BUY-SELL AGREEMENTS and APPRAISALS
Choice of AppraiserA favorite choice for appraiser is the business' accountant because of his ongoing familiarity with the business being valued. This has at least two possible shortcomings: firstly, the accountant may be a perfectly competent accountant but may not be a truly qualified appraiser; secondly, there will be the appearance (if not the actuality) of bias in that the accountant might be expected to favor the purchasing parties as they hold out the prospect of continuing business for the accountant. Therefore, generally it will be desirable to designate an independent third party appraiser. The choice should not be left open because it is likely to become a major battleground for the parties and their attorneys. There will be far less debate at the time the buy-sell agreement is being prepared than there will be when each side's immediate economic fortunes lie in the balance.
Standard of ValueAlso of obvious importance is the standard of value that the appraiser will apply. The usual choice is "fair market value", which is usually defined as the value at which a willing buyer and willing seller, both informed as to the relevant facts of the business, and neither under a compulsion to enter into the transaction, would conduct the transaction. While this is a familiar construct, it is anything but certain in application; there is rarely a defined market of willing buyers and sellers selling businesses identical to the subject business. Consequently, the appraiser will necessarily have broad latitude as to what formulas to apply, what discount and capitalization rates to utilize, what weights to be assigned to differing approaches, etc.
What is Being Valued (Part 1)Discounts and Premiums. The question of "what is being valued" has an apparently simple answer--"the selling party's interest in the business"; but lurking behind that easy answer is the hidden issue of discounts and premiums. If the appraiser literally determines the fair market value of the "selling party's interest in the business", it is likely that the value will not be the seller's percentage of the value of the entire business. If the interest being sold is a minority interest where there is a controlling interest outstanding, large discounts are likely (75% is not unheard of). Even in the case of a 50% interest being sold, some discount will be in order for the lack of control and lack of marketability.
What is Being Valued (Part 2)Conversely, if the interest being sold is a controlling interest, a premium above the percentage interest share might be appropriate. Generally the parties do not want these results; in order to avoid these results, the appraisal provision should require that the business to be valued in its entirety and that the seller is entitled to receive his percentage interest of the entirety.
Issues not (or inadequately) addressed in the appraisal process (Part 1)Even when it is clear that the "entire business" is to be valued, certain issues remain unaddressed or inadequately addressed:
not readily quantifiable risks--risks which are not readily quantifiable (but may well be known to be real), such as environmental risks, product liability risks, general competitive risks, etc., are excluded from the determination of value; standard provisions of the appraiser's retention letter will include disclaimers to the effect that (i) "there are no hidden or unexpected conditions of the business that would adversely affect value" and (ii) the appraiser will not "take into account any and all future environmental considerations and potential liability"; except to the extent such risks are manifested in the cap rate, the effect is to leave the "last guy in" holding the bag with respect to these risks, without an appropriate adjustment to price;
Issues not (or inadequately) addressed in the appraisal process (Part 2)tax posture of business--the appraisal process does not always take into account the tax posture of the business the way the parties might expect; for example, the appraisal process generally ignores the effects of an S election because a hypothetical buyer might not qualify for S status--thus S corporation earnings may be adjusted to reflect a normal income tax at the corporate level; this will probably not be appropriate in the context of a buy-sell transaction of an S corporation closely held business interest;a savvy, arms-length buyer assuredly would pay attention to such matters as the depreciable basis of the assets, the deductibility of payments, etc.
terms of sale--the appraisal process does not generally take into account the specific terms of sale contained in the buy-sell agreement such as seller-favorable financing terms (which would tend to enhance the value) and restrictive covenants (which if unusually onerous, tend to decrease the value)
General Appraisal Approaches (Part 1)Once it has been decided that the appraiser will value the business as a whole, there are numerous questions which arise as to how the appraiser should do that. Typical methodology includes valuing the business on a liquidation basis and as a going concern. The value of the business is deemed to be the higher of the two values.
asset liquidation approach--looks at the value of the constituent assets of the business as if the business were going to be closed and the assets sold off to the highest bidder;
General Appraisal Approaches (Part 2)Going concern value is determine from essentially three perspectives:
market approach--looks at recent sales of businesses similar to that of the subject business; the sales prices of these similar businesses are indicative of the value of the subject business; to the degree that there is a "market" in similar businesses (such as with certain franchises) this approach can be enlightening; however, it may be difficult to find sales which are comparable enough to shed much light
income approach--looks at the stream of income that the business can be projected to generate and then capitalizes it; it is, after all, the income that the business can generate that interests the savvy business buyer
asset cost approach--focuses on the replacement cost of the tangible assets of the business; this approach cannot be used alone as it ignores intangible values
General Appraisal Approaches (Part 3)The appraiser will then weight the values he obtains using these approaches to come to a final going concern value.
