- I'd like to lead off by having you answer one question
before Harry and John, you begin to present on this topic.
I'd like to know what's the frequency
of which business owners come to you
and they either don't have a buy sell agreement in place,
or they do and it's wholly inadequate for the business.
- Harry or John?
- Oh, hold on. I just had to unmute.
So, so, so Nicola, it's a regular event.
So we were contacted recently, actually, Dave,
from somebody from Vistage here up in Michigan.
And a gentleman said, can you help me
with his employment contract
that he's going to be receiving?
And he's going to be a shareholder in an S corporation.
So ver so this morning I received,
before our call today, the proposed buy sell agreement.
And this will just get into the meat of things.
We'll read one line, the appraised value of the corporation.
The appraised value shall be determined by the board
of the directors in its so discretion
based on re,
re reliable approved financial statements, which means nothing.
So this executive thinks he's coming in to an organization,
they, they say they're going to give him the first
4% of the company.
They haven't even talked about the
taxes and what that means.
And the fact of the matter is, this paper isn't worth it,
it's not worth anything to the individual
because the board of directors could determine they want
to fire him in a year or two.
That the value of the company is zero
and this is the binding agreement that you have.
So you have to be very, very careful about reading,
actually reading these agreements
and actually working through examples.
So that's just one of a hundred, you know,
that we see all the time
that people really don't pay attention to the detail.
Nicole also, you know, mentioned, you know,
you're doing this at the beginning of a relationship
or somebody coming in,
but remember these things need
to be looked at going down the road.
And what I mean by that is companies kind of morph.
You might be one company today
and then all of a sudden you,
you've gone off in a little bit of a different direction.
So the way you value the company could be different.
So if you're a SaaS based based company,
you're going to be based on revenue.
But what if you weren't a SaaS based company?
Originally you were just doing research and development.
So it was more on the EBITDA formula.
So that those are the things that need
to be addressed on an ongoing basis.
And it's just like your will and trust and,
and things of this nature.
The one thing we're not going to talk today about is
because we have so many insurance experts,
is when do you bring in insurance into your
buy sell agreements?
And that would not only be life insurance,
but it's also disability insurance.
We, I have personally found disability is the hardest thing
to deal with in buy sell agreements.
And when someone does become disabled because of a stroke
or whatever the case may be,
it's the most difficult for the business.
So long-winded answer Nicole,
but that's just kind of a start of this.
So John, can you pull up our, your PowerPoint?
- Sure. I think I am allowed to share here.
- You should be. I think I made you a co-host,
so you should be also in those, in those agreements.
We should, we should be defining
what a disability is, right Harry?
Absolutely. If you don't define absolutely like you have
to define like specific, like
what specifically a disability is
because you know, if if Nicola, you know, depending on
what time of the day Nico talks to me, I could be, you know,
considered disabled if it's later on in the day, especially
- Just for the record, we have tried
to have Harry declared incompetent a number of times
and it just hasn't worked.
- That's not a joke, Dave.
They wanted to be the arbitrary of who,
who decides whether I was competent to move forward.
That is no joke. Obviously that part didn't go very far.
- What, what, so
before we get into the, the PowerPoint, what is, so how,
how, how have you seen partners agree on how
to define whether or not someone is, is declared disabled?
Like how do, what have you seen be,
what's a good, a good measurement of that?
- Yeah, some of it's going to be industry specific in our,
in our industry would be, you know,
you'd have like a chargeable hour
or can you actually take care of your clients?
You know, there might be some indication like that.
But if you had a SaaS company
or a manufacturing company, you know, it might be different
where you just say, there are two doctors that have to say
that you no longer can, you know, continue on
with your, your duties.
But then the question becomes is that, are you replaceable
and should you automatically trigger a buyout
or can you still own part of your stock going forward?
So you can actually handle it in several different ways,
but you actually, your Dave, your points right on,
you got to get all that bait into the agreement
because things happen.
I mean, you know, this story, you know, I had a gentleman
that I was working with
and you know, a young kid dropped a donut
and ran a red light and killed them.
Now that's, that's a little easier on death,
but things do happen every day.
People have strokes all the time.
You know, we have more early on dementia in our society.
So these are things that are, you know, they're front
and center as you're dealing with the,
you know, the buy seller agree.
And, and if people don't think this is true, it's,
it just happens all the time.
- And the best one thing that I would add, I'm sorry,
is just clearly what Harry brought up is
that people will have a, a dual interest,
you have an interest potentially as an employee
as well as an owner.
And those two sometimes need to be separated,
other times they don't.
If somebody's terminated for,
cause you should have an automatic trigger
of a buyout on the buy sell
because if they're obviously being terminated
for cause you really want
that person being your partner moving
forward in the business,
- Right? Yeah.
