Buy-Sell Agreement Valuation

Hard to imagine today, but just one year ago, some of the largest prices paid for new cars relative to MSRP were for an EV. The Porsche Taycan, a six-figure ride in any configuration, was commonly selling for 20-25% above sticker. What a difference a year makes. Today, EVs are shunned by many (certainly the press), and Porsche is rushing out a new version of the Taycan for 2025 to address flagging sales. For those who paid premium prices to Zuffenhausen a year ago, the depreciation they’ll experience if they try to trade that year-old Taycan today would be breathtaking. Life’s a gas!Pricing MattersThe backbone of our business at Mercer Capital is valuation, so we have a self-interested bias against formula prices in buy-sell agreements. An independent valuation is, by far, the best way to manage the settlement of transactions between shareholders. Doing so annually has the added benefit of managing everyone’s expectations.Simple is not always betterI’ll concede that annual valuations can be excessive for smaller firms with a few shareholders and transactions that seldom occur. Formula pricing offers a degree of certainty and grounds expectations in what is usually a pretty simple equation. Simple is not always better, however.More often than not, the formula prices we encounter do more harm than good. The simplicity of formula pricing equations means they don’t consider important factors like debt, non-recurring items, loss of key staff or large customers, market conditions, or offers to purchase. Formulas can ground expectations but may set expectations unrealistically low or high, provide a false sense of security, and encourage partner behaviors that do not support the business model.The Object of Transaction PricingIn part, buy-sell agreements offer a mechanism to settle transactions between shareholders when some event forces a transaction. Often the event is many years, if not decades, after the signing of the agreement. Nobody expects to be thrown out of their firm, get divorced, or die — even though we know the former two happen often and, in the case of the latter, happens to everyone. Even retirement is hard to foresee when a firm is in its nascency and crafting a shareholder agreement to handle issues that seem so far off that even the inevitable is irrelevant.Signers to a buy-sell rarely foresee the consequencesAs such, the signers to a buy-sell rarely foresee the consequences of what they’re signing. Many of these consequences involve valuation.If you ask them, most people say they want the pricing mechanism in their shareholder agreement to treat everyone fairly. “Fair” is the first word in Fair Market Value, a standard of value established by the Treasury Department in Revenue Ruling 59-60 and reiterated and expounded upon in professional literature throughout the valuation community.Fair Market Value, generally, is a standard of pricing that considers the usual motivations of typical buyers and sellers, described as hypothetical parties, to distinguish them from the very specific and particular persons involved in a subject matter. The parties to a fair market value transaction are assumed to be funded, informed, and reasonable. Fair market value further assumes an orderly (not forced) transaction, and settlement is on a cash equivalent basis.Most people want something akin to fair market value pricing in a buy-sell agreement, but formulas usually only achieve this by coincidence. Most formulas will either price an interest too high or too low. This creates “winners” and “losers,” depending on who gets the better side of the transaction.When the Formula Price Is Too HighWe often see formula pricing in buy-sell agreements set at what could be called optimistic levels. I suppose this is because these agreements are usually written when firms are first established, too new to evaluate the stabilized economics of the business model when compensation patterns are observable, fee schedules are settled, and margins become regular.Formula pricing commonly relies on rules of thumbFormula pricing commonly relies on rules of thumb that don’t represent the particular economic characteristics of a given RIA’s business model. An example of this would be the old myth that investment management firms were worth 2% of AUM.The 2% rule dates back to the days before wealth management and asset management were well delineated, and money managers commonly earned a realized effective rate of 100 basis points on assets under management. At those fees, a billion-dollar shop could produce pre-tax margins between 25% and 35%. At those margins, 2% of AUM implied a value of 6x to 8x pre-tax net income. At the time, that pricing was reasonable. RIAs were not considered an established money management platform (broker-dealers were still the dominant force), and consolidation activity was minimal. Industry insiders recognized that RIA clients were stickier than those of most professional services firms, so 6x to 8x pre-tax net income was a premium to a more typical 4x-5x for other owner-operator professions.Today, of course, consolidation activity is rampant, and multiples are generally higher. But fees have taken a hit, and not every firm earns a “normal” margin. If realized fees are 60 basis points and margins are 15%, a formula that values the RIA at 2% of AUM looks pretty expensive.There is a very human tendency to get too comfortable with large numbers. Owners like big valuations, even when they aren’t real. And until an event occurs that requires a transaction, people rarely question a robust, if unrealistic, valuation. It’s a game of mental gamma, where everyone hopes imaginary pricing pulls on value like a large block of out-of-the-money call options. It feels good but doesn’t get tested until a triggering event invokes the buy-sell agreement. Then something happens. If a 25% partner in this “Now” RIA passes away unexpectedly, and the buy-sell agreement specifies purchase at 2% of AUM, the transaction price is $5 million. We’re going to posit, for purposes of this post, that the actual fair market value of this interest is 8x-10x pre-tax, the midpoint of which is 9x. At 9x pre-tax, the 25% stake has an implied value of about $2 million. If the RIA is required to purchase the interest pursuant to the formula, they will be paying over 60% of the value of the firm for a 25% stake. The estate “wins,” and everyone else loses. What are the implications of an internal transaction at 22x pre-tax? Let’s assume the buy-sell agreement states the RIA can finance the purchase of the decedent’s interest at SOFR plus 200 basis points (about 7.3% today) over ten years. The annual payment would be nearly $725 thousand, or 80% of pre-tax (a proxy for distributable cash flow). For a decade, 80% of distributions will be claimed by a 25% ownership interest.80% of distributions will be claimed by a 25% ownership interestWe’ve seen this happen, but there are reasons the formula pricing might not hold. Usually, a buy-sell gives the other partners and/or the firm the option to purchase at the formula price but doesn’t require it. In this case, the option is entirely out of the money. In that case, the firm might decide to punt on the option and pay the estate their pro rata portion of distributions ($225K per year, or about $500K less than financing at the formula price). The estate is left as an outside minority owner in a closely held business. If the estate isn’t satisfied with this, the executor will have to negotiate — from a very weak position — with the other partners. In effect, this nullifies the buy-sell agreement.When the Formula Price Is Too LowBuy-sell formulas that undervalue interests are no better than those that overvalue interests. There is no “conservative” or “aggressive” in valuation, only reasonable and unreasonable. If, in the scenario listed above, the formula price specified that the firm was to be valued based on book value, the outcome would be no more favorable.RIAs usually don’t have much balance sheet value. Our valuations in the space rarely employ an asset approach. We consider whether the balance sheet has a normal level of working capital to finance ongoing operations or if it has a material amount of non-operating assets. Beyond that, the balance sheet is rarely more than some cash, leasehold improvements, and short-term payables. Book value for a firm like the one discussed above might be no more than $250K.At book value, that formula would price the decedent’s interest at $62,500 — unreasonable for a stake that was earning over three times that much in annual distributions. The transaction would be highly accretive to the remaining partners, who would share in the distribution stream they got for next to nothing. But the specter of what would happen to their beneficiaries in the event of their deaths would dampen any sense of having won.If this buy-sell formula also applies in the event of retirement or withdrawal from the firm, who would ever leave? It would be very difficult to execute ownership succession for partners who are giving up their distributions in exchange for so little compensation. Of course, without succession, the firm eventually wears out — a circumstance in which book value might be a reasonable measure.What’s Your Aspiration?Ask yourself whether or not you think the pricing of a forced transaction should create “winners” and “losers.” There are legitimate reasons for wanting a somewhat below-market price for transactions because it benefits the ongoing firm and continuing partners. Above-market pricing just creates a race for the exit. But if your formula price is too high and transaction execution is optional, an informed buyer will pass, and you’ll be negotiating as if there were no agreement. Hardly a good solution.If this has prompted you to think about your formula pricing and you’d like to talk specifics to us in confidence, reach out. We work with hundreds of investment management firms like yours to defuse time bombs and create reasonable resolutions. Don’t let your ownership issues disrupt your operations.

