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Ownership Transfer

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Owners of privately held companies are wise to document in an agreement the terms of any potential transfer of ownership, should a triggering event occur.  When a new company is formed, the founders rarely think about what could happen in 5 to 10 to 50 years.  Initially, everyone trusts everyone, and, of course, everyone will live forever.  Why should founders even think about a transfer of ownership?  All current members are in it for the long haul!

Of course, this is not realistic.  Businesses and owners change, and owners want or need to leave the company for a variety of reasons, including divorce, ownership disputes, shareholder oppression, sickness and even owner death.  Many companies document how and when a transfer of ownership will occur, but do not clearly indicate the value of equity interests or shares in the future or how the equity is to be valued.  If an owner wants to sell to a third party, there are likely restrictions on the sale (perhaps only to family members), or the current owners have the opportunity to meet the external offering price and restrict that owner from selling to a third party.  There may be a formula or methodology in the agreement to determine the value of shares to be transferred, but, all too often, the annual valuation of the individual equity has not been determined for many years.

A Buy-Sell Agreement is utilized by relatively few companies.  This agreement typically provides how the company shares are to be valued should the shares need to be purchased by the business or other remaining shareholders should a member need to or want to sell his/her shares due to extraordinary circumstances, including death.  Usually, the company will purchase life insurance on each of the owners to cover the value of each owner’s shares. The agreement should have a formula or methodology identified, which is relevant to the type of business and could be as simple as a multiple of revenue or EBITDA, which all parties agree to when the agreement is prepared.  However, the agreement is prepared, as it should, when all parties are cooperating with each other and are generally “friendly”.  When a triggering event occurs several years later, it is likely one of the parties will not be happy with a simple multiple, as the business has grown more complex and changed, and the simple multiple is not applicable at the current date.  It will then be up to a court of law to decide how best to determine the valuation of a specific ownership interest.

A strong, comprehensive valuation of a privately held business entity is required to limit the uncertainties noted above.  In contrast to valuations required for third-party review, such as IRS valuations prepared for Estate, Gift, or Deferred Compensation purposes, or valuations for the Department of Labor for an ESOP, an appraisal (or more likely, a calculation report) for ownership transfer inside an operating, buy-sell or shareholder agreement need not require full compliance with designation standards.  The parties can determine the methodology and limitations.  For example:

  •  Asset, Income or Market approach only, based on previous years’ results
  •  Elimination or limitation on discounts for lack of control, marketability, or liquidity
  •  Inclusion or exclusion of non-operating assets, such as excess land, working capital, or outside investments

Sobel-EAC Valuations has worked with several privately held companies that have had to face these issues.  In one case we’re currently working on, the spouse of a deceased shareholder who, according to the by-laws, could not own shares in the company and must be bought-out by the company within 30 days of death, is suing the company because valuations that were supposed to be performed starting 20 years ago were never performed.   On the other hand, we’re working with another company whose management is looking to upgrade their Buy-Sell Agreement so should there be a need for ownership transfer, it is clear how the seller or his estate will be compensated by the company for his interest in this $150 million+ equity value company.

The best strategy for limiting conflict and moving to quick resolution is to have a valid appraisal in place and current at the time of the triggering event.  That means the valuation should be determined directly, with limited conflict (someone will always disagree!)

For the latter case, Sobel-EAC Valuations has provided a complex formula that’s easily modeled to determine the value of 1 share of their “S” Corporation that can be utilized over the next 3-5 years to determine the Buy-Out value of the shares which will be fair to both parties.  This Calculation Report model should be updated at 3-5-year intervals, or sooner if the business has changed products or services offered, external economic conditions have impacted the company, or the company has grown or contracted significantly from the time the original appraisal was presented.  The re-valuation can be completed by the management of the company, their accountants, or Sobel-EAC Valuations as soon as financials applicable at the date of transfer are available.  Often, an agreement will state that should a triggering event occur, the valuation will be determined by this formula as of December 31 of the previous year.

We can provide the same for your business or your clients’ businesses.  Contact us.  Our passion is to assist our clients in achieving the best outcomes.

Frank Merenda, Sobel EAC Valuations
Frank.Merenda@SobelCoLLC.com