Litigation support professionals are often asked to prepare valuations or various calculations based on the language in buy/sell agreements, operating agreements, and purchase agreements. These agreements often do not provide clear language as to how valuations or other calculations are to be performed. This article will cover some of the common problems encountered in buy/sell agreements.
Frequently, undefined terms such as “profits,” “income,” or “net income” are used to describe inputs into various formulas in an agreement. However, these terms can be vague and can easily lead to undesired outcomes if not carefully defined.
Net income or profits should be clearly defined as revenues less expenses. However, which revenues and expenses should be included in any calculation should be carefully considered, particularly if there are unusual circumstances. The term “income” is particularly unclear as it sometimes refers to revenues and sometimes refers to revenues less certain expenses. In order to properly define these terms, the drafter of the agreement should, at a minimum, address the following issues:
Accounting terms need to be properly defined; otherwise, an accountant or business valuator who is asked to prepare calculations consistent with the agreement will not have sufficient direction, and unintended outcomes may result.
Frequently, the term “GAAP” (Generally Accepted Accounting Principles) financials is used in buy/sell and similar agreements. Often the term GAAP is used as shorthand for accurate financial statements (e.g., “financials should be prepared in accordance with GAAP”). However, GAAP has a specific meaning that may not be applicable to many companies and situations.
One of the biggest problems with requiring GAAP financials in an agreement is that many companies have likely never prepared GAAP financial statements. Small and medium-sized businesses typically use cash or tax basis accounting, which does not comply with GAAP. Even if the company uses accrual basis accounting rather than cash basis accounting, the company may still not prepare GAAP financials. For example, many companies do not prepare accurate year-end accruals in accordance with GAAP. Additionally, technically, financial statements prepared under GAAP are required to have footnotes (i.e., narrative descriptions and details pertaining to the various components of the financial statements), while few small and medium-size businesses prepare footnotes to their financial statements.
Therefore, when an agreement demands that financial statements are to be prepared in accordance with GAAP, and the company has never prepared GAAP financial statements, it can create a significant problem. Many companies would not be able to switch to GAAP financial statements in a timely and economic manner. Even if it were possible for a cash basis company to prepare GAAP financial statements, the newly created GAAP financials would not be consistent with previously prepared financials. A lack of comparability to prior periods (or to projections and forecasts), may or may not impact the desired objective of the contemplated agreement.
Due to the high likelihood of problems arising from the improper use of the term GAAP, it is prudent to determine how the company keeps its books (cash and tax basis financials are the most common) and then craft the requirements of an agreement accordingly (not necessarily requiring GAAP financials).
The term “Fair Market Value” (FMV) is often used in buy/sell agreements as the standard of value used to determine an owner’s interest in a company. The use of FMV is sometimes used as a default term when Fair Value may be the more appropriate standard of value.
A FMV calculation generally requires discounts for lack of marketability and lack of control for ownership interests of less than 50% of the company. Therefore, a valuation prepared using FMV will most likely result in a value, for a minority owner, significantly less than a valuation prepared using Fair Value. A Fair Value standard generally does not apply discounts for lack of marketability or lack of control.
An alternative to specifying the application of Fair Value could be to require a value determined using FMV but specifying that no discounts are to be applied.
Other factors, such as owner’s compensation and perquisites, often need to be taken into consideration in valuing an owner’s interest in a company. Owners of small and medium-size businesses rarely pay themselves the going market rate, which will then impact, positively or negatively, the profitability of the business. Therefore, the treatment of owner’s compensation should be addressed in the agreement, unless a third-party business valuation is called for. Business valuators typically adjust for non-market owner’s compensation and perquisites when valuing a business.
Given the possibility of ending up with an unanticipated outcome, it is a good idea to consult with a valuation expert when crafting the methodology for valuing a business or an owner’s interest in a buy/sell or similar agreement.
Buy/sell and other similar agreements utilize accounting and valuation terms that should be carefully considered to achieve the objective of any such agreement. Therefore, it would be wise to have an accountant or business valuation professional, familiar with business valuations, look at your agreements to see if there are any issues or imprecise terms that require further clarity and definition to ensure the desired outcome.
We would like to thank Scott E. Evans for providing insight and expertise that greatly assisted this research.
Scott E. Evans, CPA, ABV, CFF, is a Managing Director in J.S. Held’s Corporate Finance Practice. He brings extensive experience in the calculation of economic damages, forensic accounting/embezzlement, family law matters, business valuations, bankruptcy and solvency analyses, fraudulent financial reporting, and accounting malpractice investigations related to SEC registrants and auditors, analysis of purchase price disputes arising from the sale of a business, investigations performed for the Arizona State Board of Accountancy, and audits performed under generally accepted auditing standards. He has provided expert testimony related to damages and other financial issues in federal, state, and arbitration matters, in both civil and criminal cases.
Scott can be reached at [email protected] or +1 602 396 7434.
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