- The other, and there's times like Harry said that, yeah,
because of say a physical disability, they're no longer able
to perform services as an employee,
but that doesn't necessarily mean you got to cut 'em out
as an owner of the business.
- The other thing that I wanted you to address,
and then Kyle has a question
and then we'll get to your, your PowerPoint is,
and I've seen this in in firms that I'm working
with currently, is
that they put in a mandatory retirement age, right?
And this is in a professional services firm,
so they put in a mandatory retirement age,
and there's a clause in there
that says if this person is a partner,
their shares will be purchased at.
And a lot of professional firms have a set price
for the shares, so they don't
to avoid the whole valuation issue, right?
So the, the the,
the firm will buy out their shares at X dollars.
But with medical care these days, no matter what you set
that mandatory retirement age at the people are still sharp.
Even if you set it, you know, at a, at a,
at a relatively high level,
some people will still be sharp at
that relatively high level
and the firm will want to keep them.
So the, so the buy sell agreement has
to be adjusted accordingly.
And that's just another reason,
to your point about sitting down
and looking at these buy sell agreements on an annual basis
and making adjustments to them.
You know, there's a, there's a joke at one of the firms
that I work with and,
and there are people on this call
who will know this firm very, very well, is
that the mandatory retirement age keeps getting adjusted
every time the one of the senior partners has a birthday.
So, you know, the triggering event,
if it's a mandatory retirement age, I mean there, there's,
there should be language in there
that addresses that as well.
- And, and James and James to your point,
the one thing you got to factor in now is, you know,
professions like our profession, all that's kind of changed
with private equity coming in, you know,
so the question would be is let's assume private equity
comes in and you're, you're a smaller firm
and they're rolling up, so you sell out, let's say in a six
to eight EBITDA range, you know, their ultimate goal is
to sell at 12 to 15.
So if you're a partner and you're out three
or four years into the agreement, what price should you get?
You know, so it's, it's, there's a lot of maneuverability
and a lot of play in that.
- Yeah, for sure. All right. Kyle has a question.
I want to take Kyle's question
and then we'll then we'll turn it over to John Kyle.
- This was a comment more on the disability side.
We've done this in the past, use the actual policies,
but just bare minimum,
not even necessarily covering disability like a true
disability, but a smallest possible policy on all partners.
And the triggering language is if the policy pays,
so then you, you've shifted all the liability
for determining if they're disabled onto the shoulders
of the insurance company and it can be a
$500 a month policy.
Like you're really just offloading the argument
to the insurance company for a very small amount
because that's the hardest, that's
for mental health and everything. Yeah,
- That's interesting.
It's a good point, Kyle,
because I, I think a lot
of times you might end up having a fight
amongst the partners of, okay, how did, am I really
that disabled?
And you know, like we said, we fought
with Harry a number of times and
- Yeah, if you, if you can get the insurance company declare
I'm disabled, then the rest of the contract becomes valid.
- But Kyle, Kyle, are you saying that you get the benefit
of having the group insured rather than one person insured?
And then you can do it
- If you can get large group,
you can if you have enough partners,
otherwise you do individual policies.
The, the whole purpose, like some of the partners might want
to have their income insured with disability,
but in general you want a policy on all of the partners,
even at the bare minimum, just
so you have a consistent standard
of this is the triggering event for a disability.
So then like mental, because the mental
and depression one becomes the hardest one to quantify now.
So if an insurance company will actually pay for that,
well then they've got a pretty damn good leg to stand on
that they're actually disabled
'cause they're, they're the last ones that want to pay.
And you can get guaranteed issue too.
Lenny pointed that out enough people you can get guaranteed
issued policies would help, which help significantly.
- Hmm. All right. Okay John, take it away.
- Alright, I think we're going to let Harry kick off.
You already did a heck of a job of introducing this Dave,
so I don't think we need that first
slide to go through that.
Barry, why don't you kick us off?
Nicole kind of touched on this as well, but
- Yeah, yeah, why?
Yeah, this is, you know, Nicola really mentioned this, John,
let's just keep it going to the third one.
- Yep. - Okay.
So understand in the form of the buy sell,
there are different ways that people are bought out.
There could be a redemption agreement
where the actual entity is buying out the interest,
which is different than the other partners buying it out
through a cross purchase agreement as since here,
the difference for that can be substantial from a tax
standpoint and also could be, you know, with respect to
who own ends up owning the business.
So if you had a redemption agreement,
everyone's going to go up proportionately, you know, to
that whatever is being redeemed where cross purchase,
if other shareholders have the right to purchase a person
that was in a minority position,
let's assume there were four, you know,
or three 30%, 3% owners that one leaves.
