Standard of Value in a Buy/Sell Agreement

There are many moving parts in a buy/sell agreement. They need to be reviewed and updated often. There are many difficult issues that need to be addressed. One of the decisions the owners need to make is what standard of value to use in the business valuation. It is important for the shareholders to understand each standard in order to select the standard that best fits their needs.

It is imperative that standard of value language exists in the buy/sell agreement otherwise it will be difficult to value the Company at all. Some definitions of standard of values are as follows:

FAIR MARKET VALUE

Fair market value may be the most used standard of value but it may also be the most misunderstood. People think of fair market value similar to the term used in real estate. It will also depend on whose definition of fair market value you use.

For example, under Revenue Ruling 59-60 the definition is “The price for which property would change hands between a willing buyer and a willing seller when the  former is not under the compulsion to buy and the latter is not under the compulsion to sell, both having reasonable knowledge of relevant facts.”¹

It is also defined in the Glossary of the Business Valuation Standards of the American Society of Appraisers as, “The price, expressed in cash equivalents, at which property would exchange hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

The parties are willing and able financially. They are assumed to have independent interests and act on their own behalf. It is an arm’s length transaction. There are eight factors to consider in a fair market valuation they are:

1. The nature of the business and history of the enterprise.
2. The economic outlook and general outlook of the industry.
3. The book value of the stock and the financial condition of the business.
4. The earning capacity of the company.
5. The dividend paying capacity.
6. Whether or not the company has goodwill or other intangible value.
7. Sales of the stock and the size of the block sold.
8. The market price of stocks for corporations that are engaged in the same or a similar line of business and that have their stock traded in a free and open market, either on an exchange or over-the-counter.

¹ In addition that hypothetical buyer and seller are assumed to be able, as well as willing to trade and to be well-informed about the property and concerning the market for such property.

FAIR VALUE

The term fair value is defined by state law and varies from state to state. Most states use the term equitable distribution, which usually mean that the value is prior to taken any minority, key-man or marketability discounts. Fair Value can vary from state to state so therefore it can be confusing to use this standard of value in a buy/sell agreement. In Massachusetts fair value is defined as______________Fair value is also used in financial reporting under ASC Topic 820 Fair Value Measurements and Disclosures. ASC 820 defines fair value for financial purposes under Generally Accepted Accounting Principles. There is a high likelihood of confusion with this standard of value.

INVESTMENT VALUE

Investment value is the value that an investment has to one particular buyer. This standard of value contains a “synergy value” between the buyer and the seller. The buyer may be willing to pay more for a business that has a synergy with the buyer. The challenge with investment value is you would need to know who the buyer is. That would be difficult if not impossible to predict.  

Fair market value is the standard of value of choice. What needs to be emphasized is that the definition should be stated in the agreement so there is no confusion. Buy/sell agreements should be reviewed to make sure that there are not any valuation standards of value that do not exist.