A buy-sell agreement is one of the most common tools utilized by attorneys and business advisors in protecting their business owner clients. In this course, you will learn about valuation issues that are critical to buy-sell agreements, such as the use of formulas and valuation discounts, which can significantly impact your client if and when the agreement is triggered.

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Valuation Considerations in Developing
and Executing Buy-Sell Agreements
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2. Valuation Issues in Developing and
Executing Buy-Sell Agreements
Robert A. Ranallo, CPA/ABV, JD, CVA, CFF
Sean Saari, CPA/ABV, CVA, MBA
October 22, 2015

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After completing the session, participants
will be able to:
“In the long run, men hit only what they aim at.” – Henry David Thoreau
LEARNING OBJECTIVES
• Draft and review buy-sell agreements
with an understanding of the related
valuation considerations
• Proactively plan with clients to address
valuation-related issues that arise in
connection with buy-sell agreements

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“There is no such thing as an absolute
value in this world. You can only estimate
what a thing is worth to you.”
Charles Dudley Warner 1829-1900, American Writer
QUOTE OF THE DAY

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• Best practice is for closely-held businesses
with multiple owners to have buy-sell
agreements in place to govern the purchase
and sale of ownership interests
• When an ownership transaction is not
imminent, the valuation provisions included
in buy-sell agreements are oftentimes not
heavily scrutinized, but…
• When an ownership transaction occurs and
the buy-sell must be followed, VALUATION
is often the most significant issue
OVERVIEW

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There are a number of factors that could trigger a
transaction/valuation under a buy-sell agreement:
• Resignation
• Retirement
• Termination
• Disability
• Death
• Owner discretion
TRIGGERING EVENTS
Unless the business is sold before any of the above occur, the valuation
provision of the buy-sell agreement will eventually govern the
economics, structure and terms of the transaction.

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Standard of value
• Will drive the structure and assumptions used
in valuation
Valuation date
• Value may vary significantly based on the
valuation date and what was “known or
knowable” at that time
Level of value
• Inclusion/exclusion of discounts for lack of
control and lack of marketability can have a
material impact on value
KEY VALUATION FACTORS

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Fair Market Value
• Most common standard of value (and typically most appropriate
as well)
• “The price at which property would change hands between a
willing buyer and a willing seller, when the former is not under any
compulsion to buy, the latter is not under any compulsion to sell
and both parties have reasonable knowledge of the relevant facts”
– Revenue Ruling 59-60
• “Hypothetical willing buyer and willing seller”
STANDARD OF VALUE

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Strategic Value
• Value to a particular buyer including potential synergies that may be
created as a result of an acquisition
Another “Defined” Standard of Value
• Buy-sell agreements may include a definition of a “non-standard”
standard of value
– “Market Value”
– “Value”
• Beware of defining a standard of value in the buy-sell agreement rather
than relying on Fair Market Value
– Standards of value created specifically for buy-sell agreements often have no
basis in financial theory and are not generally accepted in the valuation
profession
– The definition may be open to interpretation and could result in materially
different conclusions of value depending upon how it is interpreted
STANDARD OF VALUE

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Any number of valuation dates could be
assigned in the buy-sell agreement
• End/beginning of year
• End of month/quarter immediately preceding
triggering event (most common)
• Date of the triggering event
• Any date identified in the buy-sell agreement
VALUATION DATE
Be aware that valuation standards prevent an appraiser from
considering in his or her conclusion of value any facts that were not
“known or knowable” as of the valuation date
Values are not static and will change depending upon the valuation date

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Not all values are created equal – the level of value being
determined has a significant impact on value
• Controlling or non-controlling (majority interest vs. minority interest)
• Marketable or non-marketable
“Fair Market Value” generally includes
consideration of any applicable discounts
for lack of control and lack of marketability
Best practice is to specify in buy-sell agreement whether discounts
for lack of control, lack of marketability or any other factors will be
considered
LEVEL OF VALUE

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Lack of Control
• Reflects the potential impairment to value as
a result of a non-controlling ownership
interest not being able to control the
company and its decisions
– Distributions
– Management/owner compensation
– Management/owner perks
– Major business decisions
– Redemption of the ownership interest
– Liquidation of the company
LEVEL OF VALUE

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Lack of Marketability
• Reflects the impairment to value resulting
from the fact that an ownership interest in a
privately-held company has no ready market
for resale (which creates increased
uncertainty, longer holding periods and
additional costs to convert the ownership
interest into cash)
• Significantly higher discounts applied when
valuing non-controlling (minority) ownership
interests (compared to controlling ownership
interests)
LEVEL OF VALUE

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LEVEL OF VALUE
What impact does the inclusion/exclusion of lack of control
and lack of marketability discounts have?
• Inclusion – Favors buyer
– Pro: Provides most accurate indication of
“fair market value” and reflects what the
ownership interest could likely be sold for to
a third-party
– Con: May allow a controlling owner to
obtain additional controlling ownership at
a discounted value
• Exclusion – Favors seller
– Pro: Allows the selling party to be bought out
at a value that reflects the amount that would
be received if the company as a whole were
to be sold
– Con: Penalizes the buyer and causes them to pay more for the
ownership interest than what a third-party would likely pay for it

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Appraisal
• Valuation prepared by third-party valuation expert
Formula
• Valuation based on formula outlined in buy-sell
agreement
Agreed-upon redemption price
• Valuation based on agreed-upon value determined
by owners
VALUATION APPROACHES

