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December 30, 2024
For business owners, buy-sell agreements are important tools for ensuring a smooth transition of ownership in cases such as death, disability or retirement.
These agreements set the terms for how an owner’s shares or interest in the company will be bought or sold – i.e., who has the right to buy and at what price.
Buy-sell agreements often include a preset valuation approach to determine how much the departing (or departed) owner’s shares are worth.
Valuation methods can vary widely – from using a market appraisal to more formulaic approaches, like multiplying EBITDA by a set factor.
When drafting buy-sell agreements, the first key is to choose a valuation method that will fairly reflect the true market value of the business at the time of transfer.
Next, review this approach regularly, to ensure it remains fair to all parties involved.
In truth, many business owners fail to update these valuations, which can lead to unintended consequences.
If a business’s valuation is outdated, or based on outdated metrics, it can drastically undervalue or overvalue the company, creating disputes between partners, heirs and buyers.
This issue came to the forefront in the case of Pappas v. B & G Holding Co., leading to a four-year legal battle.
Background
In Pappas v. B & G Holding Co., William Egan, a 50% partner in B & G Holding Co., died and left his partnership interest to his beneficiary, Dean George Pappas, in his will.
However, this bequest ran up against a pre-existing buy-sell agreement in the partnership.
The agreement required that upon a partner’s death, the surviving partner – in this case, Eugene Leogrande – had the option to purchase the deceased partner’s shares at a predetermined price.
The buy-sell provision established that Egan’s interest in the business had to be sold to Leogrande based on a valuation method outlined in the partnership agreement.
Pappas, however, refused to sell at the pre-determined amount and took the matter to court, arguing that he had a right to have an accountant determine the fair market value of his 50% interest.
Ultimately, however, the court upheld the buy-sell agreement, ordering the estate to sell Egan’s shares to Leogrande for $318,348.
Based on what we can tell from court documents, it’s likely the valuation formula used a multiple of eight times the gross rent from the partnership’s assets over the past year, minus the net of any outstanding mortgage on the real estate.
B&G owned real property located in the Bronx, New York consisting of two commercial premises, each housing three retail rental units.
Other corporations, including a garage and a laundromat, may also have been included in the partnership.
Court records don’t give us insight into the finances behind the valuation, but I think it’s safe to say that Pappas didn’t think he was getting a fair shake.
Valuation methods matter
In a case like this, a regularly updated valuation – based on fair market principles rather than quick multipliers – could help prevent unfair outcomes and potential litigation.
Takeaways for business owners, include:
- Review your buy-sell agreements regularly: Ensure that any stipulated valuation method reflects current market conditions. Using old rent figures or outdated insurance policies could lead to significant undervaluation, leaving your estate or partners shortchanged.
- Certificates of valuation need updates: In the Pappas case, the valuation certificate was only valid for one year. If you have a similar clause, you need to ensure these certificates are updated annually. Failing to do so can result in a forced valuation based on potentially less favorable methods, like an “eight-x-rent” calculation.
- Fair market value should be the standard: When you’re determining the price of a partner’s shares, a fair market valuation can provide transparency and fairness for all parties involved. Standardized formulas, like the one used in Pappas, could cost surviving partners or heirs millions.
If you haven’t reviewed your business’s valuation in a while, now’s the time.
With property values and market conditions constantly changing, it’s important to keep your valuations current.
In the end, a proactive approach can save everyone from an undervalued sale, endless litigation and unnecessary financial losses.