If one can't afford to buy out the other interest,
then you could be in a situation
where somebody who's on equal grounds now actually owns
67% of the business.
So you got to be very careful in how these things are worded
and what can be done and things of this nature.
Now what we have seen in those cases sometimes is
that everyone's there has to be unanimity in certain types
of transactions
or certain things being done at the firm in
order to mitigate that.
We have one new client we brought in last fall,
very interesting.
They, they can only sell to each other.
However, if one wants to take the company to market
and they can't get somebody to buy
or agree upon a price, they have to liquidate
what they merged five years ago, which makes no sense,
you know, so you got to be really, really careful on
how these things are worded, what could happen.
And then there's obviously hybrid agreements
where you can do a redemption
and a cross purchase, you know, give flexibility.
Those get a little complicated.
You probably want to have some insurance on that.
John, you want to keep going?
- Yeah, I I just wanted
to add one thing on the redemption agreement only
because it is a current issue.
It's up to the Supreme Court.
It was a estate tax issue of whether
or not corporate owned life insurance is,
should be included in the value of the entity for purposes
of estate tax valuation.
So most of us would think it's not, it's the value
of the operations of the business
that you're being bought out at the IRS was challenging
that it should have included the value of the insurance
that's going to be used for the redemption.
So that's has made it all the way up to the Supreme Court.
We're just waiting for them to rule on that.
- Yeah, and that, and that's a, that's
a big issue out there.
I mean, how things are set up toward the insurance
and all of about the insurance experts here, you know,
it's called, I'm sure you're aware of that.
But you know, the other thing too, in all these transactions
and valuations and everything else, remember the value
of all this too upon somebody's death could impact their
estate because if they owned a certain part of, you know,
of the company, they could actually get, you know,
deferred taxes depending on the size of their estate,
which we can get into in another presentation.
So on valuation,
the stated price is probably not a great place
to be for anyone.
That's where you actually fix the price day one.
It's just not going, you know, it's easy to apply,
but it's not going to usually be reflective
of actual value if your company's growing at all,
the market changes, you know, multiples change
and is is listed here, not appropriate for, you know,
for tax purposes.
So what's interesting here, just in the state of price,
I'll get to something that's a little offline here,
but when you have a closely held company,
let's assume it's all owned by family members.
Those family members could be brothers, sisters, sibling,
whatever the case may be.
And let's assume one of 'em passes
and there's a redemption agreement
and that redemption agreement says you have to buy out
of a certain price
and let's just assume for whatever case that it may be,
is they agree to a price on the redemption and,
and you know, it gets paid
and at the same time they want to issue stock to one
of the corporate executives who's also a family member.
That valuation has to be done at fair market value,
which could be completely different than the value
that was redeemed out to the other shareholder.
So you got to watch it, you just can't take one agreement,
one value and use it for all purposes.
- So yeah, especially if if, if that exit wasn't related
to death, 'cause arguably
that should have been at fair market value.
But if somebody's just redeeming shares pursuant
to a buy sell to a stated price
or formula, that doesn't necessarily dictate what it should
otherwise be issued at to somebody else as equity
because that is a fair market value and and you're
otherwise dealing with valuation issues.
Compensation issues. Absolutely.
Those two are two
independent transactions that need to be considered.
- John, how, how have you dealt with this in your divorces,
in your marital divorces when somebody had a stated price?
- Well, not surprisingly, the business owner always wants
to argue that, you know, I've got to buy sell,
I get bought out at a bucket share
and that should be the value for divorce purposes.
Unfortunately, that doesn't usually hold the case.
So a lot of it is going to depend on the standard
of value in divorce based on the state that you live in.
Illinois is a fair market value state.
So regardless of what the buy sell says,
because just like I stated there not appropriate
for transfer tax purposes, the IRS isn't bound
by a buy sell agreement.
They will acknowledge the buy sell if it's reflective
or indicative of fair market value.
But the IRS isn't bound by a buy sell generally
and divorce courts,
family law courts clearly ignore buy, sell agreements.
That's not indicative In Michigan we have,
we don't have stated value,
but for professional service firms we call it holder's
interest, which is pretty much investment value value
to the owner, which again isn't necessarily going to be
reflected in a buy sell agreement.
- Go next one John. - Yep.
So in a formula based valuation, that's
where somebody just puts into the agreement that it's going
to be three times EBITDA or one times revenue.
Something that seems very straightforward to apply.
Like I said, it's easy to calculate, easy to communicate,
people can understand it, anybody can read it and apply it.
But I, I listed as a pro,
but it's also a con is
that usually it reflects economic value at the time it's put
into place given things have changed.
Harry mentioned that markets have changed, you know, things
that used to be three to five times ebitda.
