In the last post, I quoted a section from a buy-sell agreement related to divorce. In this post, we tackle a provision in another agreement that attempts to define the Purchase Price for that particular agreement.
This agreement is what we call a “valuation process buy-sell agreement.” As you will see, the Purchase Price is to be determined by a valuation process involving one (or three) appraisers.
The paragraph referencing the Purchase Price is quoted below. The parenthetical letters have been added to facilitate comment below.
Section 7. Purchase Price. The purchase price paid will be the deceased Shareholder’s (A) proportionate ownership interest in the Corporation multiplied by the Corporation’s (B) Fair Market Value, as defined in Treasury Regulation §20.2031-1(b) of such shares of stock (C) as of the Shareholder’s date of death. The Fair Market Value shall be (D) determined by an independent appraiser (E) with the cost of the appraisal being paid by the Corporation. (F) In the event the deceased Shareholder’s personal representative and the Corporation are unable to agree as to such appraiser, (G) such deceased Shareholder’s personal representative and the Corporation shall each select an appraiser, (H) which appraisers shall agree upon a third independent appraiser, (I) who shall then proceed to determine the Fair Market Value of such shares of stock. (J) The value so determined shall be final and binding on the parties. (K)
Level of Value (A)
This provision (“…proportionate ownership interest in the Corporation multiplied by the Corporation’s…”) is good in that it attempts to direct that the selected independent appraiser is to determine the Fair Market Value of the Corporation and that the purchase price will be the “proportionate ownership interest.” If that is the intent, then it should be specified that the value to be determined is a value at the financial control level of value.
The drafter of this agreement was clearly attempting to be specific and to define value appropriately. However, some appraisers are so habituated to develop nonmarketable minority values for minority interests that they might interpret “proportionate interest” to be the proportionate share of a nonmarketable minority level value (after perhaps applying minority interest and/or marketability discounts). And since the independent appraiser’s conclusion will be binding on all parties (J), this would be unfortunate – if the parties actually intended for the Purchase Price to be at the financial control level of value.
Standard of Value (B)
The agreement specifies that Fair Market Value is the required standard of value and further provides a citation to a definition of Fair Market Value. Again, the drafter is attempting to be specific, however, issues can still arise. Treasury Regulation §20.2031-1(b) is quoted here for reference:
(b) Valuation of property in general. The value of every item of property includible in a decedent’s gross estate under sections 2031 through 2044 is its fair market value at the time of the decedent’s death, except that if the executor elects the alternate valuation method under section 2032, it is the fair market value thereof at the date, and with the adjustments, prescribed in that section. The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate. Thus, in the case of an item of property includible in the decedent’s gross estate, which is generally obtained by the public in the retail market, the fair market value of such an item of property is the price at which the item or a comparable item would be sold at retail. For example, the fair market value of an automobile (an article generally obtained by the public in the retail market) includible in the decedent’s gross estate is the price for which an automobile of the same or approximately the same description, make, model, age, condition, etc., could be purchased by a member of the general public and not the price for which the particular automobile of the decedent would be purchased by a dealer in used automobiles. Examples of items of property which are generally sold to the public at retail may be found in §§20.2031–6 and 20.2031–8. The value is generally to be determined by ascertaining as a basis the fair market value as of the applicable valuation date of each unit of property. For example, in the case of shares of stock or bonds, such unit of property is generally a share of stock or a bond. Livestock, farm machinery, harvested and growing crops must generally be itemized and the value of each item separately returned. Property shall not be returned at the value at which it is assessed for local tax purposes unless that value represents the fair market value as of the applicable valuation date. All relevant facts and elements of value as of the applicable valuation date shall be considered in every case. The value of items of property which were held by the decedent for sale in the course of a business generally should be reflected in the value of the business. For valuation of interests in businesses, see §20.2031–3. See §20.2031–2 and §§20.2031–4 through 20.2031–8 for further information concerning the valuation of other particular kinds of property. For certain circumstances under which the sale of an item of property at a price below its fair market value may result in a deduction for the estate, see paragraph (d)(2) of §20.2053–3. (emphasis added)
The one problem with the cited definition of fair market value is that it refers to another section of the code for elaboration regarding businesses. For this reason, I normally suggest that a reference to the ASA Business Valuation Standards could be more defining:
Fair Market Value. The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
This would also tend to ground the valuation in the context of relevant valuation standards, which are discussed below.
