Breaking Deadlocks Over Valuation

By John A. Graf

Family members at odds over price can try two resolutions: “Baseball” or “Texas Shootout.”

Most first-generation businesses owe their dynamism to the single-mindedness of the owner and the spirit of entrepreneurship which usually pervades the company. When two or more generations become active in the business, however, these same qualities can generate fireworks. To ensure against possible future conflicts that could destroy the business, family members should set up orderly procedures for buying out dissidents well in advance—while the business is healthy and the generations are pulling together as a team.

The first step should be to elect all family participants in the business to a board of directors. The board takes the second step, which is to draw up an agreement that spells out the terms of buyouts. The board initiates and approves the agreement. It is important for all family members to be on the board to ensure they are committed to procedures in the agreement to cover internal disputes.

The buyout agreement can be as simple or complex as the parties want it to be. But every such agreement must provide specific answers to two critical questions: What events will trigger a mandatory purchase and sale? And how will the value of the business be determined?

The events that can trigger a buyout can be defined fairly easily. The agreement should provide that if a senior or junior family manager retires voluntarily or quits the business, the company would have a right to buy out that person. Similarly, the agreement should have a provision entitling the company to buy out employees who are stockholders if they are fired for any reason. Also, if a third party is seeking to acquire the stock of a family member, the seller should be required to offer the stock to the company first. Finally, the death of a family member is a triggering event which should require heirs not active in the business to sell stock they inherit back to the company.

The buyout agreement should establish a value for the business or spell out a formula for determining the value in a buyout situation. Family members who are employees and stockholders should discuss the valuation candidly and agree on the business value and their ownership interest.

Many cross-purchase and redemption agreements prepared by insurance companies tie the value of the business to life insurance. This approach works only in the event of the death of the business owner. The buyout agreement must incorporate other valuation techniques to cover cases of stockholders who leave the business or are terminated during their lifetimes; these include book value, earnings, return on investment, appreciation of business assets, and similar components.

In most cases, the parties are able to agree that buyout rights will be triggered upon the death, retirement, or termination of a stockholder-employee. More serious problems are encountered when junior and senior managers or business partners cannot agree on a valuation that will be the basis of a buyout.

To cover such cases, the family might consider two weapons for resolving deadlocks over price: the Baseball Plan and the Texas Shootout.

Under the Baseball Plan, the buyout agreement provides for an arbitration similar to what happens when a ballplayer and his team cannot agree on a contract price. In such situations, the ballplayer sets his price and the team sets its price. Both sides document their positions and submit their cases to an arbitrator, whose decision is binding. The arbitrator does not average the numbers or come up with a compromise figure. He selects only one winner at only one price.

Although a quick and efficient remedy for deadlock, the Baseball Plan imposes obvious risks for both player and team: The loser must agree to abide by the arbitrator's decision. In one family business, a new generation discovered the downside of the Baseball Plan. The children owned 25 percent of a business with a net worth of $500,000 that earned $250,000 before taxes on $3 million in annual sales. Seeking to buy out the parent and founder of the business, who owned 75 percent of the stock, they submitted a value of $1.2 million for the business. That would have required them to pay 75 percent of $1.2 million, or $900,000.

The parent valued the business at $2 million, and that figure was declared the winner by the arbitrator. The children had to pay 75 percent of $2 million, or $1.5 million, instead of $900,000. In this baseball game, the kids had struck out. The lesson they learned was that buyers who expect to win with a low-ball bid better be able to support such a valuation with strong evidence; otherwise, they may have to pay a higher, better documented price.

The Texas Shootout is a variation on the same theme. When the triggering event occurs, the prospective buyer submits a price to the sellers for their ownership interest. The sellers have 30 days to either accept that price and sell their equity interest—or to purchase the equity of the buyer at an identical price.

There is no arbitration. There is no litigation. There is no third party decision-maker. There is no documentation required to justify the price. It is the proverbial Wild West shoot out in which only one gunfighter walks away as the owner. If the original owner sets his price too low, he will be bought out. If he sets his price too high, he will have to buy out his opponent.

Obviously, the Texas Shootout is appropriate only when buyer and seller both have an interest in controlling the company—as when two partners decide to break up and one has to go his way.

In both Baseball and Texas Shootout, the parties must consider whether, if they win the game, they will have access to the resources of the company in order to leverage the transaction. Alternatively, the winners will have to borrow from their lending institution, which usually looks to family members for guarantees and additional collateral beyond the stock and other assets already pledged for the company's regular line of credit. It is not enough to win at Baseball or Texas Shootout: Winners must have the support of a bank's resources in order to pay the price.

The buyout agreement approved by the board of directors should thus anticipate how the sale will be financed as well as when it will be triggered. By mandating buyout provisions well in advance, family members can minimize the bad feeling that can occur in some partings of the ways. Though methods such as Baseball and Texas Shootout have their risks and are a last resort—to be invoked only when the parties cannot agree on a price—they are surely preferable to long, costly litigation over buyout terms.

John A. Graf, who writes frequently on legal and business issues affecting closely held companies, is a senior partner in the law firm of McLane, Graf, Raulerson & Middleton, based in Manchester, NH. He is a director of the Smaller Business Association of New England and chairman of the New Hampshire Advisory Committee on International Trade.

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Spring 1993

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