EBITDA are now 10 to 12 times ebitda.
EBITDA or whatever it is at the current time.
Dave, I think you
and had a post on LinkedIn not too long ago
that says it's something
that's got to be looked at on an annual basis.
You just can't put these things on autopilot and just say,
because I have a formula, it's going to move with the economy
and it's going to move with the market.
Not necessarily, you know, earnings may change,
cash flow may change that's going to impact the value,
but the multiple of what willing buyers,
willing sellers are willing to pay with it for it,
that changes as well.
And you just can't put one of these things on autopilot.
And so the third, which is obviously the most accurate,
but it's also the most expensive
or time consuming, is to have a third party valuation.
Shameless plug hire roky corporate advisors in order
to the valuation for you.
You're going to ensure
that things are going to be treated fairly at that point
because you will have a valuation
that's going to reflect current economic values.
The issue that you're going to come across though
with hiring a third party valuation of,
we've got a couple of things it it just kind of this
with differences, you know, Harry said the one,
it's going to be determined by the board of directors.
Well obviously there might be bias that's included in there.
Other times it'll say that each of the parties
or the two shareholders are each going to get their
own valuation.
What happens if they're far apart?
Sometimes they'll just say,
we'll take the average of the two.
I've seen others that have said if they're within 20%
of each other then we'll take the average,
otherwise the two value, the two independent evaluators have
to agree on a third and they'll go out
and do a, you know, a third valuation.
Things are starting to get expensive here if you have
to pay, you know, and who's going to pay
for all these valuations?
The corporation, the, the owner of the business.
And I will tell you, I've been in this position, it's not
so easy as the two of us coming up with that third party
of who's going to be, 'cause we're all going to lobby
for something that's going to push for our,
I'll say our professional opinion of
what we think it's worth.
So sometimes that third party, you know,
you could do baseball arbitration where
that third party just says, I'm going to look at the two,
I'm not going to do a third, but I'm going to say, which one do I
otherwise think is most reliable?
But just
because again you've got that third party,
it's not the easiest thing to do.
- So, so John, just one point
what you were talking about is on the formula driven
and Sheldon will appreciate this, is if, if John came up
with a 6% capitalization rate and I came up with a seven
or 7.5% capitalization rate, that could have a huge impact
on the value of the underlying real estate.
So what, what it would appear to be from the
outside a vary just a 1% change.
It's huge in the overall valuation.
So you've got to be, you know, careful
and that's what John was saying is people can differ within
a certain range but it can have a huge impact whether it's
for buy, sell or
or for estate planning. Go on John. I'm sorry.
- Yeah, no that's fine. And so, you know,
Harriet had mentioned language is important,
which is absolutely true.
So from a drafting perspective, a plea
to all the attorneys out there
that are drafting buy sell agreements be very, very specific
and cognizant of the language that you're using.
So one of the very first things is everybody will throw out
fair market value.
Yes. Well we, we will determine the fair market value
of the shares or of the unit.
From my perspective, fair market value is a term of art.
It means something that means willing,
buyer, willing seller.
And if you're talking about a minority interest,
then potentially subject to discounts for lack of control
and lack of marketability.
The common one that I see a lot is
that the attorneys will say fair market value.
By way of example, if the company is worth $20 million
and it's a 10% interest that's being redeemed,
then the value of the shares is $2 million.
That's not fair market value, that's fair value
'cause it didn't consider that you have a minority interest
that could potentially be subject to discounts.
So be very, very certain
and if you have any questions, call a valuation person
to determine what is it that we want to do.
A lot of times I will get an agreement
that it may not even have a stated value,
but it just says we're going to get an independent valuation.
First question I ask the attorneys is, what standard
of value do you want me to apply?
And they'll say, oh geez, I never thought of that.
And end up, what I end up doing is giving it
to 'em both fair value without discounts,
fair market value without discounts.
'cause obviously you're going to see that depending on
what side you're on,
they're going to have an interest in being the higher value
or the lower value.
I will leave it up to the attorneys then to fight
that battle.
That shouldn't be our battle as valuation people.
So yeah, I'll give you all the information, you do
what you want with it, but be careful with that.
Specifying the valuation date.
- I'm sure. John, I'm fair market value though.
You and I both have seen agreements
where it's a fair market value
but there's no discount for minority discounts.
So you still might do marketability for the company
but not a minority discount.
Right?
- Well but like that example that I gave where it says,
for example, fair market value company is worth $20 million,
a 10% interest is $2 million.
I'm not sure what they actually meant by that.
So yes, depending on what discounts may be applicable.
If your example ignores all discounts, did you mean
that it ignores all discounts
or was it implicitly included in the value
of $20 million that that's already on a discounted basis?