A Matter of Life (Insurance) and DeathA buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. The United States Court of Appeals for the Eighth Circuit recently heard Thomas A. Connelly, in his Capacity as Executor of the Estate of Michael P. Connelly, Sr., Plaintiff-Appellant v. United States of America, Department of Treasury, Internal Revenue Service, Defendant-Appellee. The Eighth Circuit court affirmed a district court decision that concluded that life insurance proceeds received by a company triggered by a shareholder’s death should be included in the valuation of the company for estate tax purposes.[1]Connelly is an estate tax deficiency case dominated by two themes: (i) the treatment of life insurance in the valuation of stock of a private company when a shareholder dies and (ii) the consequences of executing a buy-sell agreement that fails to meet the requirements under the Internal Revenue Code, Treasury regulations, and applicable case law, for purposes of controlling the valuation of a closely held company.[2] Using Connelly as a backdrop, we first demonstrate how opposing applications of life insurance proceeds received upon the death of a shareholder impact a company valuation. We then offer observations from a study of the Connelly buy-sell agreement from a valuation perspective that private business owners and their advisors should mind when drafting, reviewing, and amending buy-sell agreements.The Stock Purchase AgreementCrown C Supply Company, Inc. is a roofing and siding materials company founded in 1976 and headquartered in St. Louis, Missouri.[3] Crown C (an S corporation) and brothers Michael, Thomas, and Mark Connelly originally entered into a stock purchase agreement (“SPA”) on January 1, 1983. Mark’s interest in Crown C was terminated prior to the stock purchase agreement being amended and restated on August 29, 2001.[4] Crown C had 500 shares of common stock at the date of the SPA’s execution. Michael, via a trust, owned 385.9 shares of Crown C stock representing a 77.18% ownership interest. Thomas, individually, owned the remaining 114.1 shares representing a 22.82% ownership interest.Pursuant to the terms of the SPA, Michael and Thomas executed a certificate of agreed value that set the purchase price of Crown C’s stock upon a triggering event at $10,000 per share (see graphic below). Based on this purchase price per share, which disregarded accepted valuation principles and methodologies, the implied aggregate market value of the company’s stock on August 29, 2001, was $5.0 million.Therefore, at that date, Michael’s shares would have had an agreed value of approximately $3.9 million, while Thomas’s shares would have had an agreed value of approximately $1.1 million. In July 2009, with no update to the agreed value of the company’s equity, Crown C purchased life insurance policies on both Michael’s and Thomas’s lives in the amount of $3.5 million each. The rationale for purchasing the same amount of life insurance on each brother’s life when one brother’s ownership interest was approximately 3.4x larger than the other brother’s is unclear. The SPA dictatedthat life insurance proceeds were to be used to redeem a deceased shareholder’s interest.The Sale and Purchase AgreementMichael, who served as Crown C’s president and CEO, died on October 1, 2013. Thomas was the executor of Michael’s estate. Effective November 13, 2013, Thomas, as trustee of Michael’s trust and a second trust for Molly C. Connelly, Michael’s daughter, recused himself from “all matters touching upon the sale, pricing, negotiation, and transaction of any sale of the stock of Michael P. Connelly, Sr.’s interest in Crown C Supply Company, Inc.”[5] Had Thomas not recused himself he would have been in the conflicted position of negotiating on behalf of Michael’s estate with the company, of which he was now the sole surviving shareholder. Effective the same date, Thomas and Michael’s son, Michael P. Connelly, Jr., executed a sale and purchase agreement governing the redemption of the estate’s shares in Crown C as well as in other entities.[6] Thomas (representing Crown C) and Michael Jr. (representing Michael Sr.’s estate) agreed, without relying upon a formal valuation, to a purchase price of $3.0 million for the estate’s shares (see graphic below).The estate noted, however, that the $3.0 million purchase price “resulted from extensive analysis of Crown C’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.[7] I’ll discuss the importance of engaging a qualified appraiser in matters such as these below.The Estate’s Argument: Life Insurance Proceeds Are Not a Corporate AssetCrown C received $3.5 million in life insurance proceeds upon Michael’s death. Crown C immediately recognized a corporate redemption liability and used $3.0 million of the life insurance proceeds to redeem the estate’s interest in Crown C. It is interesting to note from the graphic above that Michael’s estate’s interest originally was equal to the total cash value of the life insurance proceeds, but at some point was reduced by $500,000 because the company needed additional funding.[8] Exhibit 1 demonstrates this narrative.(click here to expand the figure above)Key takeaways from this scenario:One would expect to see a “top-down” valuation methodology in which the value of 100% of Crown C’s equity is established first, followed by the determination of value attributable to the estate’s shares. However, the aggregate value of Crown C’s equity of $3.9 million was implied based on the value of the estate’s interest of $3.0 million.Crown C immediately recognizes a redemption liability equal to $3.0 million in life insurance proceeds and pays $3.0 million to Michael’s estate in exchange for redeeming the estate’s 385.9 shares; Michael’s estate is redeemed at $7,774 per share.[9]Post-redemption, the total value of the company’s equity does not change while the share count decreases from 500 shares to 114.1 shares, all owned by Thomas.Thomas now owns 100% of the company at a value of $34,067 per share,[10] which is approximately 4.4x the value at which Michael’s estate was redeemed. The value of Thomas’s ownership interest increased by 338% with no additional investment.The IRS’ Argument: Life Insurance Proceeds Are a Corporate AssetThe IRS saw things differently, arguing that the insurance proceeds should be included in Crown C’s equity value. See Exhibit 2 below.(click here to expand the figure above)Key takeaways from this scenario:The equity value of the business for estate tax purposes was $6.9 million inclusive of the $3.0 million in life insurance proceeds. The IRS did not include the excess $500,000 of life insurance in its valuation.The resulting value per share is $13,728[11].The estate’s 385.9 shares have a total value of $5.3 million and Michael’s estate is redeemed at $13,728 per share, reducing the company’s equity value to $1,566,323.Post-redemption, the share count decreases from 500 shares to 114.1 shares, all owned by Thomas at a value of $13,728 per share, which is equal to the pre-redemption value per share.As the life insurance proceeds utilized only totaled $3.0 million, the redemption liability of $5.3 million would have been underfunded by approximately $2.3 million, leaving the company (in this case, solely Thomas) on the hook to finance the shortfall.The Funding Mechanism DilemmaIt should be obvious that the manner in which life insurance proceeds are treated can have a dramatic impact on the selling shareholder, the remaining shareholders, and the company’s ability to buyout the selling shareholder. In one scenario, the estate is redeemed relative to a windfall received by the surviving shareholder. In the second scenario, the estate is redeemed at a higher value, but to the detriment of the company most likely having to finance a portion of the buyout. So, what is the fair way to treat life insurance in this situation? Ultimately, the parties to the buy-sell agreement decide what is fair with the help of their legal and other professional advisors, but such a decision must be addressed directly and without vagueness in the buy-sell agreement.The Defining Elements of a Valuation Process AgreementWe now turn to observations of the Connelly SPA itself from a valuation perspective. Valuation process agreements such as the Connelly SPA have six defining elements:[12] (i) standard of value; (ii) level of value; (iii) the “as of” date; (iv) qualifications of the appraiser; (v) appraisal standards; and (vi) funding mechanisms. The first five elements are required to specify an appraisal that is consistent with prevailing business appraisal standards. We’ve seen how the Connelly SPA addressed element #6, funding mechanisms. So, how, then, does the Connelly SPA stack up regarding defining elements #1 through #5?Standard of ValuePer the American Society of Appraisers ASA Business Valuation Standards, the standard of value is “the identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value.”[13]Fair market value, the standard that applies to nearly all federal and estate tax valuation matters and which is specified in most buy-sell agreements, is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA. Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s). In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by Crown C and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opens the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. The graphic below depicts these levels. A formal business valuation for gift and estate tax purposes will clearly state the level of value, and therefore, no interpretation is needed as to the applicability of control premiums or discounts for lack of control and lack of marketability.Per the Connelly SPA, in the scenario in which appraisers are utilized in lieu of issuing a certificate of agreed value, “the appraisers shall not take into consideration premiums or minority discounts in determining their respective appraisal values.” In the absence of minority interest discounts, Thomas’s minority interest (22.82%) would have been valued on a pro-rata basis relative to Crown C’s total value.The As-Of DateEvery appraisal has an “as-of” date, more commonly referred to as the valuation date. Why is the valuation date important? Business appraisers rely upon information that was “known or reasonably knowable” on the valuation date. For purposes of filing Form 706, the valuation date is the date of death (estates may elect the alternate date, six months from the date of death, as the valuation date). For redemption purposes, however, the Connelly SPA refers to “Appraisal Date,” which is “the date an option is exercised or a mandatory purchase is required.” As such, the Connelly SPA does allow for a redemption to occur on a specific date.Qualifications of AppraisersIf the qualifications of an appraiser are not specified, just about anyone can do the appraisal. The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements. Ultimately, this was a moot point for Connelly because no appraiser was ever hired to do a valuation. But what could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on. While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer. The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. The taxpayer’s attorney suggested that the investment banker be considered to do the appraisal for the gifting because "since they have the numbers, it would seem to be the most efficient method."[14] In court, the petitioners argued that the investment banker was qualified because he had prepared "dozens of business valuations" over the course of his 20+ year career as an investment banker. According to the court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.” The court relied on testimony at trial about appraisal experience to be instructive, as the investment banker testified that he conducted valuations "briefly" and only "on a limited basis" before starting at the investment bank the year before the appraisal. The investment banker also testified that he performed (presumably at no charge) business valuations for prospective clients "once or twice a year" in order to solicit their business. The court found the investment banker’s “uncontroverted testimony sufficient to establish that he does not regularly perform appraisals for which [he] receives compensation." The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser. Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards. The Connelly SPA did not reference any of these standards. Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Tax Court ConclusionsConnelly was first decided by the District Court in September 2021. Having been appealed by the estate, the Eighth Circuit affirmed the District Court’s decision in June 2023. The District Court Decision The IRS had contended that the life insurance proceeds should be included in the valuation of Crown C’s equity. The estate argued that the redemption obligation was a corporate liability that offset the life insurance proceeds dollar for dollar. The District Court sided with the IRS, noting that “Because the insurance proceeds are not offset by Crown C's obligation to redeem Michael's shares, the fair market value of Crown C at the date of date of death and of Michael's shares includes all of the insurance proceeds.”[15]The Circuit Court DecisionThe Circuit Court affirmed the District Court’s decision, noting “In sum, the brothers’ arrangement had nothing to do with corporate liabilities. The proceeds were simply an asset that increased shareholders’ equity. A fair market value of Michael’s shares must account for that reality.”[16]Current StatusShareholder buyouts often occur at inconvenient times, and poor planning can have financially devastating consequences. In Connelly, a poorly drafted buy-sell agreement resulted in a notice of deficiency from the IRS in the amount of $998,155 [17] and undisclosed legal and professional fees incurred to litigate the matter. The estate has sought a refund of $1,027,042 that it views was “erroneously, illegally, and excessively assessed against and/or collected from Plaintiff as federal estate tax…”[18] In August 2023, counsel for the estate filed with the Supreme Court of the United States a petition for a writ of certiorari to the United States Court of Appeals for the Eight Circuit. On December 13, 2023, the Supreme Court granted the petition for writ of certiorari, signifying its acceptance of the case for review. As of February 2024, the case had not yet been set for argument.[1] Courts have had differing opinions on the life insurance/valuation matter. In Estate of George C. Blount, Deceased, Fred B. Aftergut, Executor, v. Commissioner, the United States Court of Appeals, Eleventh Circuit ruled that life insurance proceeds used to redeem a stockholder’s shares do not count towards the fair market value of the company when valuing those same shares.[2] The buy-sell agreement that is the subject of Connelly was challenged by the IRS as invalid for controlling the valuation of the subject company’s stock in an estate tax scenario. The district and circuit courts both agreed and deemed the buy-sell agreement invalid.[3] Crown C was sold to SRS Distribution, Inc., a portfolio company of Leonard Green & Partners and Berkshire Partners, in 2018. Terms of the deal were not disclosed. Crown C continued to serve the St. Louis market as of the publication date of this article.[4] Amended and restated stock purchase agreement by and among Michael P. Connelly, trustee U/I/T dated 8/15/90, Michael P. Connelly, grantor, and Thomas A. Connelly, executed effective August 29, 2001.[5] Sale and purchase agreement by and among Thomas A. Connelly, trustee of The Michael Connelly Irrevocable Trust dated 15 August 1990, Crown C Supply Co., Inc., a Missouri Corporation, Thomas A. Connelly, individually, Connelly Partnership/Connelly, LLC, and 5200 Manchester, LLC, executed November 13, 2013.[6] Ibid.[7]Connelly v. United States, Memorandum and Order, page 21, September 2021.[8] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 3, filed June 2, 2023.[9] ($3.0 million / 385.9 shares) = $7,774 / share.[10] ($3.9 million / 114.1 shares) = $34,067 per share.[11] ($6.9 million / 500 shares)[12] Mercer, Z. Christopher, Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing LP, 2010).[13] American Society of Appraisers Business Valuation Standards (approved through November 2009).[14] T.C. Memo. 2023-34; Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent.[15] Connelly v. United States, Memorandum and Order, page 35, September 2021.[16] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 13, filed June 2, 2023[17] Complaint of Thomas A. Connelly, Executor of the Estate of Michael P. Connelly, Sr. dated May 23, 2019.[18] Ibid.Originally published in Mercer Capital's Value Matters Newsletter: Q1 2024

