|
Building Equity Value
Buy-sell agreements
Defining the valuation method when the agreement
is written will alleviate future problems
By Chris Darst
A buy-sell agreement is a legal document between shareholders/partners of a corporation/partnership that establishes a methodology to be followed by the parties regarding the buyout of the ownership of a departing shareholder when trigger events occur. Common trigger events include death, disability, termination, and retirement. The buy-sell agreement will state that either the company will purchase the interest of a departing shareholder or the remaining shareholders will purchase the departing owner’s stock. From a valuation perspective, many of the buy-sell agreements that we see are disasters waiting to happen.
A true valuation story
ABC Agency, Inc., was an independent insurance agency that had two owners: a majority shareholder who controlled 51% of the stock (Bob) and a minority owner who held 49% of the shares (Cindy). Bob founded the company many years ago and generously gifted Cindy 49% of the agency over a period of years to reward her for her dedication and loyalty. Bob was comfortable financially and was not interested in selling to an outside party. His goal was to perpetuate the agency to Cindy.
When Cindy first became a shareholder, Bob’s attorney drafted a buy-sell agreement that was cooperative between parties, but subtly more focused on the process that would take place once Bob retired and Cindy purchased Bob’s stock, as this was the expected trigger event.
Then, Cindy unexpectedly passed away. Bob then had to purchase Cindy’s shares from her estate, rather than the other way around. Cindy’s estate consisted of four children whom Bob did not know very well.
Under the buy-sell agreement, each party, in this case, Cindy’s estate and Bob, each hired an independent valuation firm to prepare a valuation for the agency. An average of the two appraisals would be used for the purposes of the buyout. Bob contacted a management consulting firm that specialized in the insurance industry to prepare the valuation. Cindy’s estate hired a friend of the family, a CPA who had recently started to build a small practice of business valuations but had never prepared a valuation for an insurance agency.
The agency did approximately $3.75 million in revenue, had 25 employees, an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of around 26%, and on the surface it appeared to be a strong performer. However, the agency specialized in one specific niche industry that carried significant regulatory risks. Additionally, more than 50% of the profit was generated through contingents, and those were expected to be $0 over the next few years, due to poor loss ratios. Last, 30% of the business was tied to one account, and that account was in jeopardy.
The value as determined by the management consulting firm came in at $3 million, which Bob thought was a little high, but in the ballpark. The value as determined by the CPA was $10 million. An average of the two valuations was $6.5 million, significantly higher than Bob’s perception of the agency’s value and significantly lower than what the estate was told the agency was worth. The estate was absolutely convinced that the agency was worth $10 million and that Bob was the one being dishonest and trying to take advantage of their deceased mother. This was the start of a very long, contentious, emotional, and expensive litigation process. Obviously this was not the intention when the buy-sell agreement was implemented and makes it clear how important a proper valuation method can be.
The remainder of this article addresses common mistakes in setting up a buy-sell agreement and provides recommendations for improving the valuation component of a buy-sell. The most common agreements used in the insurance industry are the formula method, the multiple appraiser method, and the single appraiser method.
Formula method
A formula buy-sell agreement is one that includes a valuation formula that is used for determining the value of the stock when a trigger event occurs. Common valuation formulas used in the insurance industry are a multiple of revenue or a multiple of EBITDA. The formula method has some positive attributes including the following:
1. Simple to understand and straightforward
2. Parties understand how value is calculated
3. Common in the insurance industry
4. Eliminates uncertainty regarding expectations for value
5. Relatively inexpensive to implement
In Bob and Cindy’s situation, it would appear that if the buy-sell agreement had used a formula method, there would not have been a dispute. The formula described in the agreement would be calculated and a value would quickly be agreed upon. However, many other problems could surface when using the formula method. Below are two of the most common problems that occur when using this method.
• Unsustainable valuation formula—With the passage of the Gramm-Leach-Bliley Act, financial institutions changed the dynamics of the agency acquisition marketplace and insurance agency valuations, pushing up revenue or EBITDA multiples. A formula buy-sell agreement created during this time period would take into consideration the increased demand and pricing; however, it might not be appropriate for future transactions. Similarly, a valuation formula during a hard market would be different from a valuation formula during a soft market. Consequently, due to fluctuations from both internal and external factors, one agency valuation formula is not sustainable over time.
• Defining the formula—You may have a valuation formula that appears straightforward, such as 1.25 times revenue or 5.0 times EBITDA; however, the buy-sell agreement does not clearly define the components and methodology for the calculation of revenue and EBITDA. Does revenue include actual contingents or an average of contingents? What about lost business or newly written accounts? How are books of business that are owned by outside producers handled? Do we include excess owner compensation in the EBITDA calculation? These are just a few of the many items that can affect agency valuations.