It's unclear. So that's why I am saying be absolutely clear
on what you mean and what you know.
And, and if you want,
because again, if you're doing this
for a buyout purposes, not necessarily
for estate tax purposes,
then you could have whatever standard of value
or whatever discounts you want to applied
for purposes of that agreement.
You could say that we will consider a discount for lack
of marketability, but not a discount for lack of control
or vice versa.
The fact that you got to buy sell almost would make it sound
like you've got a built-in redemption agreement
where a discount for lack
of marketability then may be somewhat neutered if there's
somebody ready, willing, and able to redeem those shares.
But yes, you're absolutely correct in
that you could consider one none.
But be clear of what your intent on doing
the valuation date.
Just clear, what do you mean? Is it the date of termination?
You know, the 30, you know, the end
of the month closest to it.
Just be clear. And then on formula based
- Evaluations, now on valuation date, I've seen a lot
of agreements.
So let's assume you're in September
and I'll say if you do anything during let's say 2024,
the valuation date is the preceding year end.
Let's assume it was December 31st, 2023.
What, what do you do when there's a significant event in
2024 where the business went from one level
to substantially higher during that time period?
You just see a lot of litigation on that
or what, what have you seen?
- Yeah, and it's something as the evaluator if that we see
that you've got to make the attorneys aware of that
because that's going to an issue.
I don't want to be in a position where somebody says,
well why did you ignore that?
And the idea is if you've got a certain valuation date,
so our standards say we have to use everything
that was known or knowable as of the valuation date.
If it was not known
or knowable, I can't include that in my valuation.
So when somebody gives me a very specific valuation date,
I need to be cognizant of that.
But I also can't turn a blind eye
and just let somebody, you know, not let somebody know
of certain things that have transpired since then that says,
Hey, I can't take this into consideration.
But be aware that say there's been a huge uptick in this
industry in the last three months that was not known
or knowable, but you may be underpaying
or overpaying for somebody's interest because of that.
And then again, on the formula based valuations, be clear of
what type or what level
or source of financial information you're using for that.
Is it a gap basis financial statement
that could present a problem?
Because if the company doesn't
otherwise prepare gap basis financials,
now you're going to have to go out
and have a restatement of those financials
or a potential review or an audit to comply with that.
If it's tax returns, Harry
and I are working on one right now where those two are tied,
their internal financials are accrual basis gap basis,
but they file their tax returns on a cash basis
and there could be a substantial difference
between those numbers.
So be cognitive of that.
Is it the last return
or financial statement closest to the triggering event?
Are you implying the last, the trailing 12 months?
So there's a lot of possibilities that can be considered,
but be certain, be clear which one you're,
what you're intending on using as part of that formula.
And again, some, just some language that I've seen
that I've talked about that creates some ambiguity
with respect to how it's going to be according, you know,
this was the without discounts, is that fair market value
or fail VA fair value.
This was the second bullet always amazes me
'cause I've seen judges do this as well.
Evaluation done in accordance
with generally accepted accounting PRI principles.
There is no such thing, there is no valuation in accordance
with generally accepted valuation principles.
You may be talking about a fair value level of standard
that's used for financial reporting purposes,
but GAP doesn't talk about what
a a valuation should look like.
And then valuation shall include goodwill.
Something that I'm dealing with now on a couple cases,
enterprise versus personal goodwill, big,
big issue on a buyout.
You know, a buy and a sale of a company, especially
with a C corp, it can be issue of whether
or not you've got too late, you know,
double taxation versus one level of tax
and how you're going to deal with that
with a potentially tying it with a non-compete agreement
as well as the buy sell.
So if you're not talking about death,
but you're talking about a triggering of it, excuse me,
because of termination, you know, Nicole mentioned that,
you know, how are you going to work going forward?
The the sister, brother sister agreement to
that would be a non-compete agreement.
If you think that other person would be able to
take business away from the existing business, that's going
to create a, a lowering of the value of the business.
And then just, you know, one of the things
that I always like to talk about is the different
standards of value.
I I, I know it sounds nerdy,
but trust me, this is really, really important
and people need to be cognizant of it.
So like giving you what those definitions are general.
So when we talk about a standard of value, we mean the value
to whom fair market value is a hypothetical buyer seller.
Fair value is value to generally,
again, it could be for financial reporting purposes
or under a dissenting shareholder
or shareholder oppression case.
That just means it's the value of the company unaffected
by discounts
and investment value generally talks about
that value at the very highest level,
which is the value to a particular purchaser.
Unlike fair market value, which would be the value
to a hypothetical purchaser, all three
of those could produce a different value
depending on how you apply it.
