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Wednesday, April 26, 2017 Noon–1 p.m. 1 General CLE credit Buy-Sell Agreements and Business Valuation

Buy-Sell Agreements and Business Valuation · Buy-Sell Agreements and Business Valuation8 `Fair market value CUsually, the value of the company as a whole, less discount for lack

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Page 1: Buy-Sell Agreements and Business Valuation · Buy-Sell Agreements and Business Valuation8 `Fair market value CUsually, the value of the company as a whole, less discount for lack

Wednesday, April 26, 2017 Noon–1 p.m.

1 General CLE credit

Buy-Sell Agreements and Business Valuation

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iiBuy-Sell Agreements and Business Valuation

BUY-SELL AGREEMENTS AND BUSINESS VALUATION

The materials and forms in this manual are published by the Oregon State Bar exclusively for the use of attorneys. Neither the Oregon State Bar nor the contributors make either express or implied warranties in regard to the use of the materials and/or forms. Each attorney must depend on his or her own knowledge of the law and expertise in the use or modification of these materials.

Copyright © 2017

OREGON STATE BAR16037 SW Upper Boones Ferry Road

P.O. Box 231935Tigard, OR 97281-1935

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TABLE OF CONTENTS

Faculty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Presentation Slides . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

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ivBuy-Sell Agreements and Business Valuation

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vBuy-Sell Agreements and Business Valuation

FACULTY

Paul Heidt, Morones Analytics LLC, Portland. Mr. Heidt serves as the Director of Valuation Research and provides business appraisals and lost earnings analysis, as well as general and litigation research. He has worked on business valuations for different purposes including transactions, gift and estate tax, reorganizations, marital dissolution, litigation, and succession planning. He is a member of the American Society of Appraisers and is an Accredited Senior Appraiser (ASA) in Business Valuation. Mr. Heidt previously served as managing editor for Economic Outlook Update, a quarterly economic publication used in appraisal reports and books contributing to the body of knowledge in the business valuation profession.

Alina Niculita, Morones Analytics LLC, Portland. Ms. Niculita specializes in business valuation and business valuation litigation support. She has worked with businesses from many industries and of all sizes on matters including transactions, buy-sell agreements, gift and estate tax, marital dissolution, bankruptcy, reorganizations, ESOP, financing, and intangible assets and personal versus enterprise goodwill. She is a member of the CFA Institute and the American Society of Appraisers. She is a Chartered Financial Analyst (CFA) and Accredited Senior Appraiser (ASA) in Business Valuation and holds two Master of Business Administration degrees, from the Joseph M Katz Graduate School of Business at the University of Pittsburgh and the Czech Management Center in Celakovice, Czech Republic. Ms. Niculita has authored or coauthored several business valuation articles, book chapters, and books, including (with Shannon Pratt) The Lawyer’s Business Valuation Handbook, 2nd edition, published by the American Bar Association. She has spoken on business valuation topics to various audiences.

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1Buy-Sell Agreements and Business Valuation

Prepared by Alina Niculita, CFA, ASA, MBA

Paul Heidt, ASAMorones Analytics, LLC

Most of your clients who have multi-owner businesses or practices have existing buy-sell agreements

If they do, in most cases, they can be improved

If they don’t, they should

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If you have a copy of your client’s buy-sell agreement on file, review it in light of this presentationIf not, or if you think the agreement needs revision, call your client

If the client has an agreement, suggest sending it to you for review

If the agreement needs revision, suggest revising it

If the client does not have an agreement, suggest that you draft one for them

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Buy-sell agreements are contracts between companies and their owners

Buy-sell agreements define what will happen with the owner’s interest when certain events occur

Called trigger events

These events may be separations from the company, disability, or divorce

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Entity purchase agreementsThe company buys the interest from the departing owner

Unless the entity resells the interest, the proportionate interests of all the remaining owners are increased

Cross-purchase agreementsOne or more individuals or entities buys the interest from the departing owners

These can become very complex as the number of owners increases

5

Hybrid agreementsCan take on a variety of forms

Usually give the entity the first right of refusal to buy the interest of the departing owner

If the entity declines, the interests usually are offered to other owners, generally, but not always, on a pro rata basis

If the other owners decline, the entity may still buy the shares

It may or may not be binding on the entity to purchase if others decline

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Minority owners have the right to sell on the same price and terms if the controlling owner sells

Gaining popularity in recent years

A company may even require that minority interests be sold when a buyout occurs

Most buyers want to buy 100% of a company, not acquire minority owners who could be a nuisance

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Fixed priceParties may agree on a fixed price at which the ownership interest will be purchased

There should be a provision for updating

Perhaps between or among the parties

Preferably by an appraiser every year or two

FormulaAlmost impossible to create a formula that will be fair to all parties at the time of the triggering event

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Negotiation among parties

Provide for a periodic meeting (usually annual) among the parties to agree on a price that will prevail for a defined period of time (usually a year) if a triggering event occurs

Need a provision for how the value will be determined if the parties cannot agree on a price or if they fail to meet

