On October 16, 2007, "Buying a Second Business", an business owner educational video, premiered on BMighty.com.
In the first segment in this educational video moderated by Valerie St. John of bizwise TV, Stan Feldman of Axiom Valuation and David Bowman of Wells Fargo discuss the benefits of buying a second business and how to pick an acquisition target, and answer the question: When should you buy out your competition?
Click here for "Buying a Second Business" video on Bmighty.com.

Cisco also has made available a podcast of the discussion by Stan and David. Click here to access this podcast.

On September 11, 2007 at the Foley & Lardner office in Boston, MA , Dr. Stan Feldman of Axiom Valuation Solutions, Jack Malley of First Jensen Partners and Ken Appleby of Foley & Lardner conducted a morning seminar at Foley & Lardner's Boston office on what CEOs and CFOs need to know to effectively manage stock option and other forms of deferred compensation for your company given 409A and FAS 123R. The PowerPoint presentations from the seminar are available in the Valuation Library Section of the Axiom Valuation website. Click below on the link to these presentations.

Just as few people ask a potential spouse to sign a pre-nuptial agreement, few people write in a valuation plan for buyout or dissolution into a business organization agreement. Survivors of marital divorce and business owner divorce look back upon the money lost due to a difficult break-up and wonder how they could have paid less for the transaction. The answer for companies is the business equivalent to a pre-nuptial agreement: a contracted valuation process.

Negotiating the terms of a breakup at the outset of a business relationship can be viewed as starting out on the wrong foot. It also costs money for legal fees, which is often the reason cited for not putting this in place by owners of businesses starting up. Owners that go the route of including boilerplate legal language for an owner buy-out process are often not much better off. Boilerplate clauses can result in a process that is cumbersome, expensive, and vague on the most important issues, such as: the specific standard of value to apply, whether discounts apply, and what valuation methods should be used.

For example, a common standard corporate agreement owner buy-out process clause calls for the opposing parties to each retain a valuation expert, and then for the two valuation experts to choose a third. All three valuation firms then produce a valuation result. A review of these buy-out clauses for businesses where Axiom Valuation has been involved finds that most did not specify two critical factors: 1) what should be done with the three results, i.e. should the three be averaged; should the court throw out the high and low and use the middle value; should the court ask the three valuators to attempt to reconcile their differences if their results differ by more than a certain percentage? and 2) whether the value should reflect discounts for minority interest and/or lack of marketability. This process is needlessly expensive, time-consuming, and still leaves significant uncertainty about what the value will be.

Valuation Legislation

While every state has a corporate statute that provides an appraisal right for oppressed or frozen- out shareholders, or shareholders in companies that are about to undergo fundamental change, no state has a specific statutory valuation technique. The only help a state statute will provide for a valuation expert is setting the standard of "fair value" or "fair market value". Telling a valuation expert to use fair value or fair market value does not offer any real direction because of the complexity of the rest of the assumptions used in all valuations. Most states use the American Bar Association's Model Business Corporation Act ("MBCA") as a template for their corporate statute. This is the only guidance the MBCA, and most states, provide on the method to value a business:

Sub Chapter C § 13.30 (d) The court may appoint one or more persons as appraisers to receive evidence and recommend a decision on the question of fair value. The appraisers shall have the powers described in the order appointing them, or in any amendment to it. The shareholders demanding appraisal rights are entitled to the same discovery rights as parties in other civil proceedings. There shall be no right to a jury trial.

States that do not have an MBCA based statute use a statute more closely modeling the Delaware General Corporation Law. Below is the excerpt concerning valuation methodology.

§ 262 (h) After determining the stockholders entitled to an appraisal, the Court shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with a fair rate of interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors.

Legislators are not valuation experts. The legislative efforts described above are designed to generate a general framework from which clear common law guidance on business valuation standards should emerge from court decisions, where the judge has decided in favor of one of the opposing valuation experts.

However, a clear set of standards applied uniformly across the country has not been the result; contested valuation methodologies in appraisal cases have created a state of legal flux. Statutes and common law precedent do not include guidance on the specific valuation techniques that should be used and are therefore of little help to a valuation practitioner.