So a lot of people like to say,
why do people care why you're doing this?
The value is the value is the value,
it's always going to be the same.
Absolutely not.
IRS is always going to use fair market value.
That's the standard of value for income tax purposes.
Estate tax, gift tax purposes,
fair value is generally a legal standard under state law
that sometimes is going to ignore any sort
of discounts that would apply.
Investment value is
what we're using when we're talking about exit
planning for a business.
It's trying to, the highest value for somebody,
which is usually a sale to a strategic buyer,
whether that be a competitor, a customer,
somebody else out there.
In certain instances it could be a private equity firm
that they're building a platform
and it's their initial transaction
that they want to get into it.
So investment value
and fair market value could be quite a wide distance
between it, but you need to be careful
and be certain of what you're otherwise trying to apply.
- John Harry, let me ask you a question along those lines.
Have you seen a buy, sell,
a poorly drafted buy sell agreement be a hindrance
to the sale of a business?
- Yes. - All right.
Explain so that this is an important concept
for people to understand.
So explain how like poor buy sell agreements will hurt
a business, the sale of a business down the road.
And this is an important concept for the folks,
particularly the professionals who are here, who are,
who are advising people to understand.
- Yeah, because you can get into a shareholders agreement
where somebody has the right of first refusal
and maybe a right of first offer.
So if that comes up, then one,
one shareholder could actually be tying up, you know,
the company where the company really can't move forward,
you know, to from one one of the shareholders to sell
or to actually sell the company
because they have their own, you know, who, who gets
to offer what.
And you know, somebody could actually manipulate those
provisions to buyout a partner at let's say the, the formula
that John here was talking about,
but they're planning to flip out the company
to another seller at a much higher level.
So those, those can be very, very difficult.
The example I gave you earlier too,
where two companies merged, you know, one's a minority,
one's a majority, you know, they, they all have
to do things in humanity,
but can you imagine trying to sell a company
that if the a sales process doesn't go through it
to one satisfaction that they have
to liquidate the company and separate it.
I mean, somebody's going to ask for that agreement to see it
because in many cases you want the outside person
to buy your stock in these companies for tax purposes
to maximize capital gains tax and not ordinary income tax.
You don't be selling assets so
that actually come into play if they see
that they're going to know they have a lot of negotiating room
with respect to the potential purchase price.
So I think it's there all the time, but John, why don't you,
- Yeah, and I I I'll put the flip on it that says,
if you've got a stated redemption price
or a formula at a time that that is greater than
what the market is, you've got somebody that's going to,
if they're looking at this buying this company says, geez,
I got to redeem, if somebody wants out,
I got to pay them more than what I'm willing
to pay for the company.
That becomes a problem.
So somehow you need to address,
or they're going to be looking at that.
It should be part of the due diligence on the acquisition is
inquiring what kind
of shareholder agreements do you have out there currently
and what are those provisions?
Because yeah, it may cause a detriment
or somebody that says, well hell no,
if someone has the ability to redeem their shares at
that high of a price
and get stuck with that obligation, I don't want to assume
that obligation or I don't want that potential based on
that given price. It's a problem.
- Yeah, no, it's an Im it's an important point.
One more question along these lines,
and I've seen this again in professional firms.
So you want to carve out, the firm grows at a rapid pace,
you want to carve out 10% of the ownership of the firm to sell
to a handful of up and coming people, right?
And you're going to allocate that, you know,
that portion based on whatever, you know,
whatever you decide is going to be that, you know,
whatever formula you're going to use.
So you know, you get 2% of that 10%
and invests over this amount of time.
How, how do, how should
that be addressed in a buy sell agreement?
- Gotcha. From a valuation perspective, Dave,
usually we would look at fully diluted shares.
So assuming that that 10% has already been allocated just
so somebody's not getting a benefit or a detriment
because of the issuance of that.
So typically yes, we would look at, you know,
especially if there's even any options outstanding
with respect to the stock, again,
looking at the fully diluted shares on that, that
they may not be in the money at that point, you know,
they may be in the money but not a hundred percent invested.
But we'd otherwise want to take a look at that
to consider all possible transactions to make sure
that somebody is again,
is getting the true fair market value
because on a, a sale of the company, yes,
they're going to also be looking at that, which sometimes
these types of, you know, allocations, whether it's be stock
or options get triggered on a trans,
on a triggering event as well.
So that, that's otherwise needs to be considered.
- Okay, thank you.
- John, you want to just flip through the next couple slides?
We have limited time.
- Yeah, just a, a a again, where we are today,
when we're talking about selling
or with perspective,
valuing a particular interest in a company,
not a hundred percent of the company,
if we're talking about a hundred percent of the company,
we're talking about the traditional control value versus
what we're now calling strategic control value.
