Common Valuation Issues in Buy-Sell Agreements and Buyout Disputes
Buy-sell agreements are fundamental to managing ownership transitions in private companies, often aiming to mitigate disputes and ensure smooth business continuity. However, despite their importance, these agreements frequently become sources of contention, especially when valuation disputes arise. This article explores the most common valuation issues that arise in buy-sell agreements and buyout disputes and provides insight into the critical roles that valuation professionals play in resolving these conflicts and the challenges they face.
Common Issues in Valuation Disputes
Valuation disputes in buy-sell agreements often arise from both technical and nontechnical factors. Understanding these issues is crucial for professionals inside and outside of the valuation industry, as they influence the valuation's fairness and accuracy.
Technical/Objective Issues
Technical disputes are usually grounded in factual disagreements over financial data, market conditions, and valuation engagement parameters and definitions.
Standard of Value Applied to a Business Interest: Determining the appropriate valuation standard and definition—whether strategic, fair value, or fair market value—is a key issue. Strategic value considers the worth to a specific motivated buyer; fair value is defined by accounting standards and certain state law or court precedent; and, fair market value represents the price between a hypothetical willing buyer and seller, with neither under compulsion. Disputes arise when parties favor a valuation level that benefits their position and agreements are unclear. For instance, a minority shareholder may prefer a strategic valuation recognizing potential synergistic buyout premiums, while the majority owner may push for a lower fair market value. Within a fair market value analysis, discounts for lack of control and marketability are typically considered.
Contractual Agreements, Ownership Percentage, and Control: Disagreements over ownership percentages and control rights often complicate valuations. A typical scenario involves disputes between majority and minority owners, where control over business decisions influences the outcome. Valuation expert Brian Alwine recalls, "I had a case a number of years ago where there were two partners. The 25 percent owner, the minority owner, as we call it, or non-controlling owner, didn't like what the majority owner was doing and was trying to get bought out. However, the majority owner would not cooperate and buy them out. So the non-controlling owner sold their ownership interest to that company's direct competitor, which led to years of litigation."
Marketability: Marketability, or the ease of selling ownership interests, is another critical factor. In privately held companies, lack of marketability often results in valuation discounts lowering value, though the extent of these discounts can be contentious. "It’s stock in a privately held company that I can't just go to my stockbroker tomorrow and sell... The pool of buyers is limited and the ability to sell may be further limited by buy-sell agreements and restrictions on transfer,” says Alwine.
Valuation Date: Even the date at which a company should be valued can become a matter of contention. Since a transaction is typically effective as of a specific date, the valuation represents a snapshot in time of what was known or reasonably foreseeable as of that date. An unforeseen event, like the loss of a major customer, a natural disaster, loss of a key employee, a large outside funding round, just to name a few examples, can have a significant impact on the value of a business interest.
Nontechnical/Subjective Issues
Nontechnical issues often involve subjective factors such as interpersonal relationships and emotional investment, further complicating valuation disputes.
Interpersonal Relationships and Personality Conflicts: Tensions between business owners, especially when relationships deteriorate, can significantly impact valuations. For example, Alwine described a case where an owner allowed a partner to run the business, but the partner's behavior—unfortunately involving substance abuse—led to financial mismanagement and a breakdown in trust. Such conflicts often lead to disputes over the company’s value, with personal grievances clouding objective judgment.
Emotional Investment and Attachment: Emotional ties to a business can also play a significant role in disputes. For many owners, their company is more than just a financial asset—it’s a source of personal pride and identity. Alwine explains how these situations can be "just as intense and stressful as going through a divorce," with emotional attachment leading to inflated valuations or unrealistic expectations. Valuation experts must navigate these emotions while maintaining objectivity to ensure fair assessments.
“There are a lot of things about the process that are important to nail down, and many clients go into business and set up a partnership and may give this a passing thought, but don't really think through what happens if it doesn't work out,” Alwine says.
The Different Roles Valuation Experts Play in the Process
Valuation experts play various roles in buyout disputes, each requiring a different approach and set of skills. While all three roles entail maintaining a level of objectivity and following professional valuation standards, the level of involvement and influence varies.
Consulting Expert
As a consulting expert, a valuation professional is typically hired by an attorney to help them understand the technicalities of the valuation. This role is more advisory, with the expert providing insights into valuation methodologies, financial statements, and industry-specific factors that might impact the case.
The consulting expert's objective is to help the attorney understand the knowledge needed to make informed decisions and present a compelling argument. While the expert's advice may shape the attorney's strategy, they do not directly engage in the valuation itself but rather support the legal team in understanding the nuances of valuation and interpreting other experts’ analysis and assessing its strengths and weaknesses.
Classic Appraisal Role
In the classic appraisal role, the valuation expert acts independently of either party to objectively and fairly value the company in question. This role requires the expert to remain impartial, focusing solely on the facts, numbers, and established valuation methodologies.
The expert must consider both parties' perspectives, but their ultimate responsibility is to deliver a fair and accurate valuation that reflects the true value of the company. Maintaining professional boundaries is critical in this role, as the expert's credibility depends on their impartiality and adherence to ethical standards. In some cases, the parties to a dispute will even agree to select a neutral appraiser, rather than each hiring their own, and live with the results.
Testifying Expert
The testifying expert's role involves presenting their valuation findings in court, often in front of a judge and jury. This role demands not only technical expertise but also strong communication skills, as the expert must explain complex valuation concepts in a way that is accessible to non-experts.
The testifying expert must be prepared to defend their valuation under cross-examination, addressing challenges from opposing counsel while remaining composed and credible. Their testimony can be a decisive factor in the outcome of the dispute, making this one of the most high-stakes roles in the valuation process.
In Conclusion
For experts in the private valuation industry, navigating valuation agreement disputes requires a deep understanding of both the objective financial data and the subjective factors that can influence the valuations. Whether acting as a consulting expert, a classic appraiser, or a testifying expert, valuation professionals play a crucial role in resolving these disputes, ensuring that valuations are fair, accurate, and reflective of the true value of the company in question. As the industry continues to evolve, the expertise and impartiality of valuation professionals will remain essential in managing the challenges of buy-sell agreements and buyout disputes.