Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Buy-Sell agreement horror stories

When business entities are formed, they often execute agreements between the shareholders, partners or members that defines the price (or formula/methodology to determine the value) at which an owner is paid for his/her interest in the business in the event of death, disability, mental incapacity, divorce, bankruptcy, resignation or termination of employment and other triggering events. These agreements can be embodied in shareholder agreements, partnership agreements, and operating agreements. Care should be taken in drafting those agreements as they can result in unintended consequences including expensive litigation. Similar problems can occur when no such agreement exists. Below are two real-life examples.

Fix it and Forget It

One recent case[1] involved a medical practice that was formed in 2000. The agreement established a value of medical practice via a Certificate of Agreed Value dated January 1, 2000 at $2.4M. This was the most recent agreed value some fifteen years later when one of the physicians decided to retire triggering a buyout of his interest. The agreement also stated that if the parties fail to agree on a revaluation for more than two years, the value shall be equal to the last agreed-upon value, adjusted to reflect the increase in the net worth of the Company, including collectible accounts receivable, since the last agreed-upon value. The parties never updated the valuation in the agreement.

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The retiring physician claimed that the value of the company was a range of $5.6M to 6.8M. The court determined the value of the Company to be $3.2M at the time the physician retired. The resulting value was based on the terms of the agreement, $2.4M increased by the collectible accounts receivable, or $3.2M. Had the parties agreed on the value periodically the result would likely have been closer to the retiring physician’s claimed value. Big impact!

In another example[2] is a company that was formed approximately thirty years prior to one of the partners passing. The partnership agreement contained a provision establishing an agreed-upon value of the partnership interests for the purpose of any buyout required on a triggering event. The value was to be determined by formula (net book value plus $50,000). The death of one of the partners triggered a buyout of her interests.

One of the remaining partners implemented a buyout of the deceased partner’s interest pursuant to the agreement for approximately $180,000. Her Estate claimed that the fair market value of the partnership was significantly greater than the amount determined by the formula. Instead of net book value, the Estate claimed the fair market value was approximately $11.5M and sought relief from the courts since there was such a large disparity in the values.

The Court, in this case, was unwilling to overturn the partnership agreement establishing the value for the buyout. The court stated that the buyout provision was clear and the disparity between book value and fair market value does not warrant the application of the doctrine of unconscionability. The Court went on to say that it is not the function of the court to make a better contract for either party. Imagine, the Estate received only 1/60th of the value.

Summary

When the value of the company increases, fixed price agreements can result in a windfall to the buyer at the expense of the party whose interest is being purchased. The reverse is true when the value decreases. In either event, there is a winner and a loser. As you can see, the disparity can be very significant. As a side note, both the above cases were determined by New Jersey courts.

 

Steve Koons, CPA, ABV, CFF, ASA

 

[1] Namerow v. Pediatricare Associates, 2018 N.J. Super Unpub., LEXIS 2633, November 28, 2018.

[2] Estate of Cohen v. Booth Computers, 2011 WL 2694288 (N.J. Super), July 13, 2011.

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