Experience teaches us many lessons. Sometimes they’re lessons we wish we never learned. Years ago, before we merged our firm into Moss Adams, I had to renegotiate a separation agreement with my former partners. As with many firms involving multiple shareholders, relationships were strained over the direction of the business, the performance of certain partners, and differences in individual goals.
When we entered into the agreement in the early days of our firm, we made the same mistake many new partners do: assuming the strength of our friendships would override irrationality, so all the protective language that our attorney wanted to put in would be moot. We weren’t thinking about bad things happening, only how we would maximize the value of the firm when we cashed out. This proved to be a na?ve approach.
In our case, loose language in the buy/sell agreement turned the forced termination of a partner into a poison pill for the business. By adhering to the repurchase obligation spelled out in the agreement, it became clear that we couldn’t afford to stay open. Our choices? Close down, or redo the agreement. Either course was sure to destroy the remnants of that relationship.
It’s easy to get mad at the attorneys for how documents were drafted, or at yourself for not anticipating the worst. But when you don’t envision scenarios such as terminating a shareholder under bad circumstances, it’s easy to be surprised. When you’re building a business, everybody thinks about how the shareholder agreement will translate into making everyone rich. Then, when you start pulling apart, you come to believe your so-called friends and colleagues are trying to stab you in the back. A partner in my current firm put it in painful terms when we encountered a simila situation with one of our clients: “I guess you can’t really hate somebody until you’ve loved them first.”
Many advisors ap-proach buy/sell and shareholder agreements the way we did: “We’ll grow the business, then exit and get paid a nice price.” You saw how that turned out. Since then, we’ve seen operating agreement horror stories. In one case, the largest shareholder and revenue producer could leave, get a multiple of firm revenue, and take his clients with him. In another, any shareholder was free to leave the business with very short notice, and without any preparation for succession, so the newest and youngest shareholder could actually be left to buy out the older guys all at once. Another agreement allowed departing shareholders to walk away from their share of the lease and other corporate obligations, right after they moved into very expensive office space with other large infrastructure expenses.
I reflected on these cases recently after receiving a spate of calls from advisors who are in disputes with their current partners and shareholders, or are trying to break up. We aren’t surprised to find that many of the agreements are not complete, or failed to give direction to appraisers attempting to value the ownership interests involved. Some agreements contemplate what happens in the event of death or disability, but often are less explicit about what happens when partners no longer get along, or when one of them decides to leave the business. What’s more, we’re seeing many advisors who are in the midst of contested valuations in which no agreement exists at all. Chances are that each of these cases will result in disputes that range from court cases to destroyed friendships. The sad irony is that it all could have been prevented with well-written buy/sell agreements.
Good buy/sell agreements do several things. They allow remaining owners to acquire the interest of a departing shareholder; they provide guidelines for the acquisition of that interest; and they restrict an owner’s ability to sell his interest, thereby protecting the firm and the remaining owners. The provisions of these agreements are usually triggered when a shareholder retires, is terminated, dies or becomes disabled, or gets divorced. The buy/sell provides liquidity when any of these events occurs. The price paid for an owner’s interest depends on the terms of the agreement, but in general, a shareholder knows she will receive something. Overall, a clearly written buy/sell decreases uncertainty, increases liquidity, and allows the company to continue operating smoothly during a transition.
Yet if a buy/sell agreement isn’t clear, trouble can, and likely will, occur. I asked one of our lead valuation consultants, Calvin Swartly, to highlight the most common problems we encounter in buy/sell agreements–the ones that usually end up causing legal fees and expert witness costs to soar out of control. They are:
How Is Value Defined? People, even financial advisors, often think that value is value. This is one reason business owners get upset with appraisers. There are, in fact, several standards of value for buy/sell agreements, including fair market value, fair value, and book value, and each can reach a different value for a business. Without guidelines as to which standard to use, an appraiser has to decide, and often one side of a dispute will take issue with the appraiser’s decision.
