/>iOne of the thorniest issues private company owners and minority investors may be required to confront in going through a business divorce is determining the value of the minority interest being purchased. It is not unusual for experts to disagree over the value of the minority interest, and this conflict can delay or even derail the business divorce from being completed. Going through endless rounds of negotiation over value may have both of the partners singing the blues. This post therefore focuses on practical solutions for business owners and investors to consider when they need to value a minority ownership interest in the process of a business divorce.
Reasons for Disagreement Among Experts
Business valuation experts generally follow a similar methodology, and as a result it may seem surprising that they can reach results that vary so dramatically. There are a number of factors, however, that help explain these conflicts. First, business valuation experts make assumptions that impact value, and these different assumptions can lead to substantially different results. As a key example, valuation experts will project the future growth rate of the business based on past trends and anticipated future events, and as a result, when the experts use markedly different projected growth rates for the business, they will reach results that have major differences.
Second, the valuation experts also typically apply substantial discounts to minority held interests, which are based on the lack of control and the lack of marketability of the interest held by the minority investor. These discounts are determined, in part, by reviewing previous transactions of similar companies, but selecting different discount rates will have a large impact on the valuation of the minority interest.
Finally, the valuation experts may rely on different data that also leads to wide variances in their opinions. In this regard, the experts will compare and apply the sales of other businesses, but they may include or reject certain sales as applicable, and using different transaction data impacts their results. Similarly, based on their own analysis, the valuation experts may use different industry multiples to apply to the company’s earnings, which is a key driver of total value of the business. If one expert concludes that the proper multiple is 5 and the other says it is 7, that difference may sound small but it will actually be quite large when the multiple is applied to the company’s earnings.
Practical Solutions to Apply to the Valuation Dispute
Given the potential, if not the likelihood, that valuation experts will reach different opinions regarding the value of a minority holding in a private company, majority owners and investors are well-advised to consider options that may allow them to avoid or at least limit these conflicts. These pragmatic approaches are discussed below.
Expert Report Averaging
If the parties anticipate that a large variance will result between the reports of the valuation experts, they can agree to a process in which three different experts are retained, and they can then average the results of all three valuation reports. Typically, this means that the company/majority owner will retain a valuation expert, the minority investor will retain a second expert, and the parties will direct those two experts to select a third, independent expert.
Once all three valuation reports are issued, the partners can agree to one of the following options: (1) they can average all three of the reports, (2) they can decide that the valuation report of the party (either majority owner or investor) that is closest in amount to the third valuation expert’s report will be controlling, or (3) they can average the amount of the two reports that are closest in value to determine the final valuation number. Selecting any of these options in regards to valuation will avoid a legal battle.
Adopt Base Value Plus Earn Out
A second option to avoid valuation conflicts is for the parties to agree on a base price for the purchase of the minority investor’s interest that references the valuation, but that also provides for an additional payment to the minority investor. In this scenario, the minority investor receives a fixed price at closing, along with a carried (non-equity) interest based on the company’s future financial performance. This structure thus provides for the investor to receive somewhat less than the full amount of the valuation price at closing, but with the potential to receive an additional amount greater than the valuation price based on the company’s future performance.
As an example, the valuation report values the minority investor’s interest at $3 million, which the majority owner considers excessive. The parties therefore agree that the investor will be paid $2.25 million at closing (25% less than the valuation report) for its interest, but the minority investor also receives a contractual right to be paid 3% of the total revenues that are generated by the company over the next three years. If the company has generated at least $10 million in revenue during each of the past three years, this might be a win-win scenario, as applying to this formula would generate at least $900,000 in a further payment for the investor if the company continued to generate annual revenues of at least that amount over the next three years.
Obviously, the potential variety of formulas that might work is infinite, but this type of win-win negotiating allows for the majority owner to push back on the total amount paid at closing to the investor while also providing the minority investor with further upside. To make this proposal work, the majority owner may need to establish a floor for the future payment, i.e., provide the investor with a guaranteed payment of at least a certain amount in the future so that the investor is not taking on a totally unprotected gamble.
Arbitration Limited to Resolution of Valuation Dispute
The third practical option to consider involves a targeted resolution process. The manner in which an arbitration is conducted is subject to contract, so rather than engaging in protracted negotiations over a lengthy period, the parties could agree to submit their valuation dispute to a prompt one-day arbitration. This is simple and straightforward as the parties should not need to obtain any discovery if they have all of the financial information necessary for the valuation. The scope of the arbitration can be limited solely to resolving the amount to be paid for the purchase of the minority owner’s interest in the company. In short, the parties submit their valuation reports and testimony from the valuation experts to explain their opinions, and the arbitrator (or panel) issues a final, binding opinion.
Considerations That Apply to Valuation Conflicts
Whatever path the parties decide to go down, they need to set guidelines that will help limit the disputes between them regarding the valuation and the ultimate cost of achieving their business divorce. The procedure for dealing with valuation is generally set forth in some form of a buy-sell agreement.
First, the parties need to set firm deadlines for issuing all of the required valuation reports. Second, they need to provide a mechanism and timetable for the minority investor to obtain access to the financial information that is necessary to determine the value of the investor’s interest, which the investor will likely provide to its own independent valuation expert. Third, they need to decide who pays the costs for the experts. Often, the company will prepare the first valuation at its sole cost, but if the minority investor then wants to secure a separate valuation, that comes at the expense of the investor. If there is a third valuation, the cost of the third valuation expert is shared equally by the parties. Finally, if there are disputes over the valuation, this is where the arbitration provision will specify how any/all disputes will be resolved promptly and efficiently.
Conclusion
The business divorce process can be frustrating, particularly when valuation disputes arise, but these conflicts can be anticipated, and they should not derail the parties’ efforts to achieve their desired business separation. The key is to be proactive. Business partners need to agree in advance on an approach to valuation before disputes take hold, because once they are in conflict, it will be extremely difficult for them to reach consensus on any form of resolution. If the partners plan ahead and implement one of the practical paths to resolution reviewed above — averaging expert reports, adopting a base value/earn out structure, or implementing a targeted arbitration — they will have a much better chance to avoid singing the valuation blues.