If you are set on using the formula approach, it is critical that the formula be reviewed and updated on a regular basis and that the various components used to calculate value are plainly defined in the agreement.
Multiple appraisers method
Another popular type of buy-sell agreement that is common in the insurance industry is a buy-sell agreement that involves the use of multiple appraisers to determine value. The process usually specifies that at the time of a trigger event, each party selects an independent appraiser to prepare a valuation for the agency. Ideally, the valuations will be similar and the parties will agree to average the two and the valuation will be finalized. If the two valuations are far apart, a third valuation would typically be performed and an average of all three would be used, or one of the valuations would be dismissed. This method can be expensive and time-consuming, but it can be an attractive choice because all parties believe that someone is working on their behalf throughout the process.
Bob and Cindy had a multiple appraiser buy-sell agreement that ended up being a disaster. However, multiple valuation agreements can work as long as they are constructed properly and address the following five areas.
• Define standard of value—There are three basic levels of value: fair market value, fair value, and investment or strategic value.
1. Fair market value—The IRS defines fair market value as the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. This would typically include marketability discounts and control discounts for minority positions.
2. Fair value—Each state defines fair value a little differently. A common definition is the amount at which the asset (or liability) could be bought or sold in a current transaction between willing parties that is other than a forced or liquidation sale. Fair value usually does not take into consideration marketability and minority discounts.
3. Strategic value—This is the value to a particular investor based on individual investment requirements and expectations.
For Bob and Cindy, the agreement stated that a valuation would be performed, but it never defined the standard of value. The valuation of $3 million was based on fair market value, while the $10 million represented strategic value. The difference in the standard of value became the number one focus during the legal proceedings. In reality, if both appraisers had used the same standard of value, the valuation difference between the two appraisals would have been significantly less. The standard of value is a very important component of a valuation and can make a considerable difference in the outcome.
• Premise of value—Once the standard of value is determined, the appropriate premise of value must then be selected. The premise of value includes book value, going concern value, liquidation value or replacement value. Similar to standard of value, two appraisers using two different premises of value can come up with drastically different results.
• Minority/marketability discounts—Will the value be discounted for a lack of marketability or minority interest? If yes, how much of a discount will be applied? The amount of minority and marketability discounts can change significantly between valuation experts.
• Effective date—Typically, this would be the trigger date or closest month ended prior to the trigger date. However, if this date is not clearly defined in the agreement, one appraiser could use the trigger date and another could use the prior year-end date, which could result in significantly different values.
• Appraiser qualifications—Since both parties choose their appraiser, to ensure consistency, you should require appraisers to have certain qualifications. It is also common to list valuation firms in the agreement that would be acceptable for the parties to choose from.
Single appraiser method
The single appraiser buy-sell agreement method involves selecting one valuation expert to be used for the valuation process at the time the buy-sell agreement is developed. The valuation expert performs a current valuation for the agency and provides annual or periodic valuation updates to help manage the expectations when a trigger event occurs. Spouses and family members receive a copy of the annual valuation report and are required to sign a letter indicating that they have reviewed and agree to the valuation assumptions in the report. Any valuation issues or disagreement would be discussed and worked out prior to a trigger event occurring.
The five items identified under the multiple appraiser method also apply when choosing a valuation expert in the single appraiser method. When implemented properly, we believe that the single appraiser approach is the most effective and least contentious method of determining value in buy-sell agreements. Below are several reasons why we believe that this is the preferred method.
• Significantly reduces the risk of disagreements regarding agency value and pending lawsuits
• Eliminates valuation uncertainty when a trigger event occurs
• Less expensive than the multiple appraisal approach
• Initially more expensive than the formula method, but in the long run could be significantly cheaper if there are disagreements regarding the formula
• Determines a valuation for the agency stock and updates this value annually
• Eliminates risk of inadvertently omitting valuation definitions in the agreement that could affect the interpretation of value
• Valuation will reflect current market conditions
• Updated valuations can be used for bringing in additional shareholders, borrowing capital or estate planning purposes.
• Creates an ongoing relationship with your appraiser who becomes familiar with your agency
In summary, all independent insurance agencies with multiple partners should have a buy-sell agreement in place to protect the partners/shareholders from trigger events. Although no approach is foolproof, it is our opinion that the most effective approach is the single appraiser method.
The author
Chris Darst is a vice president at Marsh, Berry & Company. He can be reached at (949) 234-9648 or at chris@marshberry.com. |