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Key Considerations
• Standard of value / valuation date / level of value
• What credentials must the valuation expert
possess?
• Will the valuation be prepared in accordance with
a particular set of valuation standards?
• Will a single-appraiser or multiple-appraiser
model be used?
• If a multiple-appraiser model is used, how will the
final value be selected?
• How will the valuation expert be selected?
• Must the valuation expert be independent from
the company’s accountant?
• How will appraisal costs be allocated among the
parties involved?
• What level of analysis/deliverable will be
required?
APPRAISAL

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Pros
• Most accurate value
– Considers current status of
business, industry and economy
as of the valuation date
– No “winner” or “loser” based on
the value/transaction price
• Value should be transparent and
understandable to all parties
APPRAISAL
Cons
• Time consuming
• Expensive
• Can be burdensome if multiple
appraisers are involved

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Key Considerations
• Standard of value / valuation date / level of value
• Formula should produce appropriate value when
initially established
• Metric upon which formula is based
– Revenue
– EBITDA
– Net Income
– Book Value (BEWARE!)
– Other financial metrics or rules of thumb
• Does the formula accurately determine equity
value (and not an enterprise value)?
• Will the formula be revisited in the future and
updated if necessary?
FORMULA

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Cash
Enterprise
Value
Debt
Value
Equity
Value
Market
Value of
Invested
Capital
Reconciling Equity Value to Enterprise Value
FORMULA

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Furnishings
House
Value
Debt
Value
Equity
Value
Total Value
of Home
and
Furnishings
How the Value of Your Home is an Enterprise Value
FORMULA

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Pros
• Often simple to apply
• Less expensive to implement and
execute than appraisal
• Predictable
FORMULA
Cons
• Changes in business, industry
and economy may not be
accurately considered
• Difficult to reflect expected
growth or decline in the business
• Formulas can get stale as
businesses and industries
change over time
• If initial formula is not
reasonable, the valuation results
are likely to be unreasonable in
future years
• May differ materially from value
that would be determined in an
appraisal

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Key Considerations
• Standard of value / valuation date / level of value
• How often will the agreed-upon redemption price be updated?
• Are there any mechanisms in place to ensure
that updates to the agreed-upon redemption
price are made as required?
• What happens if there has been no recent
update to the agreed-upon price before a
triggering event?
• How will the agreed-upon redemption price be determined?
• What happens if the parties cannot agree on a redemption price?
REDEMPTION PRICE
AGREED UPON

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Pros
• Simple to apply (at least in theory)
• Least expensive to implement
and execute
• Agreement of parties on value
avoids valuation issues
Cons
• The agreed-upon redemption
price will likely become stale
over time
• Requires agreement of parties to
set and update the agreed-upon
redemption price, which can be
difficult to obtain in practice
• May differ materially from value
that would be determined in
an appraisal
REDEMPTION PRICE
AGREED UPON

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FREQUENCY OF UPDATES
No matter what valuation approach is outlined
in the buy-sell agreement, the frequency of the
valuation is an important consideration
• Beginning/end of the each year (best practice)
• Some other specified time period
• Upon triggering event
Frequency of updates impacts each of the
valuation structures in buy-sell agreements
• Appraisal – What valuation date will be used?
• Formula – How often will formula be updated?
• Agreed-Upon Redemption Price – How often
will the owners need to agree on a redemption
price?

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Who will acquire the selling party’s stock?
• Other owner(s)
• Company
• Some combination of other owner(s) and the company?
Treatment of life insurance proceeds
• Included or excluded in the value of the business?
OTHER CONSIDERATIONS

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LIFE INSURANCE EXAMPLE
No Insurance Proceeds Available
Owner A - 50% Owner B - 50%
Company Exiting Owner Purchasing Owner
Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$
Insurance Proceeds - - -
Post-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$
Insurance Proceeds Included in Buyout Price
Owner A - 50% Owner B - 50%
Company Exiting Owner Purchasing Owner
Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$
Insurance Proceeds 13,000,000 6,500,000 6,500,000
Post-Insurance Proceeds Value 33,000,000$ 16,500,000$ 16,500,000$
Insurance Proceeds Excluded in Buyout Price
Owner A - 50% Owner B - 50%
Company Exiting Owner Purchasing Owner
Pre-Insurance Proceeds Value 20,000,000$ 10,000,000$ 10,000,000$
Insurance Proceeds 13,000,000 n/a 13,000,000
Post-Insurance Proceeds Value 33,000,000$ 10,000,000$ 23,000,000$

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1. Get input from a qualified, credentialed valuation expert when
drafting buy-sell agreements
2. Define the standard of value, valuation date and level of value
3. Utilize the appraisal methodology for the most accurate value
4. Avoid imprecise language and clearly define the valuation
provisions
5. Address how insurance proceeds will be treated in the valuation
SUGGESTIONS/TAKEAWAYS

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SUMMING IT UP
After completing the session, participants
will be able to:
• Draft and review buy-sell agreements
with an understanding of the related
valuation considerations
• Proactively plan with clients to address
valuation-related issues that arise in
connection with buy-sell agreements

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“It’s the little details that
are vital. Little things
make big things happen.”
– John Wooden
CLOSING QUOTE

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QUESTIONS?
Bob Ranallo, CPA/ABV, JD, CVA, CFF
Partner
Phone - (440) 449-6800 x7131
Email - branallo@skodaminotti.com
Sean Saari, CPA/ABV, CVA, MBA
Partner
Phone - (440) 449-6800 x7221
Email - ssaari@skodaminotti.com