Valuation Date (C)
The valuation date is specified as the date of death. That is crystal clear and good. However, if a trigger event occurs other than death, the least likely trigger event for most buy-sell agreements, the valuation date is not clear at all.
Qualifications of Appraisers/Business Valuation Standards (D)
The agreement calls for the parties to attempt to agree upon an “independent appraiser.” Unfortunately, the “independent appraiser” tent is so open it doesn’t have doors. Absent specific criteria describing qualifications (experience, credentials, size of firm, etc.), any accountant or college professor would qualify.
It is an excellent idea to provide a list of valuation credentials as minimum qualifications for the selection of an appraiser. I always recommend the ASA designation (Accredited Senior Appraiser) of the American Society of Appraisers (since I am an ASA).
Members of the American Society of Appraisers are required to provide appraisals in accordance with the American Society of Appraisers Business Valuation Standards and the Uniform Standards of Professional Appraisal Practice (USPAP). This is important, because you definitely want your appraiser to provide a standards-compliant appraisal.
There are many qualified business appraisers with other designations and similar valuation standards. Agreements could specify one or more potential qualifying credential(s) (and standards), including the ABV (Accredited in Business Valuation) designation of the AICPA. Appraisers with this valuation credential must follow SSVS 1, or Statement on Standards for Valuation Services 1.
Similarly, appraisers with credentials from the National Association of Certified Valuation Analysts (NACVA) or the Institute of Business Appraisers (IBA) must follow (beginning June 1, 2011) joint business valuation standards that, according to NACVA, “are in parity” with SSVS 1 of the AICPA.
The point is that it is important to be as specific as possible in describing the required qualifications for appraisers for valuation process buy-sell agreements.
Who Bears the Cost of the Appraisal? (E)
The agreement states that the “cost of the appraisal” will be borne by the Corporation. However, this could be read as applying only to the cost of the appraiser in the case where the Corporation and the deceased’s representative agree on an appraiser.
- If the shareholder has to retain an appraiser to participate in an appraiser-selection process (as called for in the absence of agreement), who must pay for that appraiser?
- One reading would indicate the Corporation. But another reading might suggest otherwise.
- Also, does the Corporation pay for its appraiser if this process is required?
I ask these questions because, if they are not addressed, they can and will come up at the time of a trigger event. I can tell you that all the appraisers will need for this issue to be clarified, and it is pretty easy to do if the parties talk about it.
If the Estate’s Representative and Corporation Cannot Agree (F)
If there are no agreed upon appraiser qualifications, it may be difficult for the parties to agree. This agreement calls for what I call (in Buy-Sell Agreements for Closely Held and Family Business Owners) a “Single Appraiser – Select Later and Value Later” process. The decision as to who the appraiser will be is put off until a trigger event (death of a shareholder) occurs. No one will know what kind of appraisal will be received until after a trigger event. The biggest problem with this structure for determining value is that all the decisions are put off until the worst possible time.
Speaking of time, there are no timeframes built into the process for selecting the appraiser and for the appraiser to deliver the appraisal. What happens too frequently is that corporations delay the process (often because of lack of focus) sometimes indefinitely, and the shareholder’s estate has nothing in the agreement to require moving things along.
What I usually recommend is a “Single Appraiser – Select Now and Value Now” process. The worst possible time to try to agree on an appraiser is after a trigger event has occurred. No one is in any condition to make critical decisions, least of all a deceased shareholder’s estate. Consider how much easier it would be for the parties to talk to appraisers now, and agree on the appraiser when the agreement is put in place.
Consider how much more information everyone would have if the appraiser conducted the initial appraisal and established the initial value for the agreement. Then, reappraisals could be done every year (or every other year) or so, depending on the economics. This is a much better structure for shareholder planning.
If No Agreement on Appraiser, Each Party Selects an Appraiser (G)
If there is no agreement on a single appraiser, which is quite possible because the interests of the parties diverge at the time of a trigger event, then each party will select an independent appraiser. The sole purpose of this procedure is for the appraisers selected by the estate’s representative and the Corporation to mutually agree on (select) a third appraiser. In other words, this procedure calls for two strangers to select the independent appraiser, rather than the parties themselves.
