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This article was originally created for the Canadian Institute of Chartered Business Valuators
Just as every apartment needs a fire escape, every shareholders’ agreement needs a buy-sell clause to set a price for the company’s shares on the occurrence of certain triggering events. A buy-sell clause outlines a process and pricing mechanism for the sale of the shares of a departing shareholder (e.g. upon death, disability, retirement, etc.) that necessitates a change in the ownership of a closely-held private company. The purpose of the clause is to provide a pre-determined procedure that ensures a fair price for all shareholders, while ensuring an orderly transfer of control to the remaining owners. Yet, in this author’s experience, these clauses can often create havoc if the pricing provisions are not properly thought out. This article provides an overview of some commonly used pricing mechanisms and discusses the pros and cons of each.
Don’t use Book Value!
The pricing mechanism in the buy-sell clause should be designed to ensure that both the buying and selling shareholders will be able to automatically transact at a price that is fair to all parties. One solution commonly adopted is for the shareholders to base the price on the net book value of the company. Net book value is simply the difference between the assets and liabilities reported on a company’s balance sheet at a point in time. The calculation of net book value is typically a straightforward mathematical exercise, but it may not result in a fair price. To understand why, consider the following example:
Because ABC’s balance sheet will present its assets and liabilities based on their historical cost, and not their current fair market value, a pricing mechanism based on book value will tend to significantly understate the value of the shares. The formula disregards the value of intangible assets and goodwill that may have developed within the company, since their historical cost is nil and their fair market value is not recognized on the balance sheet (in accordance with generally accepted accounting principles). It also ignores any appreciation in the value of certain tangible assets, such as real estate.
If book value is not a reliable method, then are there any other simple methods that can be used? Here are three possibilities, along with some caveats:
Fair Market Value
In order to avoid the drawbacks associated with the various approaches outlined above, it may be advisable to hire a third party valuator to determine the
fair market value of the shares. Fair market value is the amount that an item (such as a company’s shares) would realize in the open market. Fair market value looks at what a company’s assets are actually worth, rather than their historical cost.
The advantage of a fair market value determination is that it results in an objective and current measure of the shares’ worth, provided by an arms-length professional with expertise in business valuation such as a Chartered Business Valuator (CBV). While there is a cost associated with hiring a professional, it may pale in comparison to the cost of litigation in the event that the parties are unable to arrive at a price that is mutually agreeable and supportable.
When drafting a shareholders’ agreement, it is important that shareholders, their financial advisors and legal counsel give adequate consideration to the buy-sell clause, particularly in relation to the price-setting mechanism. Approaches that may appear easy-to-use and appropriate at a given time may become irrelevant and outdated, resulting in much acrimony and litigation. A proper, arm’s length appraisal by a Chartered Business Valuator may prove to be a sound approach in the long run.
Make sure you have an adequate fire escape!
To learn more, contact Catherine Tremblay, CPA, CA, CBV, ASA, CFF, National Leader, Valuations, at 514.861.9724 or
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