One of the most exciting things in the vintage car world is when a classic model is “discovered” in a barn or a forest, or a field, covered in mud or dust or worse.  Special because they’re untouched for decades, usually in original condition, and often with very little wear from use, these so-called “barn-finds” can sell for extraordinary sums at auction.

Forgotten and ignored buy-sell agreements are also exciting, but usually not in a good way.  Buy-sells tend to favor the business’s needs and the ownership’s thinking at a particular time.  Decades later, the business has changed, the owners’ perspectives have matured, and the agreement—instead of being helpful—becomes a source of contention.

Few RIA owners review their buy-sell agreements until something unexpected happens

Our consistent experience is that few RIA owners review their buy-sell agreements until something unexpected happens.  The partners argue over the future of the business.  Someone gets divorced.  Someone gets in trouble with the SEC.  Someone dies suddenly.  At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind.  And, unfortunately, that one thing may be subject to interpretation.

The biggest problem we see in shareholder agreements: pricing mechanisms.

If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?

The worst situations we’ve seen involved fixed-price agreements.  Second to that, we’ve seen lots of problems with formula pricing.

I probably don’t have to tell you what we think of formula pricing.  Formula pricing has the benefit of simplicity, but simple isn’t always better.

Is the formula a multiple of trailing, current, or forward earnings?  Are appropriate multiples reflective of long-term averages, current market pricing, good times, bad times?  Is the formula intended to generate a change of control value?  To a financial buyer or a strategic buyer?  Rational buyer looking for ROI or irrational buyer making a land grab?  Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis?  Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?

In one situation, the agreement called for pricing an interest based on “prevailing market value.” What does that mean?  Prevailing market conditions might work something like this:

RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million when the LOI was drafted and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing.  Assume the firm sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% over three years. 

Based on this scenario, what’s the multiple?  Is it:

• 5x (upfront consideration as a multiple of adjusted EBITDA at closing)?
• 6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?
• 7x (upfront consideration as a multiple of reported EBITDA at closing)?
• 5x (total possible consideration as a multiple of adjusted EBITDA at closing)?
• 8x (upfront consideration as a multiple of reported EBITDA at negotiation)?
• 9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?
• 10x (total possible consideration as a multiple of reported EBITDA at closing)?
• 12x (total possible consideration relative to reported EBITDA when negotiated)?

When people whisper deal multiples, they use the highest number possible

Naturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x.  It does no good to ask parties what multiple was paid.  We find that when people whisper deal multiples, they use the highest number possible—in most cases, the maximum transaction proceeds possible as compared to a trailing measure of reported earnings.  This serves the needs of all parties to the transaction.  The seller gets to brag about what he was paid—and we all value psychological rewards.  The investment banker brags about what a good job she did—and she probably did do a good job.  And the buyer gets a reputation for paying up, so the potential sellers will return his call.  All of this is good for the deal industry but not especially revealing as to valuation.

Absent some reliance on formula pricing or headline metrics, you can hire an appraiser (like us), but even that’s complicated.  Do you pick a valuation specialist or an industry expert?  Valuation folks characteristically rely on projection models that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing—it’s just reality.  Then there are industry experts—usually investment bankers—whose perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.

If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction.  But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved.  A buyer who wants something akin to intrinsic value and a seller who wants the highest bid imaginable will have a hard time coming to terms with the result of any valuation exercise.  That situation is more common than not.

I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:

• Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice.  If you have a larger firm, you might need it more than once per year.  What this process offers, more than anything, is to manage expectations.  The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest.  This is the main function of regular valuations.  Buy-sell valuations are five-figure  Buy-sell disputes are seven-figure catastrophes.
• Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a significant strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders was entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what’s for dinner.

Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction.  Pull your agreement out, dust it off, and read it.  If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, the reality will be worse than you expect.