Valuation Methodology

In the 1980's and 1990's, courts exhibited a preference for using three different valuation approaches, asset, market, and income, and weighting the value reached with each approach based on its applicability to the company. This method is referred to as the Delaware Block Method. It is also part of the Uniform Standards of Professional Appraisal Practice. While this method sounds specific, the problem is that the weighting of each approach is arbitrary and often one approach is completely inapplicable, i.e., the asset method is generally not applicable for a going concern. The appraiser is supposed to consider each method, and then use the one or ones that are appropriate for the facts and circumstances of the business and consistent with the purpose of the valuation.

There is a trend for courts to rely more upon the income method, specifically the discounted free cash flow method. The discounted free cash flow method requires the valuation analyst to specify clearly the assumptions about what future financial performance of the company, so that these can be tested for reasonableness by the court. Market methods can also be very important, if there are truly comparable company transactions of recent vintage, or if there are public company peers. Even with continuing improvement in financial analysis and research that makes valuation analysis more empirically rigorous, it is often the case that opposing valuation experts will still arrive at significantly different results.

Discounts

Then, there is the question of whether to apply discounts to the value result to reflect a liquidity discount or lack of marketability, or a minority ownership position. The most contentious discount is whether to apply a minority ownership discount, if the ownership position being bought from the departing shareholder does not change control of the company.

For example, a 25% shareholder is being bought out by a 75% shareholder. In this situation, the 75% shareholder already has control of the business assets and decision-making. If the 25% shareholder were gifting shares to a family member, there is no doubt that the application of a minority discount to the share value would be correct.

The debate over minority discounts centers around whether the departing shareholder deserves the value they would receive upon the sale of the entire business to a third party, or whether the departing shareholder deserves the price someone would pay for a non-controlling interest in the business. In the case of a business sale, both shareholders receive the same price per share, but a non-controlling interest price per share is usually reduced by a minority discount that could range widely.

There are two policy rationales behind not applying a minority discount. Firstly, the remaining owners may sell the company shortly after squeezing out the aggrieved shareholder, essentially cutting that shareholder out of the profits from the sale. Secondly, the departing shareholder typically has been overpowered in some way and courts prefer to give deference to the oppressed party. The key issue for business owners to understand about discounts generally is that discount application is not settled law, and a judge has the discretion to impose a discount, which typically ranges from 10% to 50%. The potential for a large discount is not removed by hiring a valuation expert, because the opposing expert can, within the confines of most precedent, challenge any position on discounts.

What will determine whether a minority discount will apply in an owner buy-out? The most important determinant, if there is not a specified value standard and definition in the corporate agreement, is the state in which the business is incorporated. Periodically, there are surveys of court decisions by state as to what the prevailing standard of value is, generally fair value or fair market value, and whether discounts for minority interest and lack of marketability should be applied. In a recent survey of whether discounts were applied or not, the authors found that about half of the states rejected the application of discounts, and the others either accepted the use of discounts or the application was left to the discretion of the court. Over time, the trend has been moving in the direction away from applying a minority discount if there is a shareholder dispute; however, if the business is incorporated in a state that allows discounts at the court's discretion, then the outcome will be uncertain unless the business owners contract their own buy- out process, standard of value, and method.

Contracting into a Valuation Strategy

Submitting oneself to the vagaries of business value litigation is uncertain, costly, and time consuming. Instead of running this unnecessary risk, business owners can contract into a valuation strategy. To accomplish this, the business owners need to waive their statutory appraisal rights. The MBCA and many other states' statutes provide that a shareholder may contract out of appraisal rights. Then the owners can put a process in place, define their valuation terms, decide about discounts, and specify valuation methods that are appropriate to their business and that will accurately reflect the value. Axiom Valuation sees a number of companies that have chosen to determine a value using an independent source during a non-confrontational period, and then to build in a clear process and a valuation formula based on these results into their buy-sell agreement. Although a contracted valuation strategy will protect against costly litigation in most situations, some states have refused to apply contracted for valuation technique in cases of minority shareholder oppression.

A key step in an effective business transition plan is to put in place a process for dealing with changes in business ownership. While buy-sell agreements to address the death or disability of an owner are vitally important to have in place, a buy-sell process for an owner buy-out under other circumstances should also be near the top of the priority list. Going through an expensive and time-consuming owner divorce is a serious risk to the survival of a business. Contracting into a fair valuation process and method is a smart way of ensuring that you and your fellow owners maintain control of the shareholder change process, rather than placing the responsibility into your state's court system.