Fair market value is the amount a willing buyer would pay a willing seller, with neither party under any compunction to sell, and both parties fully informed of all the facts. Fair value is the value of shares immediately prior to an event that a shareholder objects to, based on statutes and case law in the jurisdiction. Book value is the net worth of a company at any date in time: a company’s total depreciated assets minus its liabilities. Book value is easy to calculate and explain, but does not indicate the value of company as a going concern. Further, book value is especially misleading for advisory firms because it can’t account for the value of the client list or cash flow generated by the advisors. Each standard has limitations, but fair market value usually is most appropriate.
Formula pricing uses a simple calculation and is also used in some buy/sell agreements. A formula is usually objective and inexpensive, but as with book value it does not represent fair market value. A buy/sell that includes a formula pricing method should be reviewed periodically to ensure the formula accounts for changes in the company.
Inevitably, when a business owner feels that her shares are valued too low, she points to what you might call the investment value that would be paid by strategic or financial buyers. Real-life transactions can consider the benefit of synergy, cost savings, or discretionary expenses, whereas internal transactions cannot. So it’s not uncommon to see valuations determined under buy/sell agreements to be much lower than what one will find in the open market.
What Is Being Valued? Defining the “purchase price standard” plays an important role in a buy/sell agreement. The value of a whole company (or a controlling interest) is significantly different than a minority, non-controlling interest. An agreement that does not distinguish the standard that should be applied leaves open the possibility that a shareholder is entitled to something different than fair market value. For instance, a buy/sell that simply states the price to be paid in the event of a transaction equals the fair market value of the company could be interpreted to mean that the price per share for a minority shareholder is the same as for a controlling shareholder.
This problem is especially acute in financial advisory buy/sell agreements. Again, the seller or injured party in these transactions often points to real-life market prices. But if he or she is selling a minority stake (less than 51% in most states), then what is the value of the interest? Considering that surviving shareholders usually want to protect themselves against a big repurchase liability, it’s often wise to explicitly state that the valuation will consider minority interest discounts.
Remember, when drafting these agreements you have to put yourself on both sides of the transaction. It’s one thing to gear the agreement to a higher value assuming you’re the first one out the door, but what if you’re not? Or what if you have multiple shareholders and advisors who all decide to bolt at once, leaving you holding the bag?
What Information Is Missing? As we have seen, buy/sell agreements are often silent on some points or fail to consider all potential issues.To resolve silent or missing information, an expert is required to rely on state law, guidance from the company’s counsel, and experience. For example, if the standard of value is missing, it may be a judge, mediator, state law, or even case law that will set the standard.
A good buy/sell will also include a determination of the effective date of a triggering event. Without a clear triggering date, a moving target could be created, making resolution even harder. This becomes especially aggravating to a departing shareholder. Chances are good that hostility has developed long before the buy/sell agreement can be triggered. If the fight goes on for months or years, the practice itself could suffer from all the distractions, causing everyone’s value to go down.
How Does Management Stay Informed? Buy/sell agreements sometimes state that the owners will determine the value of the shares on an annual basis or some other time period. We find it rare that shareholders perform determinations each year. They tend to be done only during the first two to five years. If the annual determination is not performed and a dispute arises, chances of the parties agreeing on a value is very low.
That said, we generally like the idea of advisors performing an annual self-evaluation as part of their management deliberations, because it causes them to examine what’s not working, and to build upon what is working. However, if there is little discipline in having management meetings, or addressing these issues, you will create a big problem down the road when the buy/sell agreement is triggered.
As the advisory profession continues to evolve, and attorneys become more familiar with the unique challenges facing advisory firms with multiple shareholders, such agreements will likely be written more tightly and uniformly. Until then, it is helpful for advisors to recognize which questions to ask counsel before entering into such agreements with their partners. The headaches they save will undoubtedly be their own.
Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at firstname.lastname@example.org.