought out a price that is in no way indicative of fair market value for his or her equity interest. BSAs that call for fixed multiples of earnings or cash flow are less offensive to us, but don’t account for natural variations in cap rates and can be subject to margin manipulation by the managing partners.
- Delaying a valuation until a triggering event actually takes place. Business owners often have an inflated (and sometimes deflated) view of what their company is worth. Having the business appraised on a regular basis (annually or bi-annually) precludes the inevitable surprise that takes place when a trigger event occurs and allows both sides to gain familiarity with the appraisal process.
- Employing multiple appraisers and tie-breaker valuations when both sides’ experts inevitably disagree. Besides being costly and time-consuming, this technique can be especially problematic when there’s an outlier valuation or the parties can’t agree on a third appraiser. In any event, the process can be a huge distraction for an RIA’s management team and shareholder group.
The problem that we most often see with shareholder agreement disputes is the potential of a forced transaction creating winners and losers. If a departing shareholder is bought out at a premium to the value of the enterprise, that premium comes at the expense of the remaining shareholders. If the shares are bought at a discount, the remaining shareholders reap a windfall. Some buy-sell agreements are intentionally engineered to favor either the selling shareholder or the continuing shareholders, but if so everyone who is a party to the agreement should be aware of that long before the triggering event.
At Mercer Capital, we recommend a regular valuation process for buy-sell agreements at investment management firms for a number of reasons:
- The structure and process, in addition to being defined in the agreement, will be known by all parties to the agreement in advance.
- The appraiser’s valuation approaches and methodologies are seen firsthand by the parties before any triggering event occurs.
- The appraiser’s independence and objectivity will be evident in the consistency of methodology utilized over time.
- Because the appraisal process is exercised on a recurring basis, it should go smoothly when employed at triggering events and be less time-consuming (and expensive) than other alternatives.
Our colleague with the Trabi says that one benefit to ownership is that you never know what’s going to happen when you get into the car. Your buy-sell agreement should, on the other hand, be free of surprises. If it’s been a while since you looked under the hood of your shareholder agreement, we recommend you pull it out of the drawer, read it, and then call your legal counsel if you see the potential for any problems down the road. Then call us.