How many times have you encountered situations like this? A business has multiple owners. One or more is to be bought out. The problem is that either there is no buy-sell agreement whatsoever, or the agreement does not stipulate a buyout price / formula, terms of payment, or level of value (whether premiums and discounts for control / marketability will apply).
Well, duh, probably every buyout you have handled has at least one of these problems, or your expertise would be unnecessary … so I will venture to say that every single one of them involved at least one!
Assume the business – all shareholders as a group, not the buyer(s) or seller(s) – has engaged us to provide objective, independent, and constructive valuation advice. Assume we have helped everyone come to agreement on enterprise value – the value of 100% of the equity or capital of the business (and that this value reflects any changes in compensation or anything else that will occur because of the buyout). If this cannot be achieved, there is no way a deal can be made on a rational basis (that is, with our quantified advice. (When engaged for this type of transaction, my letter states that if there is no agreement on enterprise value, my work is complete, I am ineligible for retention by anyone in any legal action or further engagement, and if called to deposition or testimony, I will be retained in advance by the business).
Now the owners have agreed on enterprise value: the first of the three issues is resolved. The next two are the level of value and payment terms. Remember that this is an actual transaction unbound by a buy-sell agreement – so the standard of value is investment value, not fair market or fair value. (Fair market value might be relevant if the owners are family members, but I am going to assume they are not, just for simplicity. Fair value would be relevant if dissenting shareholder litigation ensues, but my engagement precludes me from involvement in that other than to testify as to what I did in the current engagement.)
The point is that the investment value standard means that the level of value (whether discounts and premiums apply) and the payment terms are negotiable, not stipulated. What counts is not what the appraiser says, but whether the parties can agree. This is CRITICAL! All the appraiser can do is offer objective advice. The parties decide whether to take it or not. When I give advice, I try to suggest processes and procedures, not specific numbers because numbers just hang everyone up.
At this point, I like to meet with the parties in person or in a conference call – the key is for all to be present, not for me to speak to one side or the other privately (which could risk my credibility).
First, I tell the sellers that they probably expect to receive their pro rata (I explain this term) percentage of the value of the business in cash. After all, if the whole business were sold, that is what they would receive. They might also feel this way if they bought in on a pro rata basis. Despite that, they are minority shareholders who suffer from lack of control and marketability (and I explain each of these), so a third-party cash buyer would pay them less than pro rata value. I also acknowledge that this might be something they had never thought abou. The bottom line is that the cash value of their individual interests is less than pro rata value. (Now I have upset but softened up the sellers a little.)
Now I turn to the buyers and tell them that the sellers do not have to accept any discount, and that the idea of a discount or a high one may be a deal-breaker. If the buyers want to make a deal, they are going to have to make the buyers willing to accept it. (Now I have upset but softened up the buyers a little.)
[Note: at no time have I disclosed how big a discount I think might apply. As you will see below, I will have done some calculations, but now is not the time for me to opine anything! Remember, the goal is to get the parties to agree. Numbers do not help, ideas do.]
At this point, I say that we can progress in a number of ways. One, the parties can just haggle. If they want to do that, I will excuse myself. On the other hand, I have an idea they might want to pursue. Would they like to hear it? (Of course!)
I propose a compromise that I call “seller’s price, buyer’s terms.” What this means is that the sellers receive their pro rata share of value – whatever number of dollar bills that is – but that the buyers get to structure the transaction to pay money out over time. For example, the buyers might accept a payout over three to five years.
[Note: I am keeping it extremely simple at this point. First, I am proposing simple seller term financing: if the payment term is 4 years, the sellers get 20% down and 20% annually for the next four years at yearend, with no interest. If the business has extremely risky prospects, I may later broach an earn-out. Also, not being an attorney, I will not get into issues of guarantees and security.)
If the parties are amenable to this, I present those three- to five-year (or whatever) payout schedules in the context of a pro forma company financial projection that assesses how easily company cash flow to equity can service the obligations.
Then I compare the present value of the payments over time (usually discounted at the company’s cost of equity capital, assuming that the payments will be subordinated to bank debt so that the payments come out of cash flow to equity; this can vary with case facts and circumstances) and compare it to the undiscounted amount. This indicates the total discount. A perceptive seller might counter that the discount rate should be the cost of debt. That is reasonable if bank financing is available, and suggests a much lower discount, which gives more room for negotiations. THEN I compare these discounts to those calculated using our traditional LOCD and LOMD methodologies.
Now I am done: I have given the parties objective, quantifiable bases to negotiate, and the rest is up to them.