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 happensOur 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 possibleNaturally, 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.

Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile – but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x – a multiple which is unlikely to be considered reasonable in any market conditions.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.

Working on your RIA’s buy-sell agreement may seem like an inconvenience, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, employees, and clients. If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.Decide What’s FairA standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all the parties in the agreement. That’s easier said than done because fairness means different things to different people. The stakeholders in a buy-sell scenario at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. It is nearly impossible to be “fair” to that many different parties, considering their different motivations and perspectives.Clients. Client relationships are often the single most valuable asset that an asset or wealth management firm possesses, and avoiding internal disputes is crucial to maintaining these relationships. Beyond investment advice, clients pay for an enduring and trusting relationship with their investment manager. As the profession ages and ownership transitions to a new generation of management, we see a well-functioning buy-sell agreement and broader succession planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Founding owners. Aside from wanting the highest possible price for their interest in the firm, founding partners usually want to have the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as winding down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn requires consideration of the other stakeholders in the firm.Subsequent generation owners. The economics of a successful investment management firm can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is a symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply.The firm itself. The company is at the hub of all the different stakeholder interests and is best served if ownership is a minimal distraction to the operation of the business. Since handwringing over ownership rarely generates revenue, having a functional shareholders’ agreement that reasonably provides for the interests of all stakeholders is the best-case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to focus on maximizing the performance of the company while at the same time avoiding costly disputes over ownership.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of stable and predictable ownership. The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that at the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available, and the firm may need to be sold to perfect the agreement. At relatively low valuations, the internal transition is easier, and business continuity is more certain, but the founding generation of ownership may be perversely encouraged not to bring in new partners, stay past their optimal retirement age, or push more cash flow into the compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an investment management firm is always a balancing act, but one which is typically best done intentionally.Define the Standard of ValueStandard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.Portfolio managers are familiar with certain perspectives on value, such as market value (the price at which a company’s stock trades) and intrinsic value (what they think the security is worth, based on their own valuation model). None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value, among others.Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of the fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The standard of value is critical to defining the parameters of a valuation. We would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of an ambiguous or home-brewed definition can be severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario clearer.Define the Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Given the potential for valuation disputes regarding the appropriate level of value, buy-sell agreements function best when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.Most portfolio managers and financial advisors will already be familiar with the concept of “levels of value,” but they may be unfamiliar with the terminology used in the valuation profession to describe these levels. A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. This is known as the “marketable minority” level of value in the appraisal world. Portfolio managers usually think of value in this context until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company and the value achieved in a strategic acquisition is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most investment management firms, the owners joined together at arms’ length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise-level valuation.In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement.Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Typically, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation-specific. Whatever the case, the shareholder agreement needs to be very specific as to the level of value.Does the pricing mechanism create winners and losers? Should value be exchanged based on a control level valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the firm's continuity. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to retain their ownership longer and force out other shareholders artificially. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.ConclusionKeeping the above considerations in mind when drafting or updating your buy-sell agreement will help create a document that promotes the sustainability and orderly ownership transition of the firm while balancing the interests of the firm’s various stakeholders and the firm itself. However, this is far from an exhaustive list of things to consider when constructing your buy-sell agreement. In next week’s post, we’ll discuss additional parameters that should be addressed when constructing your buy-sell agreement.

Over the next several weeks, we will be publishing a series of blog posts discussing the importance of buy-sell agreements and other adjacent topics for RIA owners. Ownership is perhaps the single greatest distraction for advisors looking to grow with their firm, but it can also be an opportunity to align interests and ensure continuity of the firm in a way that is accretive for the firm’s founders, next generation management, and clients. As highlighted in the Charles Schwab 2021 RIA Benchmarking Study, planning for a successful transition of ownership — whether through internal succession or a strategic sale – continues to be a key differentiator among top RIA performers.Most wealth management firms are closely held, so the value of the firm is not set by an active market. They are typically owned by unrelated parties, whereas closely held businesses in other industries are often owned by members of the same family. In recent years, the profitability and value of many wealth management firms have increased substantially as assets under management have risen with the markets and a proliferation of capital aimed at the wealth management sector has bid up multiples. As a result of these dynamics, there is usually more than enough cash flow to fund the animosity when disputes arise, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners. Clients increasingly seem to ask us about business continuity planning—and for good reason. In times of succession, tensions can run high. Having a clear and effective buy-sell agreement is imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes a process by which shares of a private company transact. Ideally, it defines the conditions when the buy-sell agreement is triggered, describes the mechanism by which the shares are priced, addresses the funding of the transaction, and satisfies all applicable laws and regulations.A buy-sell agreement establishes a process by which shares of a private company transact.These agreements aren’t necessarily static. In wealth management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to assign who gets what if the partners decide to go separate ways.As the business becomes more institutionalized, and thus, more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of a dispute or other unexpected changes in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, as well as a degree of certainty for shareholders that allows them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell agreement, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized because now they are not simply co-owners with aligned interests but rather buyers and sellers with diametrically opposed interests.Triggering EventsBuy-sell agreements govern the process and terms of a transaction if certain defined events occur. These “triggering events” can stem from voluntary or involuntary circumstances. Many buy-sell agreements call for an independent appraisal upon a triggering event to establish the price at which shares will transact. In cases where ownership is more fluid, some agreements require an annual appraisal to establish the price at which all transactions will take place.Voluntary CircumstancesAt any point in time, one generation of business owners is preparing for retirement, having planned (or frequently not planned) for a successful ownership transition from one generation of business leaders to the next. A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership, and as such, it should complement your succession plan.A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership.An effective succession plan could call for the sale of the retiring partner’s stake to current management or an outside investor group or may require the sale of the entire firm to a strategic buyer.If your exit strategy includes a sale to an insider, it should specify the terms and define the process for determining the price that shares are transacted at as an owner exits to retire. This is often a point of contention as young partners and retiring partners have inherently opposed objectives. A retiring partner will want to exit at the highest share price possible while the continuing partners are ultimately financing this repurchase.Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the process through which price is determined and the terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama. As such, a buy-sell agreement is foundational for your firm’s succession plan.If your exit strategy is to sell your firm to an outside buyer, you should be aware of your opportunities and make it explicitly known to your firm that this is your intention. For example, you should know the different incentives of potential buyers and what options exist with financial or strategic buyers.You should make sure that your buy sell agreement makes sense in the context of your other operating agreements. A buy-sell agreement should specify the process by which a sale to an outside investor group is agreed to. We once worked with a client whose operating documents required unanimous consent to bring on a minority partner, as this required an amendment to the operating agreement, while the sale of a majority of the Company just required the consent of a super majority.Knowing your exit strategy options will help clarify what is needed from your succession plan and your buy-sell agreement going forward.Involuntary CircumstancesBuy-sell agreements guard against undesirable transitions in ownership from a potential partner to an unaffiliated party; they also define a set price per share to ensure a fair transaction. In the case of death, disability, divorce, and bankruptcy, current partners will ultimately need to redeem the shares of their colleague.For instance, in the event of the death of a shareholder, a buy-sell agreement can protect the deceased’s family, ensuring such shares are bought at a fair price and in a timely manner. It can also protect your company from the inheritors of a deceased owner, who may want to benefit from the firm’s earnings but are not able to contribute to the growth of the business. Life insurance policies for owners are advised to protect your firm in case of an untimely death or a disabling scenario. A life insurance policy will secure your firm’s ability to repurchase shares in the case of the death or disability of an owner.A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Additionally, if an owner files bankruptcy, the firm will need to repurchase his or her stake to avoid the shares being acquired by the owner’s creditors. In the case of a divorce, an owner’s shares may legally transfer to his or her spouse, in which case ownership would be seeded to the ex-spouse. A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Our RecommendationWe recommend revisiting your buy-sell agreement to ensure that it makes sense in the context of your firm’s vision and in partnership with its other governing documents. If you do not currently have a buy-sell agreement in place, we highly encourage you to draft one with the help of legal counsel and an independent valuation expert. Doing so will help ensure the continuity of you firm, align incentives, and may even help avoid costly litigation down the road. If you plan on reviewing your buy sell agreement and other governance matters, please give us a call.

Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell.  Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions?  Is this a good time to sell or a bad time to sell?  As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers.  Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits.  Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM?  Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models?  Is the OEM demanding additional image requirements?  How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family?  Is the perceived value of the dealership equal to or greater than the offers in the marketplace?  Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex.  A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership.  Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction.  Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM?  Has the dealer recently completed an image requirement or are additional requirements pending?  The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads.  Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process.  A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations.  Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members?  A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts.  How long will they continue or are any set to expire?  Key contracts would include the Dealer Management System (DMS) among others.  Selling dealers must balance opposing factors with contracts:  not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues?  A selling dealer should complete an environmental survey at the beginning or during this process.  Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance.  Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities.  If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships.  Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases,  a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The most common valuation-related family business disputes we see in our practice relate to measuring value for buy-sell agreements. Far too often, buy-sell agreements include valuation provisions that appear designed to promote strife, incur needless expense, and increase the likelihood of intra-family litigation.The ubiquity of valuation provisions in buy-sell agreements that do not work is striking. While there are many variations on the theme, the exhibit below illustrates the broad outline of the valuation processes common to many buy-sell agreements.The buy-sell agreement presumably exists to avoid litigation, but the valuation processes in most agreements seem to increase, rather than decrease, the likelihood of litigation. It is almost as if failure is a built-in design feature of many plans.Top Five Causes of Valuation Process FailureAmbiguous (or absent) level of value. As we discussed at length in section 3 of the What Family Business Advisors Need to Know About Valuation whitepaper, family businesses have more than one value. There is no “right” level of value for a buy-sell agreement, so the agreement must specify very clearly which level of value is desired. Failing to specify the level of value, and just assuming that the eventual appraiser will know what the parties intended is a recipe for disaster. The difference between the pro rata value of the family business to a strategic control buyer and the value of a single illiquid minority share in the family business can be large. Yet too many buy-sell agreements simply say that the appraisers will determine the “value” or “fair market value” of the shares. That is not good enough.Information asymmetries. Most buy-sell agreements have no mechanisms for ensuring that the appraiser for the selling shareholder has access to the same information regarding historical financial performance, operating metrics, plans, and forecasted financial performance as the appraiser retained by the family business. The resulting asymmetries give both sides a ready-made excuse to cry foul when the valuation results do not meet their expectations. We recommend a thoroughly documented process of simultaneous information sharing, joint management interviews, and cross-review of valuation drafts to eliminate the likelihood of information asymmetries derailing the transaction.Lack of valuation standards / appraiser qualifications. It is not hard to find an investment banker, business broker, or other industry insider who probably has a well-informed idea of what the family business might be worth (particularly in the context of a sale to a strategic buyer). However, when executing the valuation provisions of a buy-sell agreement, it is crucial to specify the qualifications for the appraisers. While an opinion of value from a business broker might be suitable for some purposes, the scrutiny that is attached to a buy-sell transaction can best be withstood by an appraiser who is accountable to a recognized set of professional standards that set forth analytical procedures to be followed and reporting guidelines for communicating the results of their analysis. There are multiple reputable credentialing bodies for business appraisers that promulgate quality standards for their members. The buy-sell agreement should specify which professional credentials are required to serve as an appraiser for either the selling shareholder or the company.Unrealistic timetable / budget. Families often share a well-founded fear that the valuation process will prove interminable without specified deadlines. Deadlines are important but must be realistic. If there is ever a time for a “measure twice, cut once” mentality, it is in buy-sell transactions. Due diligence and analysis takes time, and the schedule set forth in the buy-sell agreement needs to take into account the inevitable “dead time” during which appraisers are being interviewed and retained, information is being collected, and diligence meetings are being scheduled. The same goes for budget: if you think a quality appraisal is expensive, see how costly it is to get a cheap one. Provisions that identify which parties will bear the cost of the appraisal can help incentivize the parties to reach a reasonable resolution, but can also be so punitive that they discourage shareholders from pursuing what is rightfully theirs. Each family should carefully evaluate what system will work best for their circumstances.Advocative valuation conclusions. Sadly, even when the level of value is clearly defined, information asymmetries are eliminated, valuation standards are specified, and the timetable and budget is reasonable, the two appraisers may still reach strikingly different valuation conclusions. Whether this is a result of genuine difference of (informed) opinion or bald advocacy is hard to say, but it is rare for the appraiser for the selling shareholder to conclude a lower value than that of the appraiser for the company. Valuation is a range concept, so it should ultimately not be too surprising when appraisers don’t agree. Yet that inevitable disagreement adds time and cost to many buy-sell valuation processes.Is There a Better Way?Given the challenges and pitfalls described above, is there any hope that a valuation process for a buy-sell agreement can reliably lead to reasonable resolutions? We think so. We have identified three steps that we recommend for clients to help make their buy-sell agreements work better.Make sure that the buy-sell agreement provides unambiguous guidance to all parties as to the level of value and qualifications of the appraiser.Retain an appraiser to value the company now, before a triggering event occurs. This is essential for two reasons. First, it transforms the “words on the page” into an actual document that shareholders can review and question. No matter how carefully one defines what an appraisal is supposed to do, the shareholders are likely to have different ideas about what the output will actually look like. This appraisal report should be widely circulated among the shareholders, so they have an opportunity to familiarize themselves with how the company is appraised. Second, performing the valuation before a triggering event occurs increases the likelihood that the family shareholders can build consensus around what a reasonable valuation looks like. People tend to take a more sane view of things when they don’t know if they will be the buyer or the seller.Update the valuation periodically. Simply put, static valuation formulas don’t work in a changing world. Periodic updates to the valuation help the valuation process become more efficient, and help all shareholders keep reasonable expectations about the outcome in the event of an actual triggering event. Discontent and strife are more likely to be the product of unmet expectations rather than the absolute valuation outcome. Periodic valuations help to set expectations and reduce the likelihood of friction. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. This week's post is an excerpt from the whitepaper, What Family Business Advisors Need to Know About Valuation. If you would like to read the full version click here.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Auto dealers, like most business owners, are focused on many aspects of their business:  daily operations, strategic vision, competition, industry conditions, the state of the economy, etc.  It is less common for auto dealers to be concerned if/when their business might need to be valued.  Often, they are made aware of the need for these services by their trusted advisors including attorneys, financial planners, accountants, etc.What are common events that trigger the need for a valuation for an auto dealership?1. Estate Planning/Wealth TransferOver time, successful dealerships can accumulate tremendous value. Estate planning allows the first generation of a family to transfer wealth to the next generation through various mechanisms.Individuals and couples can take advantage of the lifetime exemption amounts by transferring value up to the current taxable exemption of $11.7 million for individuals or $23.4 million for couples over their lifetime.1  Gifting strategies can also utilize the annual exclusion amount of $15,000 per individual.Implementation of these strategies includes many different structures requiring the valuation of the auto dealership and the specific interest being transferred.  A proper valuation assists in protecting the integrity of these transactions.  Failure to support the concluded figures with a proper valuation can often lead to these transactions being challenged or audited, causing a later described litigation dispute.2. Death of a Dealer Principal/OwnerFor certain estates, an income tax return and Form-706 will have to be filed in a timely manner after the date of death. If the decedent is an owner of a business, or in this case an auto dealership, the value of the decedent’s interest will have to be valued.  The valuation will need to be performed by a qualified business appraiser that can support the value of the dealership and specific ownership interest through accepted methodologies.3. Buy-Sell AgreementIn a prior blog post, we discussed the seven elements of a highly effective buy-sell agreement. This document, along with other corporate governance documents, describes the process and criteria for a business valuation and often requires an initial valuation to set the stock price for triggering events that will be governed by the document.  Further, some buy-sell agreements require updated valuations at regular intervals or upon the occurrence of future triggering events.  Following the provisions in these documents and maintaining regular valuations can aid in limiting or avoiding litigation disputes.4. Strategic PlanningBusiness valuations can also assist auto dealers with strategic planning. Not only can a valuation provide an indication of value at a specified point in time, but successive or regular valuations can track value over time.  These valuations could be helpful for auto dealers contemplating incentive programs to reward ownership to key management.  Auto dealers can also discover the value drivers of the current appraisal and set goals to enhance value through the improvement of those value drivers over time.5. Potential Sale of DealershipAt some point, successful dealers may reach the point where they contemplate a possible exit event. If there isn’t a viable second generation to continue the operations, a sale of the dealership may be the next best option.The auto dealer industry proved to be resilient and adaptable posting strong profitability for 2020 and continuing into 2021.  Industry transaction activity also appears high for both public and private acquirors.  Most auto dealers that have owned a dealership for a period of time have likely been contacted at one point or another with some interest either by phone or through the mail.If you have not had a recent business valuation, how can you evaluate any offers or know what your dealership is worth?  A business valuation can inform you as to the value of the dealership and manage expectations to assess potential offers.6. Litigation DisputeThe next three events that we will describe all fall under the umbrella of litigation, but each is a unique event.Shareholder DisputesShareholder disputes can come in many forms: breach of contract, wrongful termination, damages, etc. In any of these scenarios, the value of the entire dealership and a specific ownership interest will be contested.  A valuation and possibly testimony can assist the attorneys and/or triers of fact determine the outcome of the case.  Certain components of an auto dealership’s value, such as Blue Sky Value, can also be critical to the case. Taxation DisputeIf a proper valuation was not utilized in an estate planning transfer or if the valuation is being challenged by the IRS, another form of litigation involving a taxation dispute could arise. These disputes require similar elements as in a shareholder dispute – valuation of the dealership, value of specific ownership interest, and possibly testimony.  A unique element of taxation disputes is that generally an expert’s valuation report also serves as their direct testimony should the matter end up in trial.  The valuation report must communicate the expert’s methodology and support for their conclusions for the value of the dealership and any applicable discounts such as lack of marketability, lack of voting rights, etc. Family Law DisputeWhile not a popular topic, dealers or their spouses in the midst of divorce would also be in need of a business valuation and potential expert witness services. In a divorce, all of the couple’s assets and liabilities need to be compiled and valued to assist the attorneys and trier of fact in the division of assets and other matters.Some assets, such as bank accounts and real estate, are easier to value.  Other assets, such as business assets can be more difficult to value.  In the auto dealer universe, these business assets can consist of more than one entity.  Many dealerships are organized where the dealership operations and franchise agreements are contained in one entity, while the underlying real estate may be owned by a separate asset holding entity.In this example, both entities would need to be valued and the methodologies to value each are different.  Some auto dealers may also own additional entities such as separate repair and body shops or re-insurance companies that also might require a business valuation.ConclusionBusiness valuations are triggered by numerous events.  By knowing the events that dictate the need for a valuation, auto dealers can be more educated in the use of these services.  As we have previously written, the auto dealer industry is unique to valuation in the methodologies employed, the terminology communicated, and the financial information utilized.  When a valuation need arises, auto dealers are best served by someone who is both a valuation expert or an industry expert.Contact a professional at Mercer Capital to assist with you a business valuation or consultation of your auto dealership and related businesses for any of these events or others.1 The lifetime exemption amounts, estate income tax rates, and corporate income tax rates could all be subject to change with the new administration in the White House and change of control in the Legislative Branch.  These changes could have a dramatic impact on business valuations and the need for related services.