So strategic control value is
that investment value to that one buyer that's willing
to pay the highest dollar amount
because there's a, there's some sort of premium there.
They have something that the company wants as compared
to a financial control value, which is John, Dave,
Nicola, anybody else Perry looking at saying,
this looks like a good investment, it generates cash flow,
I want to invest in that company.
Once you get past that,
now you're talking about the interest in the company,
which is a marketable minority.
So that one's going to have a discount for lack of control
that says you can't control it,
but it's still a freely marketable interest
public market type values.
Well, most privately held companies don't trade at that.
You can't pick up the phone, call your broker
and say, Hey, sell my stock and you know, x, y, Z tool
and die company and get me my cash.
So therefore hypothetical buyers are going to take into
consideration this marketability discount that says
when am I going to receive the value
of whatever it is that I'm buying?
And obviously there's a lot of things
that impact it if you're considering
or if you're interested in the things that are considered.
There's a case that we use now called mandelbaum.
It was an estate tax case
and Judge RO identified what we call the mandelbaum factors
that says these are the things that we look at to determine
what, how marketable an interest is.
So you know, what industry,
your financial statement analysis,
is there a redemption agreement in place?
Do you make distributions on a regular basis?
You know, there's seven, nine factors that
the tax court identified,
but they all come into play in determining what level
of marketability discounts should apply.
- That's one John. - Yep, that's,
that's basically the end of it.
I know we had a couple comments and questions.
- Yeah, you know, John,
before, let me, let me do Susan's comment first
and I'll ask Nicole to weigh in on
this so you know I can help.
Absolutely. You know, I can have to
- Listen to a webinar when we're done on
- This.
So we, we we, we've covered the,
we we touched on the FTC decision
in Chicago
and we didn't do it in New York,
I think we did it in Chicago and Miami.
So Nico, why don't you read Susan's question
and then touch on that
and pitch it to the guys if you need to afterwards.
- I would love to sooth asked do you see the new FTC non
compete rules having any impact on buyout agreements?
So let me start with this.
So the, the FTC rule banning non-competes is actually
not effective just yet.
So it will be effective we're targeting in September,
unless it is the, the actual enforcement
of the rule becomes stayed by the current lawsuits
that are going through the court system.
They've asked for an injunction.
If that injunction is granted,
it could actually stay enforcement.
So we are waiting to see when it will be effective.
So right now the rule's not in in place.
And to answer that specific question, if the rule
as it is written becomes the law, then
that rule actually has a carve out for the sale
of a business non-competes.
So what that means is if you are selling your ownership
interest in a business
or substantially all of the businesses operating assets,
then you are entitled to have a non-compete in place
with respect to that business owner.
So the FTC has said we are going to bless that
and that's actually in line with
where the case law has fallen for decades, which is
that you are entitled to extra protection when you are
dealing with a sale of a business.
Why? Because it is the goodwill of that business.
It is everything that has been put into it.
So the law will better protect
that when we're talking about non-competes.
So with that, I am interested to hear John Harry,
your thoughts on, you know, outside of
that specific exception, you know, where you see, you know,
that new role having an impact on these agreements?
- Yeah, I'll just weigh in quickly on the,
on the valuation side Nicole,
which is we have always looked at non-competes as a way of,
or being indicative of personal goodwill
rather than enterprise goodwill.
If it's enterprise goodwill, it belongs to the business
and it transfers with the business.
So if you're buying out somebody's interest in the buy sell,
what you're going to be concerned with is whether
or not there's any personal goodwill that can,
otherwise you need to, I don't want to say block
that makes it sound like you're doing something illegal
but protecting the business interest that says yes,
we understand you have certain relationships,
you have certain knowledge that you could
otherwise take that's going to harm the business.
We want to make sure that that's going to be protected.
So along with that buy, sell
or on a sale of a business, if you see
that there's a non-compete attached to it that's indicative
that somebody believes that there's some element
of personal goodwill that creates some income tax planning
opportunities because again, you could structure it
as a sale of two bit
or two interests, one sale of your personal goodwill,
which would be capital gain versus a sale
of whatever at the business of enterprise goodwill.
If you're dealing with a C corp now you got two levels
of taxation there.
Non-compete agreements sometimes, you know,
we'll have a tie up provision
or a compensation agreement where it's ordinary income,
but that's all sorts of tax planning.
But yes, if I see
that there's a non-compete in a transaction, then yes
that tells me that there's personal goodwill.
People that don't, aren't worried about the departing owners
competing with them don't usually enter into non-compete
agreements 'cause there's nothing that they
otherwise have to pay to protect.
- Yeah, N Nicole, I I would just say that I think it kind of
further drives home that if the company has trade secrets
or processes all their ip, make sure that's protected.