Just as there are no instructions to guide the parties in agreeing on a single appraiser, there are no instructions regarding how each party will select an appraiser. The bottom line is that almost any “appraiser” will do, and that is a prescription for disaster.
The Two Appraisers Must Agree on a Third Independent Appraiser (H)
The first two appraisers have no guidance regarding the qualifications of the third appraiser and, depending on their respective backgrounds, may themselves have a difficult time in reaching agreement. At this point, the estate is interested in a higher valuation and the Corporation is interested in a lower valuation. It just works that way when the interests of the parties diverge. Sometimes, the first two appraisers are unable to agree on a third appraiser. There is no provision for what happens then, or how long they will have to attempt to reach a mutual selection.
Interestingly, when parties are faced with choices in the absence of direction, it is not surprising that the party desiring a higher Purchase Price may tend to select industry experts who tend to be biased towards strategic valuation. The party desiring a lower purchase price may select a qualified appraiser with experience with valuation discounts. With such potential differences between the first two appraisers, the selection of a third appraiser, the actual independent appraiser for the agreement, may prove difficult indeed.
Who Shall Determine the Fair Market Value “of Such Shares of Stock” (I)
“…of such shares of stock.” This seemingly innocuous phrase can undo what the parties may have thought was an agreement at the outset. The reference to “the Fair Market Value of such shares of stock” might be interpreted by some appraisers as relating to the particular interest being valued. If that interest is a minority interest, they might well apply valuation discounts, which, I don’t believe, is what the agreement intends.
The Independent Appraiser’s Conclusion is Binding (J)
The Agreement states that the independent appraiser’s conclusion is binding. That means that the conclusion is the Purchase Price and is what the Corporation will pay and the deceased shareholder’s estate will receive. Because the conclusion is binding, it is critical to get the process described appropriately in the agreement. For this reason, I generally recommend:
- That there be an initial appraisal for buy-sell agreements at the time the agreements are finalized. If the parties agree on an appraiser at the outset, that appraiser will have to interpret the agreement’s language.
- That the appraiser be instructed to provide a draft report to the parties. If the appraiser makes a different interpretation than the parties discussed, or if the parties didn’t discuss it and find out what could happen, there is time to fix the problem. The parties at that time do not have disparate interests.
- That the appraiser’s conclusion becomes the Purchase Price until the next appraisal is provided to update the price.
Life Insurance Treatment (or Not) (K)
The agreement we are discussing is silent regarding the existence of or treatment of life insurance proceeds. If there is corporately owned life insurance on the lives of any or all of the shareholders, it is important to provide instructions to the independent appraiser as to how to treat life insurance proceeds in valuation.
As written, the treatment of life insurance proceeds would be totally within the discretion of the appraiser, and you do not want him or her making that decision for you. There can be dramatically different results for the estate and the Corporation depending on whether life insurance is treated as a funding vehicle (specifically geared to repurchase stock) or as a corporate asset (to be included in value before determining Fair Market Value).
When does the Purchase Price as defined in a buy-sell agreement become the Purchase Price following a trigger event?If this discussion is indicative of potential issues, it can be take a long time to determine the price.
There are fewer than 150 words in the Purchase Price Section quoted above. I have written about 2,400 words talking about the nuances in the paragraph. If I can do this while only thinking about it, consider what the parties might do following a trigger event, particularly if the financial stakes are high.
As always, I recommend that you read your buy-sell agreements carefully. It is a good idea to have what I call a “buy-sell agreement review” performed by both your attorney and a trusted business appraiser. Given their comments, you can sit down with your other owners and advisers and “fix” problems before they surface.
In a coming post, I’ll further explore the topic of a buy-sell agreement review.
To find out even more about the issues mentioned in this post, continue to read this blog. You can accelerate the learning process by getting the book Buy-Sell Agreements for Closely Held and Family Business Owners. Please share the blog with your friends, advisers, and colleagues. We’ll be providing fresh insights as we continue to explore buy-sell agreements and and how to make them work, as well as other interesting valuation-related issues.