A business valuation can reward years of work and commitment by timely determining the proper value of an interest to a withdrawing equity holder. It can also end in years of dispute in the courts with former business partners vying for advantage. This article reviews several factors involved in buy-sell agreements and how they affect dispute resolution.
Business valuation disputes arise in many different contexts. Whether it is upon the death of a shareholder triggering a buy-sell provision, the removal of a minority shareholder from participation in the business, the withdrawal of a partner who wants to go his/her separate way, or some other variation, the goal is to obtain a valuation in a reasonable period of time on which all sides can agree. Failing that, a neutral (judge, arbitrator, mediator) may help in the process.
Attorneys are regularly involved in this process because of their experience in dealing with the numbers, legal issues and, more importantly, the parties in conflict. There is, however, always a support team needed to assist in the process, foremost among them the appraisers and accountants who work the numbers.
If the parties have planned ahead, there will be an agreement on how the valuation and division of interests will take place in a parting of ways. If not, a dispute resolution provision, or possibly a statute, may provide a means by which an equity-holder may exit and receive value, but this involves the costs of utilizing the judicial system. It is far better for the parties to map their own path, of course, and counsel is available to assist with this kind of planning.
1. Agree to Valuation Price
The simplest arrangement may be where the parties have agreed to a valuation price, for example on an annual basis, which avoids even the need to get a bookkeeper involved, let alone accountants and appraisers. However, in one recent case, the parties agreed to a price when they signed their original agreement, but that was 20 years prior. The valuation was not updated annually, as agreed, and years of litigation ensued after a court refused to enforce the stale numbers. In re Grande’Vie, LLC, 93 A.D.3d 1281 (4th Dep’t 2012).
In another case, the parties agreed in a buy-sell provision that the valuation would be “book value” as determined by the company’s regular bookkeeper. This resulted in a low number for the selling shareholder, and though there was some minor skirmishing over the appropriate rate of depreciation, the matter was quickly concluded.
2. Agree to Who Will Appraise
An appraisal can be delegated to the company bookkeeper, or to another who is trusted by those who have put the business together, but parties must be careful that the designating language is clear and unequivocal. In one recent case, purchasing members attempted to force a valuation by their selected appraiser, who did not take input from the seller, an estate, but the courts held that the selection process was flawed and ordered a hearing. Id.
Different appraisers apply different criteria to valuations, or may have limitations on appraisal ability. A Member of the Appraisal Institute (“MAI”), experienced in real estate valuations, may not be suited to value the business operating on the real estate. An American Society of Appraisers (“ASA”) appraiser may feel obliged to apply discounts to the valuation not found in the buy-sell agreement, but then face tough cross-examination on presentation. It is important to determine what appraiser or bookkeeper is best under the circumstances involved. It is also important to establish a back-up plan for selection of a substitute, in case the designated appraiser/bookkeeper is unavailable.
3. Agree to Method of Appraisal
Parties to buy-sell agreements can specify the basis for a valuation, e.g., “fair value” or “fair market value.” Valuing assets at “fair value” or “fair market value” can carry much different meanings. What formula is to be used, for example, where the parties refer to “fair value” in an agreement made 20 years ago? A reference like this in a recent case sent the attorneys to research publications of the ASA to determine the definitions as of the date of the agreement (20 years ago).
Generally speaking, a “fair value” valuation may be more favorable to the selling party. See Friedman v. Beway Realty Corp., 87 N.Y.2d 161, 167 (1995). In a recent case, Phillips Lytle LLP argued (successfully) that the “fair market” language of the agreement meant that no minority discount should be applied, resulting in the avoidance of a substantial discount.
4. Agree to Controlling v. Non-Controlling Interests and Marketability
In valuing a business interest, it is important to distinguish between a controlling interest and a non-controlling interest. In the latter case, substantial discounts may apply to the valuation. A minority discount can have severe consequences on the valuation. The buy-sell agreement can define whether a valuation should apply a minority discount.
There is also a marketability discount that may be applied. One expert recently testified that if an interest cannot be sold within three days on the market, then it suffers from lack of marketability and should be discounted accordingly. There is a big difference, of course, between shares that are traded on the New York Stock Exchange, as opposed to shares in the family business that have never been offered to the public. Such discounts can range up to 30% of valuation.
But should a marketability discount be applied if the entity’s principal asset is real estate? It is well known that it takes time to market and sell real estate. A school of thought holds that under such circumstances, no marketability discount is appropriate because of the nature of the asset. See Vick v. Albert, 47 A.D.3d 482 (1st Dep’t 2008), a theory Phillips Lytle LLP successfully employed in a recent valuation trial.
5. Plan Ahead
The best practice is to create agreements that cannot be misunderstood when it comes to the process of withdrawal of an equity holder, and the best time to do the exit-planning is when the parties are entering into their business agreement. Having said that, if a dispute arises, there are a number of approaches that can be applied to try to resolve a dispute expeditiously and successfully.