So if that person does leave with a non-compete,
they can't utilize that information.
We've had a number of cases where people just get up
and open up a new company next door, you know,
they not only stole the data
but they're stealing the ip, the process and,
and you know, trade secrets you have
to document a certain way.
So I would say that, you know, it's going to force companies
to really look at their IP differently if this new role does
come into place because that's usually
what your company has, right?
It's the IP about how you do things,
how you process them and how you approach them.
So I think they have much broader implications
and I would just say to all the professionals here,
you should be talking to your clients about how
to protect all that now.
So I mean who, who in the hell knows
how this case is going to come out?
- Yeah, the one thing I would ask Nicole is,
'cause I heard somebody mention it,
that there is a difference,
and I don't know if they're treated differently under the
FTC rule is a non-compete versus a
non-solicitation provision. Oh boy, here
- We go.
Yes, yes. So I'll give you the short answer.
You, you're right John.
They are non-solicitation clauses are going
to survive the rule.
So they are not impacted by that rule so long
as they do not function as a non-compete.
Meaning if you write them so broad
that essentially you're locking someone out from going
to another company and still performing the same job, then
that's going to be considered a unsolicited.
So generally speaking, they survive,
they are going to be treated different.
- Gotcha. Thank you. - And what,
- What but the big car out, I'm sorry Harry, go ahead.
- Go. No, I was going to say Nicola, what if you have them base
that if you do do certain things
that you just then owe the company X percent of
that business rather than saying it's not a non-compete.
So it's a, you know, somebody leaves, they take part
of the business and then they have to pay you X percent,
- There's a financial penalty Yes
- For them there's a financial penalty on it,
but you're allowing them to compete.
- Yeah, I, I, I mean in the way you are describing it,
I don't see that being a problem.
So it really comes down to like exactly what, how is that,
how is that written and what is it actually doing?
So not just, you know, it's,
it's the function over the form here.
It's like, you know, what is it actually intended to do
and what will it end up doing?
- Right? But you can I get to kind of the same place,
not exact by, by putting in those staple provisions.
- I, you know, I want to, I want to highlight
what you said at the beginning there Nicola too in that
that this is one of the things that whatever you think
of this ruling and
however it proceeds, this is one of the areas you said
that is carved out
where it absolutely does apply when
you go to sell a business. Correct?
- Correct, correct.
It's the one area where the FTC is clearly blessed
and said this is going to be an exception.
- You know, and I spell that out
because as I'm sure none of you would be shocked to hear
somebody who does this sort of thing for a living was like,
oh there was just a thing the FTC said non-competes.
And I'm like, nope, talk to Nala.
Completely applicable, completely applicable here.
So, you know, misinformation,
bad information is way,
way worse than no information at all.
So, you know, and we could go on
and on about where you're getting your facts from,
but always, always check with the experts
before opining on something like this
because there's things, you know, this
and the Corporate transparency act are two things in the
last six months that have been blatantly bastardized
and misquoted over and over again.
And, and I'm as guilty as anybody else.
Bill Byers and I had a conversation about this last week,
so make sure you check with the experts
before opining on any of this other questions
before we let John and Harry off of the hot seat.
Okay. Nicole it to you.
- Okay. I just want to say thank you.
That was very informative Harry and John.
Really appreciate it. If I could just highlight two things
that in particular to just really
allow that to stick with you.
It's make sure that you're really focused on the details.
I mean, how much have we heard here today
that the details really matter
what you are putting into that agreement.
The more you think through it
and the more detail you spell out in the agreement,
the less you leave to chance
or determination by whatever the default laws are in the
jurisdiction where that agreement is going to be operative.
So if you don't spell something out
how the valuation is going to occur
or what happens in the event that you know,
one partner is no longer part of that business,
or if it's something happens in changes in the business
that you didn't account for it, you default to state law.
So that may not be what the partners contemplated the time
that they entered into this business.
It could be completely different
and you're stuck with that if it's
not spelled out in the agreement.
And the other thing I would highlight again is just making
sure that's an organic document, that it is living
and breathing and as that business changes
and shapes into something different over time,
it should be addressed in the agreement itself.
So definitely make sure you're, you're working with,
with your, you know, not only your attorneys
but valuation experts, your accountants, you know,
those were, that agreement touches on a lot
of different areas as we heard insurance as well.
So you really ask those questions to the professionals
that have the answers to those
as you're putting them together
so you have a really tight agreement that makes sure
that everything's taken care of in the end
and there's a plan in place.
Thank you both again, really appreciate it.
And at this point I will turn it over to Dave
'cause we've gotten an interview coming up
with Sherry Jamay.