UC Goering Center news

By Gabriel J. Kurcab

While there are many advantages to owning a private business, the ease with which an owner can exit is not one of them. Compared to shares of public companies, private company shares often have no immediate buyers and no continuous market forces to provide real-time feedback on the market value of the business. For that reason, private business owners should agree not only on a mechanism for exiting the business, but also how an owner’s shares should be valued. Both the mechanism and the valuation methodology are typically contained in a private business buy-sell agreement.

The gold standard for private company valuation is a formal appraisal by a qualified appraiser. However, for reasons of cost or efficiency, many business owners elect an alternative valuation methodology, which can range from the simplicity of a mutually agreed annual value that gets written down in a journal (which we never recommend as anything other than a temporary stop-gap measure, given the number of problems it can create), to the complexity of a formula of multiples of earnings before interest, taxes, depreciation and amortization (EBITDA). While there is rarely a perfect formula to land on – and certainly no one-size-fits-all formula – many private business owners opt for a formula that will not realistically approximate market value. Some make that decision consciously because they feel the relative simplicity of a formula that doesn’t require corporate finance expertise to devise or implement is more intuitive, and therefore, fairer to everyone involved. However, many opt for the wrong formula or metric accidentally. And in those cases, the error is often compounded because it is only discovered after an event that triggers a buyout at the wrong price.

Recent events such as the COVID-19 pandemic provide a striking example of why many popular valuation formulas for private businesses can fail dramatically – and why buy-sell agreements should be updated to ensure that they are optimized for changed (and changing) circumstances.

When one looks at the market value of most publicly traded businesses, their market capitalization as of the date of this writing reflects optimism about their future prospects and the future prospects of the economy. Investors appear to feel that the COVID-19 pandemic is a “black swan” event – something extremely rare – and something that can be minimized or even ignored as they evaluate a business’ long-term prospects. What is true for many publicly traded firms is doubtless also true for many private firms. But what about a private business that has a valuation formula that values the business at five times trailing twelve months’ net income? That formula treats pandemic related losses the same as it would treat an organic collapse of the business’ sales. Yes, if sales rebound, so too, eventually, will the formula. But might a buyout be triggered in the meantime? After all, one of the most common triggering events for a buyout is an owner’s death, since other business partners don’t want to find themselves in business with a new person or persons (the heirs), and therefore negotiated for a right to purchase the departed owner’s interest in the business. Since the COVID-19 pandemic presents a direct threat to the health of many business owners, there are businesses whose valuation formulas are temporarily and meaningfully depressed, and whose buyout provisions are likely to be triggered by tragic and unexpected deaths.

So, what should a private business owner do? If you are already in the habit of periodically taking a critical eye toward your buy/sell arrangement, now is a good time to revisit that issue. Similarly – and even more critically – if you are not in the habit of reviewing and updating, now is the time to work with trusted legal and financial counsel to make sure that no nasty surprise is hiding in that (dusty) buy/sell agreement.

Gabriel J. Kurcab is an attorney at law at Katz Teller. Reach Gabriel at gkurcab@katzteller.com or 513-977-3485.

Katz Teller is a Goering Center corporate partner, and the Goering Center is sharing this content as part of its monthly newsletter, which features corporate partner articles.

Featured image at top: Photo/Amy Hirschi/Unsplash