A couple of weeks ago, the crew of a ship known as The Felicity Ace noticed smoke coming from the cargo hold. Below deck were 4,000 cars being ferried from Europe to Rhode Island, including at least 2,000 Volkswagens, 1,100 Porsches, and nearly 200 Bentleys. The fire spread quickly and the 23 members of the crew were evacuated by a Portuguese military helicopter. The ship was left to drift several hundred miles off the coast of the Azores; bad weather has made it difficult to reach The Felicity Ace and tow it to port. The ultimate fate of the ship and its cargo are still unknown, but it’s certain to be a mess.
I was reading about The Felicity Ace while we were publishing our recent blog series on buy-sell agreements (here, here, and here). The former is a decent metaphor for the latter. When RIAs are formed, they often enter into some kind of shareholder agreement whereby the parties agree upon rules to buy or sell ownership interests under given circumstances. No one thinks much about it because the expectation of a terminal event – like the sale of the business or the retirement of a member – is so far off in the future. It’s like loading 4,000 cars on a ship and sending it out to sea, assuming that, at the end of the journey, the cargo will be reliably delivered and offloaded in good condition. No one thinks about the ship while it’s on the way from one destination to another until a fire breaks out.
Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected 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.
Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens.
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?
I probably don’t have to tell you what we think of formula pricing. 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? Meant to represent a change of control multiple? 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?
We had one situation where the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Current prevailing market conditions work something like this: RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million at the time of negotiating the LOI, and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing, sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% in three years. 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)?
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 tend to go for the highest number possible – in most cases the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This makes more than a bit of sense, because it’s also self-serving. 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.
We find that when people whisper deal multiples they tend to go for the highest number possible
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 people characteristically rely on DCFs that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing – it’s just how my tribe is wired. Then there are industry experts – usually investment bankers – who’s 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 high bid from a strategic buyer in a competitive auction are going to 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 manages, more than anything, is 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 exercises. 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 huge strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders were entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what to have 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, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, it will be worse than you expect.
There has been considerable speculation as to what sort of cars are in the hold of The Felicity Ace. Are they all conventional internal combustion engine cars with a minimal amount of gasoline in their tanks, or are some of them EVs carrying highly combustible lithium-ion batteries? Whichever the case, it’s too late now to do anything about it. Don’t wait until your ship is adrift and on fire to check your buy-sell. If business is good and your partners are happy – consider this your opportunity.