What does standard of value mean?  In a valuation context the word “value” can have different meanings.  Therefore, it is necessary to define what standard of value will be used in a valuation process buy-sell agreement.  If the buy-sell agreement is silent, then a standard of value will be selected by the appraiser(s).  “Fair market value” is the standard of value I have seen most commonly in buy-sell agreements.  Fair market value is also the standard used for tax valuation matters and is defined in Internal Revenue Service Ruling 59-60. 

Per Revenue Ruling 59-60 fair market value is defined as: “[t]he price at which a 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 have having reasonable knowledge of the relevant facts.”

Additionally, fair market value is defined by the ASA Business Valuation Standards of the American Society of Appraisers as: “[t]he price, expressed in cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

Both definitions are similar and contemplate an arm’s length transaction – meaning both parties are independent and will act in their own interests.  There are also eight factors to consider under Revenue Ruling 59-60.  These factors are as follows:

1.       The nature of the business and the history of the company from its inception;

2.       The economic outlook in general and the condition of the specific industry in particular;

3.       The book value of the stock and the financial condition of the business;

4.       The earning capacity of the company;

5.       The company’s dividend paying capacity;

6.       Whether the company has goodwill or other intangible value;

7.       Sales of the stock and the size of the interest to be valued; and

8.       The market price of stocks for companies that are engaged in the same or similar line of business that are traded in a free and open market. 

Further, under Revenue Ruling 59-60, appraisers are also directed to consider all the relevant facts and exercise common sense, informed judgement and reasonableness. 

The fair market value standard is often the most widely used in a buy-sell agreement context. There are other standards of value that an appraiser can select so a best practice is to define what standard of value an appraiser shall apply in the buy-sell agreement.

Another type of buy-sell agreement is known as a valuation process agreement.  Under this type of buy-sell agreement, a process is set forth that will direct the selected third party appraiser(s). Thus, a valuation process agreement is much different than a fixed price or formula type of buy-sell agreement.  The owners are essentially agreeing on a process to value the company at a future date.  The valuation process can involve one or more business appraisers that will value the company as of the triggering event.  With a multiple appraiser process agreement, you will have a minimum of two separate appraisers determining the price.  A single appraiser process agreement is where one appraiser will be selected to determine the price.  Please recognize that multiple appraiser agreements can get quite labor intensive and can be very expensive.  I typically view the single appraiser agreement as the best option in this category – due to the quagmire that often ensues when two or more appraisers are involved. 

It is critical that the valuation process agreement specify what the appraiser(s) will be doing and identify the standards to apply.  If the elements are not laid forth, then the appraiser(s) will have to use their own judgment and/or make assumptions.  Some of the most important elements to define in a valuation process agreement are as follows:

1.       Define the standard of value to be used by the appraiser(s). 

2.       Define the level of value to be used by the appraiser(s). 

3.       Define the valuation date to be used by the appraiser(s).

4.       Define what business valuation standards will be used by the appraiser(s). 

5.       Specify whether the appraiser(s) will be required to have certain valuation credentials. 

There are many more elements to consider, but the above will lay the road map for the appraiser(s) in the buy-sell agreement. The next few posts will dive deeper into these critical factors.