Page 9 - Asset Valuation

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Asset Valuation | Monday, May 16, 2016 | S9
ment was an amazing bargain in comparison to many court battles that have been waged challenging the validity of agreed upon valu- ation methods (or fighting the outcome or circumvention of such agreed upon methods on equitable grounds) with millions of dol- lars at stake.
What types of valuation methods are typi- cally used and what are the advantages or disadvantages of such methods for differ- ent types of businesses? The following sum- marizes certain conventional methods that are used to determine the purchase price for buy-sell arrangements and certain relevant considerations for closely held corporations:
Appraisal
The appraisal method is valuation by an independent third party (or multiple third parties, e.g., seller selected appraiser, buyer selected appraiser and third mutually select- ed appraiser).
Advantages:
• Objectivity (of the appraiser)
• Expertise
• May provide the most supportable valu-
ation if the company anticipates a challenge or objection
Disadvantages:
• Time consuming (if annual or periodic outside appraisals are not regularly done)
• Expensive
• Depends upon estimates and assump- tions for projections based on historical trends and expected future results that may be disputed
• Gathering appropriate market compari- sons and benchmarks
• Subjective determination of key inputs such as discount rates
Special Considerations:
• Early-stage and technology-focused com- panies may be difficult to appraise using tra- ditional financial metrics and the technical requirements to evaluate such companies may also prove challenging and also raise confidentiality concerns about key know-how and intellectual property
• Best suited for companies with lengthy operating history or value tied to specific assets with a more readily identifiable market value, e.g., securities or real estate
Formula
The formula method utilizes predeter- mined calculated values, generally based on accounting measurements, e.g., book value, sales, eBIT, eBITdA, net income, asset values, etc., or formulas or metrics special to a par- ticular industry, e.g., oil and gas reserves, or some combination of the foregoing.
Advantages:
• Certain and predictable in advance (if funding is needed to consummate)
• Quick calculation
• Inexpensive
• Can be structured to be similar to criteria
that would ordinarily be considered by an outside purchaser, e.g., 5x eBITdA
• Generally correlates to the financial con- dition of the business
Disadvantages:
• Accounting measurements are inherently backwards looking and business prospects differ materially
• Static, e.g., market conditions for actu- al transactions may no longer support the agreed upon 5x multiple
• Depends upon accounting estimates, poli- cies and assumptions that may be disputed • Susceptible to challenge if patently unfair
Special Considerations:
• Regular mandatory review (and revision, if deemed necessary) of accounting measure- ments selected versus terms of actual compa- rable transactions is strongly recommended to verify the result is arguably close to fair market value
• Best suited for companies with lengthy operating history in established industries with publicly available market information
Internal Agreed Upon Value
With Internal Agreed Upon value, each owner (or a predetermined percentage of owners) periodically agree upon the value of each share, which is often coupled with a “back-up valuation” based on a formula method to take effect if an agreed value has not been adopted within a certain period of time (usually 18 months).
Advantages:
• Mutual agreement of owners
• Certain and predictable within the “lookback” period (if funding is needed to consummate)
• Quick calculation
• Inexpensive
• Evolves over time with the expectations
and views of the owners
Disdvantages:
• Failure to reach agreement
• Time consuming (if annual or periodic agreements are not regularly reached)
• Static, e.g., business events may materi- ally change in the 18 month or other “look- back” period subject to the agreed upon value
• Lack of financial or business acumen of certain owners
• Disadvantages associated with Formula method if agreed value lapses
Special Considerations:
• Regular mandatory agreement is strongly
recommended
• Best suited for companies with familiar
and amicable co-owners that are involved in the daily operations of the business and generally capable of compromise
• Not recommended for situations in which there are more than a few co-owners, espe- cially where there are significant disparities in age, health, or levels of active participation in the business which often result in disagree- ments as to business objectives and distribu- tion of profits to owners
Put/Call Option
With Put/Call option, each owner has a right to initiate a procedure with its co-owner under which one owner eventually purchases the shares of the other owner, but neither owner knows at the outset who will be the buyer and who will be the seller. The initiating owner (whose intention may be to buy or sell the shares) proposes a price for a sale of the shares. The other owner then must choose whether to sell its shares at this price or buy the initiating owner’s shares at this price. Typically, the right to initiate the process is not available for a certain number of years.
Advantages:
• Mutual agreement of owners on price so the price is not likely to be challenged since it is negotiated at arm’s length
• Certainty
• Quick conclusion on the value question • Inexpensive
Disadvantages:
• Lack of financial resources of one owner
to purchase the shares of the other
• Does not address the need for a purchase price in the period prior to the put/call right
being available
• Generally, only works well with two
owners
• Dependence of business on one of the
owners, i.e., an owner may feel compelled to sell at any price if such owner is unable to run the business without the other but the opposite is not true
Special Considerations:
• Best suited for companies with two own- ers with similar external financial resources • Best suited for companies with co-owners that are both involved in the daily operations
of the business
• Careful coordination is required to coor-
dinate the put/call option with provisions of organizational documents related to mergers or sale of the company and drag along or tag along right, to avoid conflicting rights or unjust enrichment
What are some other things to keep in mind related to buy-sell agreements? own- ers of closely held corporations often also
serve as officers of such corporations and the different roles may become intertwined so that employment agreements may contain buy-sell provisions and shareholder agree- ments may contain provisions containing consequences for actions related to employ- ment. Frequently, an agreement will provide that an employee terminated with cause will have his shares repurchased at a discount. Agreements may provide that an employee terminated without cause would have his shares repurchased at their full value, but a voluntary early retirement or a termination for cause may result in a purchase with a substantial discount to full value, or a delayed payout, or both. If there are provisions for sale at a substantial discount, the employee may favor a valuation method that maximizes the estimated value to mitigate the effects of the discount. While requiring a substantial discount in certain circumstances may be typical, excessive discounts that effectively result in the forfeiture of ownership interests are likely to be successfully challenged in court. It is important to coordinate the terms of the relevant employment agreements and the shareholders’ agreement and to consider employment law implications.
It is worth noting that irrespective of the valuation method selected, the owner buy- ing the shares (or the business) may need to finance the purchase of the shares. If financing the purchase through a third party, it is very important that valuation coincides with the financing parties’ lending guidelines. The sell- ing owner may also agree to seller financing, meaning that the buyer (or the company) pays the seller over time (usually two to five years) on agreed upon terms.
Conclusion. Buy-sell provisions are among the most fiercely negotiated provisions in shareholders’ agreements or organizational documents of closely held corporations and often the most litigated. More often than not, the method of establishing the purchase price is the central issue in the debate or dispute. It is critical that the methodology used results in a valuation that can be determined with certainty but is also responsive to foreseeable and unforeseen changes to business condi- tions in the future. With careful analysis of the industry and market information available to the owners and careful consideration of the business’ nature and prospects, the busi- ness owners themselves will inform the best valuation methodology to select. Thoughtful consideration of all of these matters and the factors described above and careful planning can save thousands of dollars wasted on unnecessary litigation and also help owners of closely held corporation avoid forfeiting billions of dollars of value in the next Apple or other great company.
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