Buy Sell Agreements: Purchase Price Valuation
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[Farm Law editor’s note: the following piece is in draft pending academic peer review, and written as part of the series Farm Law: Owning, Managing and Transferring Farm Interests, sponsored by the North Carolina Tobacco Trust Fund Project # #583400-10363. Comments to email@example.com are welcome.]
When a purchase option is exercised, the owners of interest subject to the option (the seller) and the person exercising the option (the buyer) will have to agree on a price and payment terms. Often, the buyer and seller may simply come to an agreement on the terms of purchase. However, dispute may arise over the true value (buyer will want a lower price, seller will want a higher price), so a method for objective appraisal should be put in place before the event causing exercise of the option. After the event, it is too late.
Determination of fair market value of a company is a task that may be undertaken annually as a matter of company business. In that event, those charged with making binding decisions for the company will have set the price to be used when an interest is to be purchased under an option agreement. In the event a fair market value has not been set at least within a time near to the purchase event, there must be a process.
In addition to a process for valuation, because many companies are closely held – often between family members – a discount on the value is applied prior to purchase. Because it is important to restrict transfer of interest in the company, the company interest subject to the option may not be sold on the open market, and must suffer a reduction in value. The discount figure is agreed between those accepting the contract that governs company business between owners.
Should a dispute arise, the value is set by an object appraiser. The option agreement will normally assign who chooses the first appraiser and pays their expenses (normally the seller or company.) If the party on the other side of the purchase (i.e. the buyer) believes the first appraisal has overvalued the company interest to be purchased, he may commission a second appraisal. The company agreement may then call on the two appraisers to reconcile their figure, and it they cannot, a third appraiser is chosen.
As a practical matter, in small company situations, the expense of fully pursuing appraisal valuation may be an incentive for compromise. However, in the event both buyer and seller cannot agree to a valuation and price, a legally defensible method must be available to the parties.
The language below illustrates the process for valuation of a company interest subject to a buy-sell option to purchase.
§ Purchase Price Transferred Interest (Determination of Fair Market Value). The fair market value for any Company Interest purchased under Voluntary Transfer, Involuntary Transfer, Disability, Death will be the most recent annual value determined by the Managers under [previous section number]. For any such transfer, the purchase price is: 1) the fair market value, 2) divided by the total number of units, 3) then multiplied by the number of units to be redeemed. All units subject to redemption are applied a fifteen percent (15%) discount in value.
§§ Fair Market Value. Fair Market Value is that value annually determined by the Managers pursuant to [previous section number].
§§ Use of Appraiser. In the event the Managers have failed to determine an annual fair market value within thirty-six (36) months prior to the notice of the proposed transfer of a Company Interest, the Managers shall set the fair market value of company interests by use of an appraisal of the assets, with the Departing Interest Holder naming the appraiser, which in the case of an estate is the appraiser of the estate. The Departing Interest Holder shall pay the appraiser’s expenses.
a) Challenge of Appraisal. If the purchaser of the Company Interest (i.e. the Company) (“Buyer”) should question the value as determined by the Departing Interest Holder’s appraiser, he or she may select and pay the expenses of a second appraiser. The two appraisers shall proceed to determine a fair market value. Their valuation shall be final and binding on all parties.
b) Resolution of Different Appraisals. If the two appraisers cannot agree on a fair market value, the two appraisers shall select a third appraiser. If the third appraiser’s value is outside of the range of the first two appraisers, the value of the first two that is closest to the third shall be used. If the third appraiser’s value is within the range of the first two appraisers, the third appraiser’s value shall be used. This determination shall be final and binding on all parties. The Departing Interest Holder and purchaser(s) shall each pay half of the expenses of the third appraiser.
c) No Consideration of Insurance Proceeds. In determining the fair market value of Company Interest, no consideration may be given to the proceeds or value of any life insurance owned by the Company on the life of any Interest Holder, except to the extent of its cash surrender value.
d) Payment of Appraiser Fees. All fees and expenses of any appraisers retained in connection with any determination of fair market value under this § must be borne fifty percent (50%) by the Departing Interest Holder and fifty percent (50%) by the Buyer, except that the two fees of the two appraisers who are appointed individually by the Departing Interest Holder and the Buyer shall be paid individually by the party appointing that appraiser.
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