A few of our recent auto dealership valuation engagements have involved disagreements among family members and the next generation or what might otherwise be termed a business divorce.  Inevitably, one of the first questions I always ask "Is there a buy-sell agreement or governance document that will provide a roadmap into the valuation of the business and the respective subject interests?"  Often the answer is "I’m not sure, I don’t know, or maybe but we haven’t reviewed it in some time."We’ve also encountered plenty of examples where these documents exist, but they are either poorly written, do not contain the necessary information, or have not been contemplated in many years since the drafting of the document.  In Stephen Covey’s popular management book, he discussed the seven habits of highly effective people.  In this post, we cover seven factors of a highly effective buy-sell agreement for auto dealerships and also touch on several other considerations.1) Standard of ValueThe standard of value establishes the parameters for how the auto dealership will be valued.  It should be clearly defined and give clear indications for how the participants in a hypothetical transaction should be viewed:  buyer, seller, motivations, knowledge of facts, etc.  The most common standard of value is fair market value and is generally defined as a hypothetical buyer and a hypothetical seller both having reasonable knowledge of the business and all relevant factors and neither being under any compulsion to buy or sell.The other most common standard of value in buy-sell agreements is fair value.  Simply put, fair value is fair market value without consideration of any applicable discounts for lack of control and lack of marketability for the subject interest.  Fair value is often used in legal proceedings.  The difference between these two standards of value and the lack of clarity in defining which standard is governed by a company’s buy-sell agreement is often the impetus to litigation.2) Level of Value Level of value is a valuation concept describing the differences between various “levels” of a company’s value. Levels of value can include financial control, strategic control, marketable minority interest, and non-marketable minority interest.  Each level has a distinct difference in the amount of control one can exhibit over the operations of a business and/or their ability to sell an interest in that business.  For the layperson, the levels of value ultimately dictate whether premiums or discounts would be applied to the subject interest being valued.3) Define Triggering Events If the goal of a buy-sell agreement or governance document is to provide a roadmap for the valuation, then it’s important for these documents to define the events that will be governed under their parameters. These events are often referred to as triggering events and can include the death of an owner, termination of an owner, divorce, change of control, etc.  By defining the triggering events, it will be clear when the document will be enacted and enforced and when it will not apply. For example, selling or gifting a minority interest in the business to future generations is not likely to be a triggering event in this context and almost certainly would not be valued at anything besides the nonmarketable minority level of value.These events can also have unique ramifications on auto dealerships.  For example, each franchised dealer has a dealer principal that has to be approved by the manufacturer.  The death or divorce of a dealer principal can also pose challenges as the transferability of that interest and title of dealer principal is not guaranteed and cannot occur without approval from the manufacturer.4) Avoid Formula Pricing Often these documents contain a formula or a methodology to value the business.  The formula might consist of the applicable financial information to consider and the multiple to apply to those metrics to determine the value.  At the time of the drafting of the buy-sell, these formulas might establish the shareholder's perceived value of the business.  If considerable time has passed between the drafting of the document and the triggering event, these formulas and concluded values could be stale and outdated. As we’ve previously discussed in this space, the auto dealership industry is unique from a valuation perspective.  Traditional formulas such as EBITDA multiples often utilized in other industries are not as informative in this industry.  The drafting attorney may not be as familiar with the nuances of auto dealership valuation.  Even if an industry-appropriate metric, such as a Blue Sky multiple or formula is used, it is likely be dated in a short period of time.  National auto brokers (Haig Partners and Kerrigan Advisors) publish and update these Blue Sky multiples by manufacturer quarterly. As we’ve seen during the COVID-19 pandemic, operational conditions and perceived franchise values can change both quarterly and over a longer time horizon.  Additionally, dealerships could evolve over time and acquire or divest of different franchises that could drastically change their operations and perceived value.Finally, what adjustments are to be considered? Even if a buy-sell agreement has language providing for a multiple to be updated with the current market environment, significant one-time or non-recurring income or expense items can inflate or depress value.5) Specify Valuation DateThe buy-sell agreement should explicitly define the date to be used for the valuation. Typically, the date of valuation would be at or near the triggering event depending on its proximity to the timing and availability of current and reliable financial information.  A proper valuation should consider what is reasonably known or knowable as of the date of valuation.  Any ambiguity in defining the valuation date or the financial information to be used could have a significant impact on value.  Since franchised auto dealers must submit monthly financial statements to the manufacturer, an appropriate valuation date might be set to be the month-end prior to the triggering event.6) Defining Appraiser Requirements Who should perform the valuation?  Often buy-sell agreements will utilize language such as a “qualified appraiser” and may even include certain valuation credentials such as an Accredited Senior Appraiser (ASA), someone who is Accredited in Business Valuation (ABV), or a Certified Valuation Analyst (CVA) from national valuation accrediting organizations.  Since the auto dealership industry is so unique, these credentials may not be enough.  Should your buy-sell agreement also require that the appraiser have specific industry experience?  Finally, independence is key.  We recommend selecting a third-party valuation firm with experience in valuing auto dealerships so that the appraiser will be qualified and unbiased.7) Make It a Living Document How often does a company have a buy-sell agreement or governance document drafted only to be placed in an electronic file, a desk drawer, or a file cabinet and never reviewed or contemplated again? The value of an effective buy-sell agreement is to provide a roadmap for how to value the dealership at a triggering event.  If the document was never used since drafting, can it be reliable?Effective buy-sell agreements are not only drafted, but they are utilized.  Some require ongoing valuations at annual anniversaries or other timeframes to provide the owners with a value indication that could be used for strategic planning or contemplation of an upcoming triggering event.If the document didn’t clearly contain the items in this post and was never used since drafting, it could create confusion leading to litigation or the buy-sell agreement could be ignored in an eventual litigation. Frequent use or at least consideration of the terms considered in the document are likely to be much more relevant in a litigation context.Conclusion and ConsiderationsAn effective buy-sell agreement can provide a roadmap to defining the valuation process through many challenging events during the lifetime of an auto dealership.  As we’ve discussed, the document should contain and clearly define these seven elements, among others, to accomplish that goal.Other considerations to contemplate are the premise of value, funding mechanisms for repurchase, and managing expectations.  The premise of value will establish whether to determine the value of the dealership if it continues as a going-concern business as opposed to liquidation.  Funding mechanisms and repurchase requirements can also dictate the mechanical treatment of certain assumptions in the valuation such as the impact of recognizing life insurance proceeds at the death of an owner to establishing a market for the subject interest that could possibly impact the applicable discount for lack of marketability.Does your auto dealership have a buy-sell agreement or governance document?  When was it drafted?  Who drafted it?  Does it contain and discuss these seven key items?  If it contains formula pricing, would buyers and sellers find the methodology employed reasonable today? These are all items that need to be considered.To discuss the impact of your buy-sell agreement, assist you and your attorney in drafting an effective buy-sell agreement, or determine the valuation of your auto dealership at a triggering event, contact a professional at Mercer Capital today.

Working on your RIA’s buy-sell agreement may seem like a distraction, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately.  Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, your employees, and your clients.If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.1) Decide what’s fair.In our experience, buy-sell agreements tend to function well when they attempt to strike a balance between the interests of the various stakeholders in an investment management firm, including the founding partners, next-gen management, employees, clients, and the firm itself.  By balancing the interests of the various stakeholders, a well-structured buy-sell agreement can be a competitive advantage by facilitating a smooth transition between founding partners and next-gen management.  Ultimately, this enhances value for everyone.2) Define the standard of value.Standard of value is an abstraction of the circumstances giving rise to a particular transaction.  It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions.  We wouldn’t recommend getting creative here.  Unconventional standards of value can and do lead to different interpretations that can result in wildly different conclusions of value.  For most purposes, using one of the more common definitions of Fair Market Value is advisable.  Fair Market Value contemplates a hypothetical willing seller and willing buyer, both of whom have reasonable knowledge of the subject asset and neither of whom are under any compulsion to buy or sell.  This standard has an almost universally agreed-upon definition and is well established and understood in the valuation and legal communities, all of which helps to remove uncertainty as to its valuation implications.3) Define the level of value.Valuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest.  For example, a non-marketable minority interest may be worth less than an otherwise identical controlling interest.  From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value.  Naturally, sellers would prefer a premium and buyers a discount, but it helps to keep in mind that today’s buyers are tomorrow’s sellers, and today’s sellers are yesterday’s buyers.  When transactions are done on a consistent basis over time, it helps to promote a sustainable marketplace for the company’s shares.4) Avoid formula pricing.We often see buy-sell agreements that use a formula to determine value (usually a fixed multiple of a historical performance metric).  These formulas often reflect what the principals of the firm thought the business was worth at the time the buy-sell agreement was drafted.  As market conditions and the business’ economics change, formula prices can quickly diverge from market value, but the ink on the page remains.When it comes time to buy or sell, perhaps years or decades after the buy-sell agreement was drafted, the formula price will inevitably be benchmarked against the actual buyer and seller’s perceptions on the current market value of the interest.  If the formula value is greater than the perceived value, then the selling shareholder may find there are no willing buyers or no reasonable way to finance the sale.  If the formula value is less than the perceived value, then the selling shareholder may be incentivized to hold on to their ownership longer than is optimal from the perspectives of the firm, next-gen management, and clients.5) Specify the valuation date.A buy-sell agreement should be explicit about the “as of” date of the valuation.  Typically, valuations will consider only what is known or reasonably knowable as of this date.  As a result, a difference of just a few days can have a significant impact on the valuation if an unexpected event occurs at the firm.  Consider, for example, the death of a key executive.  Such an event will often trigger buy-sell agreement provisions, and whether or not the event factors into the valuation will depend in part on the valuation date specified by the agreement.  For firms with larger shareholder bases and relatively frequent transactions, it often makes sense to specify an annual valuation date that then applies to transactions throughout the year.6) Decide who will perform the valuation. We recommend selecting a reputable third-party valuation firm with experience valuing investment management firms.7) Manage expectations. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled.  Testing your buy-sell agreement now by having a valuation prepared can help to center or reconcile those expectations and might even lead to some productive revisions to your buy-sell agreement.For more information on RIA practice management issues, register for our upcoming conference, RIA Practice Management Insights. More information can be found below.Early Bird Pricing for the Upcoming RIA Practice Management Insights Conference Ends in 7 DaysMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Take advantage of early bird pricing to receive $100 off conference registration. Offer ends next week.Have you registered yet?

Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Is there a ticking time bomb lurking in your family business?”When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs.   One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.For more information or help with your buy-sell agreement, don't hesitate to contact us.

Due to the historical popularity of this post, we revisit it this week. Originally published in 2016, the purpose of this post is to equip ownership to understand the consequences of their buy-sell agreements before a controversy arises, and to make informed decisions about the drafting or re-drafting of the agreement to promote the financial health and sustainability of their firm.The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. Similar to the one pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then, an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well,” we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties.Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long-term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long-term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules of Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule of thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value,” does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level of value," as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of the other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value.Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts.”Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well-known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience.Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long-term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses. Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one? Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.” Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future. Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business? Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements. Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution? Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements. Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes? Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs.   One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process. Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties. Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses? Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes. Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements? Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!” ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.

Clients writing new buy-sell agreements or re-writing existing ones frequently ask us how often they should have their RIA valued.  Like most things in life, it depends.  We usually recommend having a firm valued annually, and most of our clients usually do just that.  “Usually,” though, is subject to many specific considerations.How many shareholders are there in the RIA?  The more owners you have, the more transactions will occur and the more useful a semi-annual or quarterly valuation might be.  Small firms with only a couple of owners typically don’t need to know their value on an annual basis, but checking in on some scheduled basis – such as every two or three years – is helpful to keep track of firm performance, update any life insurance coverage, and to plan for succession issues or sale of the firm.Is your firm growing rapidly?  If so, an annual valuation might become stale very quickly.  Mature firms probably only need to look at their valuation metrics once per year to see how their performance and outlook compares with the greater market for investment management firms.Even annual valuations can be inadequate, however, when an RIA experiences big increases or decreases in assets under management.  Since we have been operating in a low volatility market (at least for U.S. equities) for some time, it’s easy to forget that normal, but nonetheless major, market swings can have a material impact on profitability and valuation.  In the case of a market swoon, even a mature RIA with healthy margins can lose ground rapidly, and a valuation that looked reasonable six months earlier may no longer be practical.  Consider an equity manager with $2 billion of AUM, realized fees of 60 basis points, and a 40% EBITDA margin.  If the regular annual valuation is prepared at an effective EBITDA multiple of 9x, then enterprise value would come in at around $43 million.One might expect that a valuation such as that would satisfy the needs of an investment management firm over the course of a year, until the time came for the next update.  Markets are fickle, though.  Imagine the same RIA endures a significant market downturn late in the summer, and then an event happens which triggers the buy-sell.  AUM drops 20% versus the start of the year, nothing changes in the expense base, and the valuation multiple is steady.  Because of the inherent operating leverage in the asset management business, the profit margin drops from 40% to 25% on 20% lower revenue, and because of that compounding effect value declines by half. This example has more simplifying assumptions than not, and most firm valuations would not move so dramatically just because of a 20% downturn in AUM.  That said, market events and client whims can have an outsized impact on RIA profits and, consequently, valuation, such that an annual valuation may not hold up over the course of a year. So what’s a firm to do?  One option, of course, is to accept the vagaries of the market – any unusual events during the course of the year may be just as temporary as conditions at the annual valuation date.  One of the functions of the buy-sell agreement is to get the parties to agree to what they are willing to live with, and what they are willing to live without.  Many firms do just that. This brings me to the subject of the photo above.  European rally car races have always fascinated me, although I’ve never been brave enough to actually attend one.  During the 1980s Audi ruled the rally scene with the Ur-quattro.  The Ur-quattro was a hatchback that Audi developed after the racing rules were changed in the late 1970s to allow four-wheel drive.  The Audi could handle anything, and to underscore that point the manufacturer used both Italian (“quattro” for four wheel drive) and German (“Ur” for primordial or original) to name it.  Regardless of snow, mud, gravel, flat curves or deep hills, the Ur-quattro couldn’t be beat.  Audi’s rally reputation was such that they started to offer the quattro system in all of their passenger cars, and all-wheel drive has become commonplace today – from Subaru to Lamborghini. A client of ours that is drafting a new buy-sell agreement recently brought us an idea which we think offers a similar level of preparation for any circumstance.  In their agreement, they’ve added a provision which would call for an interim update to their otherwise annual valuation if 1) the prospect of a transaction arises and 2) AUM is more than 10% higher or lower than at the time of the previous valuation.  The annual valuation is important to set a pattern of expectations for parties to the buy-sell of how they’ll be treated in a transaction, and most of the time will suffice when a transaction occurs.  Adding the update provision is a simple way to prepare for the possibility of substantial changes in the financial performance of the RIA.  Even if they never use the provision, having it offers peace of mind for parties to the agreement that they’ll be treated fairly if the company’s performance changes radically over the course of the year. In the decades since the Ur-quattro was introduced, Audi has sold cars with quattro to millions of people whose morning commute is nothing like a rally race.  Most people buy all-wheel drive cars for that “just-in-case” moment that will make the added expense worth it.  Like all-wheel drive, you may never need an event-based update provision in your buy-sell agreement.  It’s nice to know, though, that your buy-sell is all-terrain ready, no matter how rough the ride gets.

The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. One of the most famous is pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely-held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five figure settlement in some industries is a seven figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well”, we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties:Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules-Of-Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule-of-thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value”, does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level” of value, as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely-held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression. By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts”.Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience:Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

There are roughly 13,000 Registered Investment Advisors (“RIAs”) in the U.S., and each tailors its services to a unique set of clients and maintains an individualized business model. Be that as it may, most who call us face one common issue: ownership succession.Ownership can be the single biggest distraction for a professional services firm, and it seems like the investment management community feels this issue more than most. In Schwab’s 2019 Benchmarking Study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership.Most investment management firms are closely held, so the value of the firm is not set by an active market.They are typically owned by unrelated parties, whereas most closely held businesses are owned by members of the same family.Compared to other industries, a greater-than-normal proportion of investment management firms have significant value, such that there is more at stake in ownership than most closely held businesses.Consequently, when disputes arise over the value of an interest in an investment management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for these businesses.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners.Clients increasingly seem to ask us about business continuity planning—and for good reason.In times of succession, tensions can run high.Having a clear and effective buy-sell agreement is truly imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.