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Shotgun agreements

The party can offer to buy (or sell) ownership interests to another party and the other party has the right (or obligation) to sell (or buy) the interest at the price offered

Independent outside appraisal

Can be by a single appraiser or a panel of appraisers

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We highly recommend that you retain a business appraiser at the drafting stage of the buy-sell agreement

Usually several hours

May pitfalls can be avoided by gaining the insight of those who have dealt with resolving the valuations under many diverse wordings of buy-sell agreements

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We also recommend that the appraiser be present at the signing of the buy-sell agreement to answer questions about the valuation provisions

Not only parties to the agreement, but also spouses should be present at the signing meeting

Helps to make sure all parties to the agreement understand the implications of the valuation language going into the agreement

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Standard of value

Level of valueMinorityProportionate share of enterpriseDepends on triggering event

“As of” date

Appraiser qualifications (if outside appraisal)

Definition of triggering event

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Strategic valueThe price one could expect to achieve selling a buyer with synergies

CompetitorCustomerSupplier

Also known as acquisition value

Fair valueThe value of a company as a whole, without any discounts for lack of control or lack of marketability

Also known as control value

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Fair market value

Usually, the value of the company as a whole, less discount for lack of control and lack of marketability

May buy-sell agreements use the term “fair market value” without some or all of the parties realizing that means discounts from a pro rata value of the company as whole.

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The date as of which the interest is to be valued

Values of companies and interests in them can change drastically, even in short time

Internal and external factors

Common to have “as of” date the date of the triggering event

For convenience, the “as of” date should be set on a date when financial statements normally would be prepared

End of the month prior to the triggering event

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Any or all the following events may trigger implementation of the buy-sell agreement:

Death

Disability

Divorce

Severance of employmentSome companies distinguish between quitting and being firedThis distinction could lead to a dispute

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Some buy-sell agreement list exceptions to the previous list

Some buy-sell agreements may distinguish between the terms of the buyout in different circumstances

The company may specify fair value in the case of death

The company may specify fair value less 20% in the case of termination

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If the buy-sell agreement calls for an appraisal, it should specify that the appraiser be qualified

If the buy-sell agreement names the specific appraiser or appraisal firm, it should address the selection of an alternate if the individual or firm is not available

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We recommend that the buy-sell agreement specifies that the appraiser have accreditation from one or more of the following:

American Society of Appraisers: FASA, Fellow of the ASA; ASA, Accredited Senior Appraiser; AM, Accredited Member.AICPA: ABV, Accredited in Business Valuation.National Association of Certified Valuation Analysts: CVA, Certified Valuation Analyst; AVA, Accredited Valuation Analyst.Institute of Business Appraisers: MCBA, Master Certified Business Appraiser; CBA, Certified Business Appraiser.

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If there is to be a single appraiser, he or she may be named in the buy-sell agreement

Most practitioners believe it is preferable to name a firm rather than individual

Higher likelihood of the individual being unavailable when the triggering event occurs

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If firm or individual is unavailable, there needs to be a process by which an appraiser can be chosen

We recommend the choice being made by a neutral party

Judge

State’s corporation commissioner

Head of a regulatory body

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If the parties don’t want to name a firm or individual in the buy-sell agreement, a common procedure is to have each side submit several qualified appraisers when the triggering event occurs and come to an agreement

May require multiple submissions

Must be a procedure in the agreement to break a deadlock

If a firm is named, it is essential that the lead appraiser is accredited

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Advantages:

Eliminates future uncertainty over the selection of the appraiser

Cost is reasonably known

The selected appraiser can be viewed as independent

The appraiser’s valuation process is seen by all the parties at the outset

A baseline is created

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Advantages continued:

The subsequent appraisals tend to become less time consuming and expensive than other alternatives

The parties should gain confidence in the process

The parties always know the value for the buy-sell agreement (helpful in financial planning)

The appraiser’s knowledge of the company and industry will grow

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Some buy-sell agreements call for two appraisers (one appointed by each side)

A third appraiser may be appointed by the two appraisers if the first two appraisers are apart by some percentage

In most buy-sell agreements, the percentage limit is usually set at 10%

Then the average of the two sets the price

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We suggest the percentage limits be set a little more broadly

15% to 25%

The 10% limit is probably workable for real estate appraisal, but business appraisal is far more complex

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Selection of the third appraiser should be made at the outset of the process

Greater likelihood of a quick agreement at this stage

More contentious later on

Selection of the third appraiser should be left to the sole judgment of the first two appraisers

Making the choice subject to client approval usually delays the process and can cause increased contentiousness between the parties

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The role of the third appraiser variesUsually is provided with access to the work of the first two appraisers

Generally is allowed to contact the first two appraisers

Value arrived at by the third appraiser:Sometimes the final value, or

Bounded by the high and low value of the first two appraisers, or

Averaged with the closer one of the first two appraisers

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AdvantagesProvide a defined structure

