May 16th, 2014 by Kelly Noll
In many buy-sell agreements, the buyout clause for shares of privately-held stock is determined by a valuation formula, such as “shares will be purchased at a 4 or 5 times multiple of the company’s most recent year EBITDA (earnings before interest, taxes, depreciation, and amortization) as defined by GAAP (generally accepted accounting principles) upon death, disability, or termination.” However, while seemingly straightforward, formula prices designed without the input of a valuation professional often bear little resemblance to fair market value. Further, there is not a single formula that will provide a reasonable price over time, particularly over a number of years. Here’s why:
1. Businesses evolve.
What if the company’s business operations have evolved to add additional capacities or a new proprietary technology to where the specified multiple is no longer relevant? Formulas will not capture any changes in the business, for better or for worse.
2. Creates a disincentive to invest in operations.
If someone with the ability to control the budget is getting his or her shares bought out and is only concerned about a multiple of EBITDA, they may be leery of investing in the business as this would reduce current year EBITDA. This would generally be to the detriment of the business and other shareholders as the exiting shareholder is not seeking to maximize future cash flows of the business, which ultimately impacts the long-term success of the company.
3. Subject to manipulation.
If an unscrupulous business owner knows that a large number of shareholders are retiring next year, what is to stop him or her from running up expenses so as to reduce current year EBITDA and therefore the buyout price?
4. No adjustments for discretionary, unusual, or one-time expenses.
Contrary to popular opinion, EBITDA according to GAAP only adjusts net income for interest, taxes, depreciation, and amortization. That’s it. If a company stands to generate $5 million of EBITDA, and the business owner decides to take a $5 million bonus or purchase a $5 million company jet, EBITDA would be $0 and the shareholder who stands to get bought out that year would get $0.
5. Do discounts apply?
Oftentimes buy-sell agreements are silent as to whether discounts such as a discount for lack of marketability or discount for lack of control apply. Typically, a minority interest it is worth less than a controlling interest (due to the inability to make distributions, sell the company, effect changes in the business, etc.). However, inevitably when a buy-sell agreement gets triggered, the application of discounts is often one of the most hotly-contested items as it is not specifically stated in the formula (though common practice in valuation). These discounts can potentially reduce the value of the company up to 40% in some instances.
6. What about debt and cash?
Not considering the debt and cash of a business is like saying a house is worth $300,000 with an associated mortgage of $200,000 and the equity is worth $300,000. Common sense would say that equity in the home is not $300,000, rather it is worth $100,000; however, the value of $300,000 is exactly what many formulas imply when they omit debt and cash.
Our take: annual valuations create fewer headaches
Many times, the intent of a buy-sell agreement is to establish an equitable value. However, as companies evolve, multiples of EBITDA rarely bear resemblance to fair market value. On the contrary, selecting a well-qualified valuation firm to provide periodic valuation opinions assures a current value in the buy-sell agreement and enables shareholders to monitor the wealth in their closely held business. In a best case scenario, the selection of the appraiser is done well before a triggering event. This way, all parties feel they have a say in the selection of the appraiser and can voice any fears of bias at the onset. Further, it is recommended that the appraiser conduct an initial appraisal of the business to form a basis of value. The initial appraisal should involve a detailed analysis of the specific factors which are most influential in determining a company’s value. Therefore, because the process is observed at the onset, all parties have a better idea of what will happen when the triggering event occurs. Further, subsequent appraisals, either annually or at triggering events, should be less time-consuming for the appraiser and therefore less expensive for the company. Lastly, if the valuation is updated regularly, all parties will have a good understanding of the valuation process, thus limiting the potential for disagreements, surprises, or costly legal battles.
GBQ Consulting’s business valuation group has significant experience in the valuation of companies for buy-sell purposes. The authors of this article can be reached using the contact information provided herein.