Why Do I Need a Valuation? Management and Shareholder Buyouts

(Originally Posted January 15, 2018)

If you’re ready to sell your business, some of the most likely purchase candidates are the company’s management and other shareholders. They know the market. They know the business. They likely have a passion for the business. Whether you are selling to management or other shareholders, there are a few intricacies you need to be aware of.

What is a fair selling price?

Determining the selling price for your business can be challenging. A deal lacks appeal if you charge too much. But charge too little and miss out on being compensated for your hard work. Figuring out a fair selling price can be difficult in any sale, but determining the price in a management or shareholder buyout has additional complications.

The starting place for determining price is often an examination of the historical and projected financial statements to determine the company’s value. The financial statements should portray a realistic representation of the past and future performance of the company. But if the financial statement preparers (i.e. management or other shareholders) are purchasing your business, then they have an incentive to under-report profits or over estimate future risks. With all else equal, a lower operating profit and/or a higher risk assessment would result in a lower business value. To help protect you from management’s potential bias to under-report, a Chartered Business Valuator (“CBV”) can be engaged to examine the financial documentation and determine a fair selling price.

In the case of a shareholder buyout, the shareholder agreement may already stipulate the method to determine value. The agreement may contain an agreed-upon formula for determining value, or it may stipulate that value is to be determined by a CBV. Regardless of how shareholders agree to determine price, a CBV can help ensure the end result is fair.

What terms may be in the shareholder agreement?

Shareholder agreements can often contain several clauses relevant to the sale of a business. In the process of selling your business, it’s important that you review your shareholder agreement for any of the following clauses:

Shotgun Clauses (aka put-call clauses)

Ed and Jon are 50-50 shareholders in a sports equipment retail store. Ed is no longer interested in working with Jon, and offers to sell his shares to Jon for $50,000 per share. Jon can either buy all of Ed’s shares at $50,000 each, or turn down the offer. According to the shotgun clause, if Jon turns down the offer, then Ed must buy all of Jon’s shares at $50,000 each.

Right of First Refusal

Ryan and Rachel are shareholders in a guitar manufacturing company. Ryan has decided that he would like to retire and he is obtaining offers to purchase his shares from different buyers. Once the offers are all in, Ryan determines that the best offer was made by a large musical instrument manufacturer, with an offer of $250,000 for his shares. Before Ryan accepts this offer, Rachel has the right to buy Ryan’s shares for $250,000. If she isn’t interested, Ryan can accept the offer from the large manufacturer.

Right of First Offer

Similar to the right of first refusal, Ryan has decided that he wants to sell his shares for $250,000. Before he can solicit offers from third-parties, he must present Rachel with an opportunity to purchase his shares for $250,000. If she isn’t interested, Ryan can then seek offers from other parties.

Drag-Along Provisions

 Kelsey owns 90% of a beverage company and Jordan owns the remaining 10%. If Kelsey decides to sell her shares for $15,000 per share, then Jordan must also sell his shares for $15,000 per share.

Tag-Along Provisions (aka coattail provisions)

Similar to the drag-along provision, Kelsey has decided to sell her shares to Ralph for $15,000 per share. Because of the tag-along provision, Jordan has the opportunity to also sell his shares to Ralph for $15,000 per share.

If you’re thinking of selling your business to management or existing shareholders, give the experts at Davis Martindale a call. We’d love to work with you.