All parties know, at least generally, what the process will be in advance

Fairly commonly known and understood by attorneys who know the problems with fixed price and formula agreements

The illusory benefit – the false sense that my appraiser will protect my interest

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Disadvantages

Expensive and time consuming

Price is not determined in advance

Potential for dissatisfaction with process for all parties

Uncertainty over what will happen when a trigger event occurs and the final price

Distracting for management

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The buy-sell agreement should specify how the appraisers are to be paid

Sometimes the company pays the entire bill of the appraisers

More commonly, in a multi-appraiser scenario, each side pays the appraiser it selects and the company pays the third appraiser

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Since the payout may be substantial relative to the company’s normal cash flow, the payment terms may be spread out, usually at the company’s option

The typical payment period is five years, but we have seen payment periods up to ten years

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There may be no interest, but usually there is either a fixed rate of interest or a specified method of setting the rate

The U.S. Treasury rate for the term of the payout period

Moody’s BBB bond index rate

Usually, even if the company elects a payout period, it reserves the right to pay it off sooner

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Unless the company’s articles of incorporation or bylaws contain language as to who can own interests in the company, many buy-sell agreements have language about rights of first refusal

A right of first refusal specifies that, if an owner wants out, before they can sell to a third party, the remaining owners or the company have the right to match the third-party offer

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Normally, the right of first refusal acts to discourage offers because it requires the offeror to keep the offer open for the specified period of time that the right of first refusal specifies for the company or other owners to decide whether to match it

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Every owner does not have to be a party to the buy-sell agreement

For example, it may not be appropriate for a control owner to be a party to the agreement

Passive owners may not be parties to the agreement, or may only be subject to certain triggering events, such as death or divorce

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Ideally, when the buy-sell agreement is first adopted, the price is set by an appraisal, and the appraisal is updated every year or two or when a significant event occurs

AcquisitionLoss of a significant contractMajor business interruption

This often does not happenPrice could then be unfair to one party or the other

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Make sure that the buy-sell agreement does not conflict with other company documents

Articles of incorporationOperating agreementPartnership agreementBylaws

If the buy-sell agreement conflicts with other corporate documents, the articles and/or bylaws will probably prevail

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If the buy-sell agreement is funded with life insurance, it is common to have a lump-sum payment up to the net proceeds realized from the life insurance and extended payments on any balance

If funded by life insurance, the buy-sell agreement would specify whether or not the insurance proceeds are a company asset

Involves substantial tax ramifications and sometimes valuation ramifications

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In a repurchase scenario, the company would the beneficiary

In a cross-purchase scenario, the owners or their estates would be the beneficiaries

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If all the provisions in this presentation have been followed, implementation should proceed smoothly when the triggering event occurs

If a formula price has been specified, either a CPA or a business appraiser should be able to compute the amount of the payment based on the formula

They should be instructed to resolve any ambiguities before staring their computations or appraisals

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The parties should execute engagement letters with the experts specifying that the engagement is in accordance with the buy-sell agreement as of a given date and document specification

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Like most valuation matters, courts are all over the map with respect to the impact of buy-sell agreements in divorce cases

The IRS regulations may have some impact, but we suggest, if this may be an issue, to study the case law in the jurisdiction where the matter is likely to come up

Most professionals advise against leaving any interest in the company to the non-operating spouse

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For estate and gift tax, the buy-sell agreement may be:

Binding for other purposes, or

May be given no weight at all, or

May be given some weight along with other approaches and methods of valuation

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Section 2703 of Internal Revenue Code Chapter 14, enacted October 8, 1990, requires that in order to be binding for estate, gift, or generation-skipping tax purposes, any buy-sell agreement created or significantly modified after that date must meet the following criteria:

It is a bona fide business arrangement

It must not be a device to transfer the property to the natural objects of the transferor’s bounty (such as family members) for less than adequate and full consideration in money or money’s worth

Its terms must be comparable to similar arrangements entered into by persons in an arm’s-length transaction

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All owners have relatively equal interests and all work in the business

The business has one dominant control owner and one or more minority owners who collectively have no control

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All the owners are passive outsiders; none work in the business

Some owners work in the business and others do not

The family-owned business where all or substantially all of the owners are family members

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Call your clients who have interests in businesses or professional practices

Force those that have buy-sell agreements to review them and those that don’t to instigate one

Be sure that all parties to the agreement fully understand its implications and its impact on them

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“Understanding Buy-Sell Agreements,” Hugh Gottschalk, J.D., webinar by Business Valuation Resources, September 12, 2008.

“The Lawyer’s Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony,” 2nd Edition, by Shannon Pratt and Alina V. Niculita, American Bar Association, 2010, pp. 499-500

“PPC Guide to Business Valuation,” 22nd Edition, Fishman, Pratt, and Griffith, 2012.

“The Ten Most Common Mistakes of Buy-Sell Agreements,” Drake, Whiteley, and McDevitt, Journal of Financial Planning, July 1992.

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Questions?

Alina Niculita, CFA, ASA, [email protected]

Paul Heidt, [email protected]

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