It is tempting to select a formula approach to pricing shares when business partners come and go. After all, a formula is easy for everyone to understand, and in theory at least, inexpensive to apply. If you’re satisfied with getting to a price, any price, then congratulations – job done. But the goal is to arrive at a price that is fair to all concerned. This article discusses some of the unforeseen problems with buy-sell pricing formulas that we as valuation experts encounter frequently.
As a quick introduction, buy-sell agreements usually employ one of three basic approaches to pricing shares upon buy-sell trigger events (when a shareholder retires, dies, becomes disabled, etc.):
- Fixed Price: Shareholders agree on a price per share and agree to periodically revisit that price.
- Formula: Shareholders agree on a formula to calculate share price. Examples include: book value; adjusted book value; 4 times trailing 3 years average EBITDA, etc.
- Independent Valuation: Shareholders agree on a professional business appraiser to determine fair market value (or another appropriate standard of value).
The pricing method prescribed in your company’s operating agreement, by-laws, or shareholder, buy-sell or stock restriction agreement, as the case may be, is important to the success of your next buy-sell transaction. So, what are these hidden problems with the formula method?
Businesses evolve, and formulas are static
No single formula will consistently produce a fair market value result year in and year out. It is common, for example, for companies to move from a project-based model to a recurring revenue model over time. The latter sell for higher multiples, yet the multiple stated in the buy-sell agreement still reflects the old business model. In this scenario, the buyer wins and the seller loses. Formulas don’t capture changes in the business, and eventually become irrelevant. Shareholders usually have every intention of updating pricing formulas, but in practice buy-sell agreements get filed away and forgotten about, and their formulas become stale. As years go by and shareholders’ interests diverge (some become buyers and some become sellers), renegotiating a formula to bring it in line with market value becomes increasingly difficult.
Value is forward looking, and formulas aren’t
One of the central tenets of valuation is that the value of an operating business is based on expected future financial returns, considering risk and market conditions at a point in time. Valuation is therefore a forward-looking concept. Past performance may be a strong indicator of what to expect going forward, or it may not. Let’s say a manufacturing company has invested heavily in new product development for the past three years or has just added significant equipment to increase production capacity. A multiple of earnings formula would grossly under-value the shares in this case. In our work testing buy-sell formulas and providing benchmark valuations, we find that prices determined by formulas often bear little resemblance to fair market value.
Formulas are seldom 100% replicable
I’ve seen three reasonable financial experts apply the same price formula to a company and arrive at three different answers because there were at least three ways to interpret the formula. Rarely do we see pricing formulas that are totally unambiguous. When the formula was created, no one was sweating the details. Years later, when buyers and sellers emerge, a formula that leaves room for interpretation will almost certainly result in a dispute. While seemingly straightforward, a pricing formula that is not designed by a seasoned valuation professional is very likely not 100% replicable.
Formulas can create the wrong incentives
An earnings formula creates a disincentive for a managing shareholder to invest in operations toward the end of his or her reign. If he or she expects to be paid a multiple of EBIT, they might hold back from making investments that fuel growth or allow the company to remain competitive. The exiting shareholder receive more per share, while reducing future cash flows, which reduces actual value. Conversely, an unscrupulous controlling shareholder who knows that other shareholders are nearing retirement, could overspend for a few years to reduce EBITDA and therefore the buyout price. It does happen.
Bottom line; pricing formulas often yield results that are not true economic values. They produce winners and losers, which leads to hard feelings, disputes, and sometimes litigation, which becomes shockingly expensive, time-consuming and disruptive; and destroys shareholder value for all concerned.
All of the above shortcomings can be overcome by having a valuation-based buy-sell agreement and appointing a qualified and experienced business appraiser. However, if you insist on using a formula, I recommend that you at least hire a valuation expert to do a benchmark valuation of your company and design a formula that is more accurate, more replicable, and more robust. Then have that appraiser update the valuation and test and revisit the formula every three years or so.