If you, a friend, a client, a relative, or anyone you know is a partial owner of a business (partner, shareholder, member), it is only a question of time before they have a "trigger event." What exactly is a "trigger event?"
A trigger event is an event that requires the buyout of an owner's interest, an event that, although not always consciously recognized, will certainly occur at some point in time. Examples are:
* Sale of interests
A trigger event, unless specifically addressed in a buy-sell agreement, will often result in litigation, especially if the ownership interest that is being bought out represents a minority interest.
What constitutes a "minority interest?" A minority interest is any interest that does not have full control and therefore also lacks in total marketability. A 50 percent interest, or less, therefore, does not have full control and therefore has limited marketability.
What affect does lack of control and limited marketability have on a business' value? It usually means that the minority business interest is subject to a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). What kind of discounts? They often run as high as 60 percent to 80 percent combined.
Here is one example, in which we establish the the value of a 40 percent interest in a partnership where the 40 percent owner is retiring and there is no buy-sell agreement:
100 percent value of company $1,000,000
40 percent interest $400,000
Discount for lack of control estimated at 30 percent ($120,000)
Discount for lack of marketability estimated at 30 percent ($84,000)
Value of 40 percent interest after discounts $196,000
In the above example the 40 percent interest owner felt he was entitled to 40 percent of the 100 percent value of the business and a lawsuit followed. All of this could have been avoided by a properly prepared buy-sell agreement.
Let's examine buy-sell agreements. In many cases they address germane issues. However, in many cases they do not address practical issues that arise or will arise. They are often prepared by attorneys who resort to Internet boilerplate, but who have little or no experience in business or valuation matters. For example, few owners and attorneys or judges for that matter really understand the concept of fair market value.
Fair market value is defined: "That price which a hypothetical, willing buyer would pay, that a hypothetical willing seller would accept, all parties being in possession of the relevant facts, no party being compelled to act and the business or practice being exposed to the market place for a reasonable period of time."
A number of buy-sell agreements that I've reviewed say the minority owner shall receive "fair market value" with no discounts. Exactly what does that mean? It means that there is a conflict in terms, creates a controversy and sets the stage for litigation.
How could and should this be avoided? The first step is to retain an attorney who is experienced and competent in business and valuation issues, and who will prepare a proper buy-sell Agreement. The next step is to retain a business appraiser who is experienced, certified, and preferably one who is also experienced in business brokerage and transaction making. Both attorney and appraiser should work hand-in-hand to develop the buy-sell agreement. Among the things they should consider:
1. By whom is the business or practice to be valued (a nonqualified accountant, a broker, a banker, your next door neighbor, or a certified appraiser)?
Both attorney and client should understand the various business appraisal designations, the organizations that confer them and what it takes to become certified. They include:
* Institute of Business Appraisers-IBA (highest rating). Designations are Master Certified Business Appraiser, Certified Business Appraiser and Business Valuator Accredited in Litigation.
* American Society of Appraisers-ASA (highest rating). Designations are Accredited Senior Appraiser and Accredited Member.
* National Association of Certified Valuation Analysts. Designation is Certified Valuation Analyst.
* American Institute of Certified Public Accountants. Designation is Accredited Business Valuator.
2. What performance standards should be followed (fair market value, fair value, investment value, liquidation value, etc.)?
3. What professional standards should be followed?
4. How are differences of opinion to be handled (arbitration, third party valuation, etc)? Averaging is a violation of professional standards.
Jerry F. Golanty is president of BizVal of Reno and a Master Certified Business Appraiser certified in litigation support. Contact him at 332-4881 or firstname.lastname@example.org.