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Valuation Issues in Developing and Executing Buy-Sell Agreements

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Page 1: Valuation Issues in Developing and Executing Buy-Sell Agreements

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Valuation Considerations in Developing and Executing Buy-Sell Agreements

WELCOME!

Linkedin.com/company/skoda-minotti

Twitter.com/SkodaMinotti

Facebook.com/SkodaMinotti

Page 2: Valuation Issues in Developing and Executing Buy-Sell Agreements

Valuation Issues in Developing and Executing Buy-Sell Agreements

Robert A. Ranallo, CPA/ABV, JD, CVA, CFFSean Saari, CPA/ABV, CVA, MBA

October 22, 2015

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After completing the session, participants will be able to:

“In the long run, men hit only what they aim at.” – Henry David Thoreau

LEARNING OBJECTIVES

• Draft and review buy-sell agreements with an understanding of the related valuation considerations

• Proactively plan with clients to address valuation-related issues that arise in connection with buy-sell agreements

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“There is no such thing as an absolute value in this world. You can only estimate

what a thing is worth to you.”

Charles Dudley Warner 1829-1900, American Writer

QUOTE OF THE DAY

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• Best practice is for closely-held businesses with multiple owners to have buy-sell agreements in place to govern the purchase and sale of ownership interests

• When an ownership transaction is not imminent, the valuation provisions included in buy-sell agreements are oftentimes not heavily scrutinized, but…

• When an ownership transaction occurs and the buy-sell must be followed, VALUATION is often the most significant issue

OVERVIEW

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There are a number of factors that could trigger a transaction/valuation under a buy-sell agreement:

• Resignation• Retirement• Termination• Disability• Death• Owner discretion

TRIGGERING EVENTS

Unless the business is sold before any of the above occur, the valuation provision of the buy-sell agreement will eventually govern the economics, structure and terms of the transaction.

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Standard of value• Will drive the structure and assumptions used

in valuation

Valuation date• Value may vary significantly based on the

valuation date and what was “known or knowable” at that time

Level of value• Inclusion/exclusion of discounts for lack of

control and lack of marketability can have a material impact on value

KEY VALUATION FACTORS

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Fair Market Value • Most common standard of value (and typically most appropriate

as well)

• “The price at which property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy, the latter is not under any compulsion to sell and both parties have reasonable knowledge of the relevant facts” – Revenue Ruling 59-60

• “Hypothetical willing buyer and willing seller”

STANDARD OF VALUE

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Strategic Value • Value to a particular buyer including potential synergies that may be created

as a result of an acquisition

Another “Defined” Standard of Value• Buy-sell agreements may include a definition of a “non-standard” standard of

value– “Market Value”– “Value”

• Beware of defining a standard of value in the buy-sell agreement rather than relying on Fair Market Value– Standards of value created specifically for buy-sell agreements often have no

basis in financial theory and are not generally accepted in the valuation profession– The definition may be open to interpretation and could result in materially different

conclusions of value depending upon how it is interpreted

STANDARD OF VALUE

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Any number of valuation dates could be assigned in the buy-sell agreement

• End/beginning of year• End of month/quarter immediately preceding

triggering event (most common)• Date of the triggering event• Any date identified in the buy-sell agreement

VALUATION DATE

Be aware that valuation standards prevent an appraiser from considering in his or her conclusion of value any facts that were not “known or knowable” as of the valuation date

Values are not static and will change depending upon the valuation date

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Not all values are created equal – the level of value being determined has a significant impact on value

• Controlling or non-controlling (majority interest vs. minority interest)• Marketable or non-marketable

“Fair Market Value” generally includes consideration of any applicable discounts for lack of control and lack of marketability

Best practice is to specify in buy-sell agreement whether discounts for lack of control, lack of marketability or any other factors will be considered

LEVEL OF VALUE

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Lack of Control• Reflects the potential impairment to value as

a result of a non-controlling ownership interest not being able to control the company and its decisions

– Distributions

– Management/owner compensation

– Management/owner perks

– Major business decisions

– Redemption of the ownership interest

– Liquidation of the company

LEVEL OF VALUE

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Lack of Marketability

• Reflects the impairment to value resulting from the fact that an ownership interest in a privately-held company has no ready market for resale (which creates increased uncertainty, longer holding periods and additional costs to convert the ownership interest into cash)

• Significantly higher discounts applied when valuing non-controlling (minority) ownership interests (compared to controlling ownership interests)

LEVEL OF VALUE

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LEVEL OF VALUEWhat impact does the inclusion/exclusion of lack of control and lack of marketability discounts have?

• Inclusion – Favors buyer– Pro: Provides most accurate indication of

“fair market value” and reflects what the ownership interest could likely be sold for to a third-party

– Con: May allow a controlling owner to obtain additional controlling ownership at a discounted value

• Exclusion – Favors seller– Pro: Allows the selling party to be bought out

at a value that reflects the amount that would be received if the company as a whole were to be sold

– Con: Penalizes the buyer and causes them to pay more for the ownership interest than what a third-party would likely pay for it

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Appraisal

• Valuation prepared by third-party valuation expert

Formula

• Valuation based on formula outlined in buy-sell agreement

Agreed-upon redemption price

• Valuation based on agreed-upon value determined by owners

VALUATION APPROACHES

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Key Considerations• Standard of value / valuation date / level of value• What credentials must the valuation expert possess?• Will the valuation be prepared in accordance with a

particular set of valuation standards?• Will a single-appraiser or multiple-appraiser model be

used?• If a multiple-appraiser model is used, how will the final

value be selected?• How will the valuation expert be selected?• Must the valuation expert be independent from the

company’s accountant?• How will appraisal costs be allocated among the

parties involved?• What level of analysis/deliverable will be required?