The creation of buy-sell agreements involves a certain amount of future-thinking. The parties must think about what could, might, or will happen and write an agreement that will work for all sides in the event an agreement is triggered at some unknown time in the future. This article addresses the important characteristics of buy-sell agreements that are important for business owners and for attorneys advising them.What Do Buy-Sell Agreements Do?Buy-sell agreements are entered into between corporations and their shareholders to protect companies against disruptive, harmful, or nonproductive owners (including divorced spouses, competitors, disgruntled former employees and the like). They also provide protections for shareholders who may, for any number of reasons, depart the company. The estates of deceased owners need protection, as do shareholders who have been terminated, with or without cause.It is important that buy-sell agreements be entered into while the interests of the parties (the corporation and the shareholders) are aligned, or at least not sufficiently misaligned, that they cannot discuss the business and valuation aspects of their buy-sell agreements. To the extent possible, attorneys should encourage parties to enter into buy-sell agreements or to review their agreements and update them if they are out of date or circumstances have changed.What is known for certain is that once a trigger event has occurred, the interests of the parties (i.e., the buyer(s) and the seller(s)) diverge and agreement over the pricing and terms of necessary transactions can become difficult or impossible to achieve.Characteristics of a Good Buy-Sell AgreementFrom valuation and other business perspectives, buy-sell agreements generally incorporate several important aspects defining their operation. The list of characteristics of successful buy-sell agreements below is taken from my book, Buy-Sell Agreements for Closely Held and Family Business Owners.Require agreement at a point in time (before trigger events or other dissension) among shareholders of a company and/or between shareholders and the company. It may seem obvious, but if there is no agreement between the shareholders and the company, then there is no buy-sell agreement. Such agreements must be evidenced by a writing of the agreement and by the signatures of all parties who will be subject to the agreement. Agreement is not always easy to obtain. Shareholders have different backgrounds, financial positions, personal outlooks, and involvement with a business, so agreement is not automatic. However, it is important that attorneys continue to work with clients to encourage agreement and that business owners remain committed to reaching agreement and signing their buy-sell agreements.The point in time at which agreement is reached is the date of the signing of each particular buy-sell agreement.Relate to transactions that may or will occur at future points in time between the shareholders, or between the shareholders and the corporation.When the shareholders of a new venture come together to discuss a buy-sell agreement, it is foreseeable that many things can happen that will trigger the operation of a buy-sell agreement. Owners may quit, one may be fired, another may retire, one could die, still another could become divorced, and another could become bankrupt — to name a few.The owners can discuss these future potential trigger events and which ones they want to include specifically in their buy-sell agreements. It is important that all owners think seriously about these issues because, at the time a buy-sell agreement is being drafted, no one knows what might happen to him or to her or to any of the other owners. In other words, no one knows who will be a buyer and who will be a seller.When the owners of an existing enterprise come together to review their buy-sell agreement, they may know that some of the above-mentioned events have already happened in the lives of their fellow owners. They will know if the buy-sell agreement operated satisfactorily, or was triggered at all.For all owners of all enterprises, discussions about buy-sell agreements reflect a form of future thinking, which is sometimes (perhaps always) difficult. As Yogi Berra famously said: “The future’s hard to predict. It hasn’t happened yet.”Choices have to be made regarding buy-sell agreements. Ignoring the importance of these documents because it is difficult to future think about them is one choice. Based on over thirty years of working with businesses and business owners, ignoring the issue is not a good choice.Define the conditions that will cause the buy-sell provisions to be triggered. Most often, business owners think of death as the most likely trigger event for buy-sell agreements. It is actually the least frequent trigger event for most companies.Trigger events have to be defined specifically. Death is fairly obvious. However, firings can be with or without cause, and agreements may need to specify what happens in each circumstance. The parties to an agreement must future think a bit to anticipate what could happen and document the agreement appropriately. If this sounds like work, it is.Determine the price at which the identified future transactions will occur (as in price per share, per unit, or per member interest). Because of the diverging interests of parties following trigger events, this is one of the hardest parts of establishing effective buy-sell agreements. This is why many appraisers and other advisers to closely held businesses recommend appraisal with a pre-determined appraiser as a generally preferable pricing mechanism for substantial business enterprises.There are buy-sell agreements with fixed prices. Unfortunately, these agreements are seldom updated and are ticking time bombs. For a poster child example of what can happen with fixed price agreements, read here.Other buy-sell agreements contain formula pricing provisions. Unfortunately, we haven’t seen a formula yet that can reasonably value any company over time with changing conditions at the company, within its industry and markets, in the local, regional or national economies, and in all market conditions and interest rate environments.Then, there are what we call valuation process agreements, which provide for a valuation process to determine the price. Many agreements have an embedded multiple appraiser process which will not be exercised until the occurrence of a trigger event. These agreements, too, are fraught with potential pitfalls.We assert that the best pricing mechanism for most buy-sell agreements of successful closely held and family businesses is a single appraiser process where the appraiser is selected by the parties at the outset and provides an appraisal to determine an agreement’s initial pricing. The appraiser is then asked to provide reappraisals each year (or every other year at most) to reset the price for the buy-sell agreement.Determine the terms under which the price will be paid.Many buy-sell agreements call for the price determined under their terms to be paid by the issuance of a promissory note by the company. Quite often, the price determined by appraisal will be the fair market value of the interest. However, many notes defined in buy-sell agreements are not worth par, or their face amounts, so recipients end up getting less than fair market value for their interests.A promissory note might be worth less than par if it has a below market interest rate for notes of comparable risk. Often, there is no security for promissory notes issued in connection with buy-sell agreements, and no protection against future financings that are subordinated, leaving the promissory note less protected.Provide for funding so the contemplated transactions can occur on terms and conditions satisfactory to selling owners and the corporation (or other purchasing owners). This element is important and often overlooked.Life insurance is often considered as a funding mechanism for buy-sell agreements. One big problem is that the only time that life insurance is received is when an insured owner dies. However, death is the least likely trigger event for most companies. Firings, retirings, divorcings, disabilities, and other things happen with far greater frequency.Funding may come from a promissory note as discussed above. It can also come from outside financing if the company is able to obtain such financing. Sinking funds have their own issues, because a selling shareholder was present while any sinking fund was accumulated, and would likely desire to share in its value.Satisfy the business requirements of the parties. While buy-sell agreements have much in common, each business situation is different, and unique parties are involved. In the end, legal counsel must draft buy-sell agreements to address the business issues that are important to the parties. Clearly, establishing and agreeing on the key business issues and having them reflected in the agreement can be difficult. If the owners do not reach agreement on key business issues, no attorney can draft a reasonable document for the parties.All of the potential trigger events discussed above are business issues (and personal issues) for business owners. Other business issues could include the maintenance of relative ownership between groups of shareholders, the admission of additional shareholders, and other issues that may or not relate directly to potential future trigger events. Some family businesses add clauses in the event of a shareholder’s divorce to preclude the shares from being granted to a divorcing spouse who is not of direct lineal descent of the family.Provide support for estate tax planning for the shareholders, whether in family companies or in non-family situations.One client of many years has a buy-sell agreement and the family has engaged in significant gift and estate tax planning. Several years ago, the gift tax returns of the owners of a client company were audited. Agreement could not be reached with the Internal Revenue Service, and the matter proceeded on a path towards Tax Court. One of the key issues in dispute was whether the buy-sell agreement met the requirements of IRS Code Section 2703 (b). After much discussion and preparation for trial, agreement was reached that the buy-sell agreement withstood the exceptions (subparagraph (b)) to the general rule of Code Section 2703:(b) Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.As part of the preparations for trial, I was asked to render a supplemental report on behalf of Mercer Capital to assist the court in analyzing the relevant shareholder agreements from business and valuation perspectives. Fortunately, the case settled on the eve of trial with agreement that the relevant agreement satisfied the requirements, and with settlement at the conclusions of fair market value issued by Mercer Capital for the relevant years. The issues raised by the relationship of buy-sell agreements and estate planning are important.Satisfy legal requirements relating to the operation of the agreements. Buy-sell agreements must be drafted such that they are legally binding on the parties to them. In addition, agreements must be drafted to comply with laws and/or regulations that may be applicable to their operation. Business owners must rely on legal counsel regarding such matters.Business owners must agree on the business and valuation issues relevant to their buy-sell agreements. However, those agreements must be memorialized by competent legal counsel, who should be involved in the discussions to begin with, together with estate planning counsel, other financial advisers and a qualified business appraiser.ConclusionBuy-sell agreements are business and legal documents that are created in the context of business, valuation and legal requirements. We need to engage in future thinking in order that our agreements will withstand not only the tests of time, but also potential challenges from the Internal Revenue Service.

Detective shows are usually good for automotive product placement, and the 1980s television series, Magnum, P.I., was no exception. It didn't hurt that the show's main character, Thomas Magnum, solved crimes in tropical settings throughout Hawaii, necessitating a requisite number of bikini-clad women sipping Mai Tai's in every episode. But the show's most memorable character was probably Magnum's car, a Ferrari 308. The 308 wasn't the fastest Ferrari of all time; the 3.0 liter eight cylinder motor didn't muster much more than 200 horsepower. It was small enough to have great handling (the seat had to be modified to fit Tom Selleck's 6'4" frame), it had a targa top, and at full throttle it sounded like Barry White eating wasps. With a car like that, a do-gooder role mysteriously funded by an anonymous millionaire, and a very-casual-Friday-everyday dress code, one thing was certain: Tom Selleck had a good job.The closest we get to detective work at Mercer Capital is when we're jointly retained to resolve a shareholder disagreement over a buy-out. Whether we've been court-appointed or mutually chosen by the parties to do the project, we've done enough of these over the years to learn that the process matters as much as the outcome.As a consequence, we've developed some fairly strict procedures for engagements involving buy-sell fights. The backstories for most shareholder disputes in the investment management industry have common themes: long-time partner ends up at odds, usually for economic reasons, with the rest of the ownership and is more or less forced out. There are usually lots of negative emotions on both sides, mistrust, and even impaired careers. The necessity of the buyout is obvious: the ex-partner wants to be paid so he or she can move on, and the remaining partners don't want to share the spoils of ownership (distributions) with their ex any longer than necessary.As the jointly retained appraiser, we're often in the awkward position of serving as judge and jury on the valuation, without the usual protections afforded by a judge or jury (like unlimited indemnification or an armed bailiff). So, like a private detective, we're left on our own to design and conduct an investigation to reach a reasonable outcome. If the process is sufficiently robust and fair, the two parties may not like the result, but they'll have to accept it. Doing so involves focus on a few key issues.Working in a Glass HouseThere is no substitute for transparency. We generally require that all information requested by and shared with us be shared with both parties. We also copy all parties on our communications and request that they do the same. When we conduct interviews with the parties as part of our normal due diligence, we open those meetings to both parties. Typically, the parties agree to not attend each others' interviews so that they'll feel free to speak to us more openly, and inevitably this leads to accusations at some point of our being lied to "in closed door meetings." In reality, no one is blind to the motivations of the parties in a buy-sell dispute, and we usually hear some level of hyperbole from both sides.Separating Fact from OpinionLike any valuation engagement, we start with an information request to get the basic facts of the situation: financial statements, regulatory filings, organization charts, strategic plans, etc. Then we interview the parties, and (frequently) get very different interpretations of those facts. It is not unusual for both sides to have very earnest, if diametrically opposed, opinions of why the facts are the way they are. Squaring those interpretations against what we can discern to be the reality of the situation is part of our job.The Value of Client ReviewIn a normal valuation matter, we prepare a draft report for client review to make sure we understand key elements of the enterprise being valued. In the case of a shareholder dispute, this review process is more structured. We usually have both parties review our work product independently of each other and give a written review that is distributed to us and the opposing party. Then we allow the parties to comment (also in writing) on each other's review. Our expectation is that knowledge of this cross-review process will dissuade the parties from misconstruing issues in their initial comments on our draft. That doesn't always work, but at least we have the benefit of both perspectives before we issue a final report.Economic IndependenceA client in one of these matters told us that he had heard jointly retained appraisers tended to favor the firm over the ex-partner (he was an ex-partner). I haven't heard the same thing, but it's easy to be accused of bias. One of the ways we guard against this is by structuring the engagement such that it is clear our payment is not contingent on the outcome. We start the engagement with a retainer that is applied against the final billing and stipulate that bills be paid current before we release a draft report or a final report. This assures both parties that we're not in anyone's back pocket and that we have the economic freedom to express the opinion of value we think is appropriate.No Man Can Serve Two Masters…Suffice it to say, we've learned a lot of this the hard way. It's no fun to be the punching bag between former partners who no longer want to have anything to do with each other, and business divorces are among the most fractious engagements we find ourselves in. But it doesn't help matters for us to offer to make someone else's problem our problem. Our kind of detective work involves sticking to a disciplined process that is respectful of the facts and allows both parties to openly participate. Unfortunately, it doesn't involve much intrigue, car chases, or hair gel – which probably explains why so few television series are about finance.Tom Selleck on the job as Thomas Magnum | Photo Credit: Magnum Mania!

