Shareholders’ Agreements
Personal Business Risk

Minority-ShareholderOne very controllable shareholder business risk may be easily and respectfully addressed by the preparation of a thoughtful shareholder buy-sell agreement.

The agreement should identify and establish a solution by disclosing and addressing concerned risks, including asset transfer issues, pricing and financing.

One major issue often resulting in disputes is the flawed approach to the business transfer price, how that value was determined and who do the shareholders rely upon to determine the value. I have encountered, especially in older agreements, the following approaches used to determine business value for non-real estate companies:

  • Net book value –Archaic and usually results in below market value
  • Fair Value – Present value of the risk adjusted rate of return on investment, further adjusted by illiquidity risk
  • Fair Market Value –  Same as Fair Value but further reduced by lack of control pursuant to minority interests
  • Rule of Thumb Formulas – Market multiples of sales, gross profits, and/or EBITDA based on market transactions  of comparable businesses
  • Capital Account Formulas

Absolute clarity and fairness consensus is required to appropriately address the business risk, plans for the business to finance, remove threats of misunderstandings which result in litigation. Valuation theory and methodologies may become dated or outdated and subject to differing interpretations, resulting in expensive and acrimonious litigation if left unresolved.

However, before making decisions, shareholders need to understand the triggering factors, valuation approaches discussed and the potential impact on valuations. Results, depending on approach selected, may yield either an over or undervaluation. In addition, if the approach selected is not periodically updated for economic and financial relevance, value may be irrelevant.

All agreements will have trigger factors, which are the risk events identified causing the agreement to guide on the value transfer. Such trigger events include death, disability, substance abuse, voluntary and involuntary termination, failure to agree on substantial business decisions and other factors. There is no way to predict when the factors will materialize, so preparation and consideration in the agreement is essential.

Understanding and considering other risk factors should be addressed:

  • Shareholder marital problems and divorce since business ownership may be marital property
  • Ability to be productive :physical, emotional, mental  and other disabilities
  • Family and children
  • Financing and ability to pay
  • Non competes

Shareholders need to consult with experienced professionals to design a plan and agreement which deals with the risks associated by the triggering factors identified above and how to deal with these factors.

Dennis B. Kremer, CPA/ABV/CFF/CGMA, CVA, CFE