APPRAISAL

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Pros• Most accurate value

– Considers current status of business, industry and economy as of the valuation date

– No “winner” or “loser” based on the value/transaction price

• Value should be transparent and understandable to all parties

APPRAISALCons

• Time consuming • Expensive• Can be burdensome if multiple

appraisers are involved

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Key Considerations• Standard of value / valuation date / level of value• Formula should produce appropriate value when

initially established• Metric upon which formula is based

– Revenue– EBITDA– Net Income– Book Value (BEWARE!)– Other financial metrics or rules of thumb

• Does the formula accurately determine equity value (and not an enterprise value)?

• Will the formula be revisited in the future and updated if necessary?

FORMULA

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Cash

Enterprise Value

Debt Value

Equity Value

Market Value of Invested Capital

Reconciling Equity Value to Enterprise Value

FORMULA

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Furnishings

House Value

Debt Value

Equity Value

Total Value of Home

and Furnishings

How the Value of Your Home is an Enterprise Value

FORMULA

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Pros• Often simple to apply• Less expensive to implement and

execute than appraisal• Predictable

FORMULACons

• Changes in business, industry and economy may not be accurately considered

• Difficult to reflect expected growth or decline in the business

• Formulas can get stale as businesses and industries change over time

• If initial formula is not reasonable, the valuation results are likely to be unreasonable in future years

• May differ materially from value that would be determined in an appraisal

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Key Considerations

• Standard of value / valuation date / level of value

• How often will the agreed-upon redemption price be updated?

• Are there any mechanisms in place to ensure that updates to the agreed-upon redemption price are made as required?

• What happens if there has been no recent update to the agreed-upon price before a triggering event?

• How will the agreed-upon redemption price be determined?

• What happens if the parties cannot agree on a redemption price?

REDEMPTION PRICEAGREED UPON

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Pros• Simple to apply (at least in theory)• Least expensive to implement and

execute• Agreement of parties on value

avoids valuation issues

Cons• The agreed-upon redemption

price will likely become stale over time

• Requires agreement of parties to set and update the agreed-upon redemption price, which can be difficult to obtain in practice

• May differ materially from value that would be determined in an appraisal

REDEMPTION PRICEAGREED UPON

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FREQUENCY OF UPDATESNo matter what valuation approach is outlined in the buy-sell agreement, the frequency of the valuation is an important consideration

• Beginning/end of the each year (best practice)• Some other specified time period• Upon triggering event

Frequency of updates impacts each of the valuation structures in buy-sell agreements

• Appraisal – What valuation date will be used?• Formula – How often will formula be updated?• Agreed-Upon Redemption Price – How often will

the owners need to agree on a redemption price?

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Who will acquire the selling party’s stock?• Other owner(s)• Company• Some combination of other owner(s) and the company?

Treatment of life insurance proceeds• Included or excluded in the value of the business?

OTHER CONSIDERATIONS

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LIFE INSURANCE EXAMPLENo Insurance Proceeds Available

Owner A - 50% Owner B - 50%Company Exiting Owner Purchasing Owner

Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$ Insurance Proceeds - - -

Post-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$

Insurance Proceeds Included in Buyout Price

Owner A - 50% Owner B - 50%Company Exiting Owner Purchasing Owner

Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$ Insurance Proceeds 13,000,000 6,500,000 6,500,000

Post-Insurance Proceeds Value 33,000,000$ 16,500,000$ 16,500,000$

Insurance Proceeds Excluded in Buyout Price

Owner A - 50% Owner B - 50%Company Exiting Owner Purchasing Owner

Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$ Insurance Proceeds 13,000,000 n/a 13,000,000

Post-Insurance Proceeds Value 33,000,000$ 10,000,000$ 23,000,000$

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1. Get input from a qualified, credentialed valuation expert when drafting buy-sell agreements

2. Define the standard of value, valuation date and level of value

3. Utilize the appraisal methodology for the most accurate value

4. Avoid imprecise language and clearly define the valuation provisions

5. Address how insurance proceeds will be treated in the valuation

SUGGESTIONS/TAKEAWAYS

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SUMMING IT UPAfter completing the session, participants will be able to:

• Draft and review buy-sell agreements with an understanding of the related valuation considerations

• Proactively plan with clients to address valuation-related issues that arise in connection with buy-sell agreements

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“It’s the little details that are vital. Little things

make big things happen.”

– John Wooden

CLOSING QUOTE

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QUESTIONS?Bob Ranallo, CPA/ABV, JD, CVA, CFFPartnerPhone - (440) 449-6800 x7131Email - [email protected]

Sean Saari, CPA/ABV, CVA, MBAPartnerPhone - (440) 449-6800 x7221Email - [email protected]