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 DateIn 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 AppraiserObviously, 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 ValueIf 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 PremiumsUsually, 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 PracticeEven 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.

The 1970s weren’t too kind to the auto industry. Between the OPEC oil embargo, new environmental regulations and disco, automotive design mostly devolved into underpowered, uninspired boxes. One noteworthy exception to all this was the Pontiac Trans Am. Neither boxy nor underpowered, the Trans Am was a hot mess with a huge motor that overpowered the car’'s weak brakes and lousy handling. All in all, though, it worked. From the driver's seat, you could forget all about the "malaise" while you stared up at the sky through the T-tops or across the giant decal of a flaming bird on the hood. As GTs go, it was no Aston Martin, but it was good enough to help Burt Reynolds smuggle a semi full of Coors across the southeast in Smokey and the Bandit.What was a perfect statement about America in 1977 is not so applicable today. Almost 40 years later, Burt Reynolds is still around, but Pontiac isn't, and people are more likely to cross state lines to buy craft beer than Coors. It's a point worth remembering when thinking about how to value your RIA for purposes of a shareholder agreement: times change.A recurring problem we see with buy-sell agreements are pricing mechanisms that are out of date. Usually, this shows up in the form of some kind of rule of thumb valuation metric that is no longer market relevant. We've also seen buy-sell agreements that cite standards of value that don't exist in the modern valuation lexicon, and even some that specify appraisers from firms that no longer exist.Keeping the language in your agreement up to date is important, but the most reliable way to avoid some unintended consequence of your buy-sell agreement is to have a pricing mechanism that specifies a regular valuation of your RIA's stock. An annual valuation accomplishes a number of good things for an investment management firm, but the main one is managing expectations.If your ownership sees a set of consistently prepared appraisals over the course of several years, they know what to expect. By this I mean there is some level of agreement over who is to provide the valuation, what information will provide the basis of valuation, and how the valuation itself will be constructed. This doesn't guarantee that everyone will be satisfied with the conclusion of value, and our experience is that partners in investment management firms often have differing opinions of the value of an RIA. Some difference of opinion is to be expected, but the process of having a regular valuation prepared by an independent party can go a long way toward narrowing that difference of opinion. If there is little difference of opinion over the values at which ownership in a firm transacts, there will be little incentive to litigate when a sizable transaction comes along.Recommending an annual valuation may sound a little self-serving and, indeed, doing that sort of work is good business for us. We also handle dispute resolutions for shareholder disagreements, however, and the cost of that work is never less than several times the cost of an annual appraisal – not to mention substantial legal fees and the immeasurable cost of management distractions. All in all, we would rather dispense the ounce of prevention than the pound of cure.P.S.: There is an updated edition of the Trans Am available.

In 1961, Jaguar stunned the automotive community by adapting its highly successful D-type race car, which had won the 24 hours of Le Mans three consecutive years in the late 1950s, to create the E-type road car. The E-type was instantly acclaimed. It had everything you could ask for in a sports car at the time: an inline six-cylinder motor that powered it to 60 mph in under seven seconds, monocoque construction, disc brakes, rack and pinion steering, independent front and rear suspension, and a top speed of over 150. Most importantly, it was gorgeous. Enzo Ferrari himself said it was "the most beautiful car ever made."No one ever said a particular buy-sell agreement was the "most beautiful" ever written (even in our office), but some are better than others. And, like a good sports car, you can break down the key elements of a buy-sell agreement that must be there for the agreement to be successful. The first hurdle to clear is for the buy-sell agreement to specify that the company is to be valued within reasonable parameters appropriate to the situation. We don't see many shareholders' agreements in the RIA community relying on "rule-of-thumb" like multiples of revenue or AUM – probably because, while simplicity is appealing, it's too easy for that kind of high level analysis to create unintended winners and losers in a buy-sell action.But that begs the question: if an asset manager's buy-sell is going to specify reasonable expectations for the value of the firm, what are they? We think there are at least four.1. A Buy-Sell Agreement Should Clearly Define the "Standard" of ValueThe standard of value is an important element of the context of a given valuation. We think of the standard of value as defining the perspective in which a valuation is taking place. Investment managers might evaluate a security from what they think it's worth (intrinsic value) as opposed to its trading price (market value) and make an investment decision based on that differential.Similarly, valuation professionals such as our squad look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The standard of value is so important, it's worth naming, quoting, and citing specifically which definition is applicable. The downsides of not doing so can be reasonably severe. Take, for example, the standard of "fair value." In dissenting shareholder matters, fair value is a statutory standard that can be very different depending on the legal jurisdiction. By contrast, fair value is also a standard of value under Generally Accepted Accounting Principles, as defined in ASC 820. GAAP fair value is similar to fair market value, but not entirely the same. In any event, it pays to be clear.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional writing on the implications of the standard, and thus makes application to a given buy-sell scenario more clear.2. Unless it is Clarified, There will be Costly Disagreement as to "Level of Value"Investment managers in publicly traded securities don't often have reason to think about the "level" of value for a given security. But closely-held securities, like common stock interests in RIAs, don't have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be "winners" and "losers" in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm's length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. 3. Don't Forget to Specify the "As Of" Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to avoid confusion), then the date might be the calendar year end. Consider whether you want the event precipitating the transaction to factor into the value? If not, maybe the as-of date should be the day before the event. Or maybe it matters that, say, a given shareholder died or otherwise left the organization, and it's worth considering the impact of the departure. If that's the case, then maybe the appropriate valuation date is the end of the fiscal year following the event giving rise to the transaction.This blogpost doesn't begin to name all of the reasons that specifying an "as-of" date matters to the appraisal, but you get the idea.4. Appraiser Qualifications: Who's Going to be Doing the Valuation?Obviously, you don't want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of "valuation experts" and "industry experts."Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated matters Industry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industry In all candor, there are pros and cons to each "type" of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor was absurd. The company had hired a reasonably well known valuation expert who wasn't particularly experienced in valuations in the RIA community. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value – much to the delight of his client. The departing shareholder, by contrast, hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company's appraiser. We were brought in to make sense of it all. The buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to consider the ins and outs of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you shouldn't have to explain your business model in the process.Final ThoughtsI'll cover in a later blogpost how the appraisal process itself works, and the considerations above are by no means meant to be exhaustive. But when you consider just these four elements, you can see how ambiguity in a buy-sell agreement can be highly disruptive at an investment management firm. While we do occasionally advise clients on setting up shareholder agreements, more often we are called in when an "agreement" is in dispute. We'll cover one such story in next week's blogpost.

Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.The Ideal Time to Review Your Buy-Sell AgreementThe time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.Things to Look for When Reviewing Your Buy-Sell AgreementAs you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.Fixed Price Agreements Are Typically Never UpdatedFixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.Formula Agreements Often Outgrow Their FormulaFormula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?Valuation Process Agreements Are Often the Most WorkableBuy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.We suggest a Single Appraiser - Select Now, Value Now process. For more information on this valuation process, see this article.Six Things That Should Be Clear in Any Valuation Process AgreementRegardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.Standard of value. The standard of value is the identification of the type of value to be used in a specific valuation engagement. The proper identification of the standard of value is the cornerstone of every valuation. Will value be based on “fair market value” or “fair value” or some other standard? The parties to the agreement should select that standard of value. If they do not, the appraisers will have to select it and the parties may not like their choices.Level of value. Will the value be based on a pro rata share of the value of the business or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process and to the shareholders of any business who are parties to its buy-sell agreement. If knowledgeable choices are not made by the parties to the agreement, someone else, i.e., the appraiser(s), will make it for them. The problem is that many agreements are written such that they are subject to differing interpretations regarding the appropriate level of value.The “as of” date. Every appraisal is grounded at a point in time. That time, referred to as the “as of date” or “valuation date”, provides the perspective, whether current or historical, from which appraisals are prepared. Unfortunately, some buy-sell agreements are not clear about the valuation date which should be used by appraisers. Because value changes over time, it is essential that the “as of” date be specified.Qualifications of the appraiser(s). If the parties do not decide on the kind of appraiser(s) they want to help for their buy-sell agreements, then, unfortunately, almost anyone can be named by either party to the agreement. Do you want a college professor who has never done an appraisal as the appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? How about a shareholder’s brother who has an MBA but has never valued a business before? The picture is clear. Buy-sell agreements must specify the qualifications of appraisers who may be called when trigger events happen.Appraisal standards to be followed. It is in the interest of all parties to ensure that selected appraiser(s) follow accepted business valuation standards. Some buy-sell agreements do this by naming the specific business appraisal standards that must be followed by the selected appraiser(s). Business appraisal standards provide minimum standards (criteria) to be followed by business appraisers in conducting and reporting their appraisals.Funding mechanisms. The funding mechanism is thought of separately from valuation yet is an important aspect of any buy-sell agreement. Why? Because life insurance is often purchased on the lives of one or more owners of companies having buy-sell agreements. Does the agreement tell the appraisers how the parties want the proceeds to be treated in their valuations? Appraisers will develop potentially widely divergent valuation conclusions depending on whether the life insurance is a funding vehicle (and not considered in reaching a value conclusion) or a corporate asset (and added to value prior to determining price for the agreement).A Tool to Help in Reviewing Your Buy-Sell AgreementBuy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.