The problems arise in the application of these approaches and the broad discretion that they allow the appraiser. Obviously, the market approach involves a good deal of judgment in determining comparability of businesses and adjusting for same; while somewhat less obvious, there is also tremendous latitude with the income approach:
normalization: to apply the income method the appraiser must project what the business' income stream will be; the appraiser will usually base his prognostications on current income; to determine current income the appraiser will normalize income and expense items--i.e., adjust income to reflect expected results (and eliminate extraordinary income items) and adjust expenses (such as salaries, rents, etc.) to bring them into line with market numbers;
General Appraisal Approaches (Part 4)the theory is that an arms-length buyer would eliminate excesses (or be forced to pay full market if there was a bargain element); the problem is that the appraiser will ordinarily seek to do this in an idealized world rather than in the world as it actually exists for the business
capitalization rate: the cap rate should reflect the rate of return necessary to attract capital to investment in the type of business in which the subject business is engaged; a host of risk factors may (should ) be built into this rate; further, the question of whether the lower cap rates (higher multiples) applicable to publicly held companies should be considered; obviously, broad discretion and judgment are called into play in determining the cap rate
Finally, the relative weights to give the three approaches is also largely a judgment (discretion) call.
Miscellaneous Other Issues (Part 1)Earlier appraisals--As part of his information request the, appraiser will typically ask for any prior appraisals that have been done. Such appraisals can be extremely prejudicial (in the same way that prior unreported decisions are frequently very persuasive to a judge). Unless the buy-sell appraisal provisions expressly exclude consideration of same, a party contemplating triggering a buy out can effectively "salt" the mine by having appraisals prepared until one to his liking is produced.
Projections--Also as part of his information request the, appraiser will typically ask for management projections. While management's assessment of the future may be relevant, they may also have been driven by considerations (such as bank loans) separate and apart from an accurate prognostication of the future. Consideration should be given in advance as to whether the appraiser should take these into account.
Miscellaneous Other Issues (Part 2)Ex parte communications--General ground rules for communicating with the appraiser should be established ahead of time. While it is cumbersome, unless a significant degree of trust exists, it might be prudent to prohibit ex parte communications with the appraiser.
Appeal rights--Courts have found that the standards for vacating an appraisal are similar to those required to vacate an arbitration award. Generally, arbitration determinations are subject to attack where the award was procured by fraud, where the arbitrator is guilty of prejudicial acts or where the arbitrator exceeded or "imperfectly executed" his powers. Thus, there will be only limited appeal from an appraisal award. However, the courts have set aside appraisals where the appraiser failed to abide by the strict terms of the appraisal agreement.
A Few Practical (?) Suggestions (Part 1)If parties to a buy-sell agreement are to be well-served by an appraisal mechanism, as onerous as it may be, a substantial effort should be made to design comprehensive guidelines for the appraisal in order to narrow the breadth of the appraiser's discretion. Failure to do so may be tantamount to submitting the valuation to a black box roll of the dice. The guidelines should be tailored to the particular business and the particular parties' needs. The guidelines should be periodically revisited so that they can evolve with the business and the parties.
Appraisers are human and make mistakes. It is therefore advisable to have the appraiser prepare his report in draft so that the parties can submit their comments/critiques before the appraisal becomes "etched in stone"; an appraiser acting in good faith will correct a patent error.
A Few Practical (?) Suggestions (Part 2)To the extent that the appraiser will (predictably and understandably) exclude from the valuation process major unknowns such as environmental risk, it may be desirable to contractually provide for the continued sharing of same by the seller.
In the best of all worlds, the buy out appraisal would be conducted expeditiously in a spirit of openness and cooperation. However, this is often not the case and there can be a significant lapse of time between triggering the buy out and final closing. The buy sell agreement should contemplate who will control the operations of the business during the pendency of the appraisal process--i.e., whether the buyer should be permitted to begin to control his destiny by controlling the business.