One of the hardest decisions a small business owner has to make is parting ways with the business they have dedicated blood, sweat, tears and treasure to build and/or grow. The difficulty of this decision is compounded if there is not an agreement with the other owners as to how to calculate a buy-out of the departing owner’s ownership interest in the business. Valuing the business in the absence of such a controlling agreement often leads to litigation between the owners. To help avoid such litigation, it is important to put a procedure in the business’ governing documents to control the buy-out process. While every business is different, there are some common methods in valuing businesses that you can utilize when it comes time to form your business. We will discuss some of the main formulas/methods to effectuate a smooth buy-out for your corporation, limited liability company or partnership.
- Requiring the owners to set an annual valuation price of the business. Such method is cost effective as it does not involve any third-party accountant or appraiser. The owners, assuming they are all getting along, should have a joint interest in setting a fair price on an annual basis. If, however, they fail to agree to such annual valuation price for the business, disputes and litigation often arise to set the buy-out price on departure.
- Utilizing a book value of the company for calculating the buy-out of a departing owner is another cost effective and generally straightforward calculation. Book value simply looks at the assets and subtracts the liabilities of the business and then divides the number by the proportionate share of the departing owner’s interest in the business. Book value calculation does not provide any value for goodwill or take into account future income of the business.
- Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) is another often utilized formula. Because the EBITDA calculation ignores the impact of non-operating expenses, the result is a metric that reflects the business’ operating profitability. Depending on the industry of your business, the EBITDA calculation may also be multiplied by a particular number to determine the value. EBITDA is frequently utilized in businesses that are manufacturing heavy.
- Having a neutral third-party appraiser provide an opinion is another option. This could be a single appraiser or it could be the case that the departing owner appoints an appraiser, the company appoints an appraiser, and those two appoint a third appraiser. While this can be an effective way to value a business if there is concern on setting a formula at the commencement of the business to be utilized at some date far in the future for setting a buy-out, appraisers often require several thousands, or in complicated situations, tens of thousands of dollars to complete their appraisals.
- A ‘Texas Shoot-Out’ clause provides that one owner makes an offer to the other owner(s) for the buy-out. The owner(s) receiving the offer then has the option of either purchasing the offering owner’s interests or, conversely, selling their interest in the business at the same price. This clause is thought to keep owners honest with each other as they would not want to make an offer that is so low the other owner will turn around and buy their interest out at that price. The downfall is that oftentimes there is an owner that is financially better off and may make an offer that is below market, but above what the other owner can pay so they effectuate the buy-out at a discounted rate.
In addition to these methods, you may want to consider including a lack of marketability discount and/or a lack of control discount. Lack of marketability discount takes into account that closely held businesses are not publicly traded and thus the market for selling is smaller and more difficult. Whereas a shareholder of Apple stock can easily sell (or buy) the same through their ETrade or Charles Schwab or other brokerage account, a closely held business owner cannot. A lack of control discount is applied if a minority owner sells his/her interests. Because the owner does not have a controlling stake in the business (less than 51%), a lack of control discount is applied. In some instances, both discounts may be relevant.
The appropriate appraisal method for calculating the buy-out formula of your business is dependent upon what type of business you own or are starting and what goals you are seeking to effectuate. To (hopefully) avoid litigation, it is important to have a controlling agreement setting forth how to effectuate a buy-out and on what terms (i.e. lump-sum or over a period of time).