Spring 2014 Newsletter: Should Courts Rely on Agreements Between an Owner and the Company When Determining the Value of a Business Interest?

By Stephen Bravo

The author thanks Michael Mattson for his insights and assistance with this article

It is not unusual to find there is an agreement in force governing the business relationship between an owner-spouse (hereafter, just the “owner”) and the Company for which he or she (hereafter, just “he”) is employed. Depending on the type of entity such an agreement can take the form of a shareholder agreement (if a corporation), an operating agreement (if a limited liability company) or a partnership agreement (if a partnership).  There may also be additional agreements executed between the owner and the Company covering matters such as special voting rights regarding specific business strategies to be enacted, compensation, distributions, benefits, hiring, and other rights to direct the management and polices of the business enterprise.

One issue that has important valuation implications is whether these agreements stipulate to a formula, fixed dollar amount, or other mechanism for determining the purchase price if the owner were to sell his ownership interest back to the Company.  The importance of this issue heightens when the owner has a non-controlling equity percentage.[1]

Our office has been involved in valuation cases where agreements between an owner and the Company have been a central issue in arriving at a value of the owner’s equity interest.   The question from an appraisal perspective is: should such an agreement be the primarily, or even sole, determinant in estimating the value of the owner’s equity interest?

The requirement to consider such governance is discussed in the valuation standards promulgated by many valuation societies. Several examples are discussed below:

-        USPAP requires an appraiser to identify characteristics of the subject interest including all buy-sell and option agreements, investment letter stock restrictions, restrictive corporate charter or partnership clauses, and similar features or factors that may have an influence on value.[2]

-        SSVS No.1 indicates a valuation analyst should, as available and applicable, obtain and understand the classes of equity ownership interests and rights attached thereto and, where applicable and available, ownership information regarding the subject interest to enable him or her to understand other matters that may affect the value of the subject interest, such as shareholder agreements, partnership agreements, operating agreements, voting trust agreements, buy-sell agreements, loan covenants, restrictions, and other contractual obligations or restrictions affecting the owners and the subject interest.[3]

-        BVS-VI of the ASA standards states that in reaching a final conclusion of value the appraiser should consider the effect of relevant contractual and/or other legal restrictions.[4]

Revenue Ruling 59-60 also requires that restrictive agreements be considered.[5]

The above valuation standards and the IRS revenue ruling suggest that an appraiser might simply opine on the value of a subject interest based on the provisions contained in an agreement between the owner and the Company.  But is it really that simple?  Or, more importantly, does it produce a credible result within the context of the requisite standard of value?  Does the agreement amount result in a value that actually comes close to the value indications resulting from conceptual approaches to valuation? For example, is the amount close to that derived from a discounted cash flows method that has thoroughly analyzed the Company’s expected future cash flows? Does it align with a value based on pricing multiples of publicly traded companies? If not, should the appraiser accept the fixed/formula driven computation and justify it based on the equity interest being a non-control position and, possibly disregard market-based evidence?

The place to begin to answer these questions is by carefully considering the standard of value. The standard of value is driven by the type of valuation being sought.  It contains many assumptions that represent the underpinnings of the type of value being utilized in the specific valuation engagement and sets the criteria upon which appraisers rely.[6]

In the context of Massachusetts family law, the standard of value is equitable value.[7]   In Bernier I the Court looked to the fiduciary relationship between the parties.[8]  A fiduciary relationship has been described as “of utmost good faith and loyalty”.[9]

As a means of background, Bernier I, in part, concluded there is no marketability discount if there is no intent to sell and no lack of control (minority interest) if there is also no extraordinary circumstances.[10] These are modifications to the fair market value standard, and often times results in a higher value indication than fair market value.[11]  These modifications do not, however, alter the underpinnings of fair market value, nor do they replace fundamental financial analysis and objective interpretation of such analysis that are at the cornerstones of the fair market value standard.

In fair market value cases there are Tax Court cases that have pondered this conceptual framework.[12]   The Tax Court considered important premises regarding a transfer, including, but not limited to:

-        It is between a hypothetical buyer and hypothetical seller

-        It is at arms-length

-        There is no compulsion to transact

In one notable case, the Tax Court said, in part, that the willing buyer–willing seller test was objective and that the transfer must be analyzed from the point of view of the hypothetical seller trying to maximize (emphasis added) his profit. It was also not lost on the Court that the there is no compulsion to transact.[13]

In two recent divorce cases in which we were involved the non-control owners each asserted that the only value appropriate to use in determining the value of the marital estate was that determined by following the purchase price formula provided for in the agreement between them and their Company.

In the first case the formula was based on recent historical performance which we noted was particularly poor since it included the recent severe recession. The resulting value produced using the formula was quite low.  Discussions with management indicated the Company had turned the corner and that revenue growth and improved cash flows were expected. Indications of value derived from the discounted cash flows and guideline public company methods corroborated these future expectancies and resulted in much higher values.

In the second case the agreement called for a fixed threshold value amount to be exceeded before any value was assigned to the owner, in the event the owner left the Company.[14]  As the Company grows this threshold remained fixed and became a smaller percentage of the Company’s value (assuming the Company’s value grows).  The owner took the position the stated threshold amount should be subtracted from today’s value. The owner’s business appraiser agreed, substantially reducing the owner’s value by several million dollars.  We took issue with this application noting the owner was young and most likely should be expected to work for many more years.[15]  We pointed out that the effect of a fixed-dollar threshold diminished each year the owner remained;[16] but the owner would continue to collect his proportionate share of the annual (and growing) distributions.[17]

The essential question, in our minds was; whether it was reasonable to expect that an owner would self-impose a significant financial penalty on himself when he is under no compulsion to do so? The concept of equitable value assumes both parties in a divorce situation are acting as fiduciaries with respect to the assets in question.  In particular, it implies that a business owner would not intentionally impair the asset with which he or she has been entrusted (usually a share in a closely held business).  In these two cases with which we were involved, in our judgment, it is not reasonable to expect the owners to voluntarily act to maximize the penalty to value.  If we were to use a fair market value standard instead of an equitable value one, we would have to make this same assumption – that is, rational profit- or value-maximizing behavior, as discussed above.

In Pabst Brewing, Judge David Laro indicated that reasonable, realistic, and objective possible situations in the near future should be given the greatest weight in assessing the value of an asset; whereas, those elements that depend on events or occurrences, while possible but not reasonably probable, should be  excluded from this consideration.[18]

This is not to say all such agreements for determining value are inappropriate in a divorce setting.  We have also seen where a formula was established and included in an agreement between an owner and the Company that was appropriate for determining the value of the marital estate. Here, the owner was one of approximately fifty shareholders in a physician practice. As a condition of employment each physician was required to purchase a share of stock in the Company. The owner physician held approximately 2% of the outstanding shares. He was unable to change the agreement or control the practice. It was the practice’s policy to pay all income in the form of compensation.[19] The formula was equal to the net book value divided by the number of outstanding shares multiplied by the number of shares owned by the physician. The formula was used to determine the purchase price of a physician buying in to the practice as well as for redemptions of departing shareholders.  There were many historical equity transactions that supported this policy. We also discussed with management if there was any intention to change this policy and were told “No.”  Thus, in this case, if we were to ascribe any value above the practice’s formulaic value, we would have been double-counting the physician’s income (which included all income/distributions) and his value in the practice.  Furthermore, the value from this formula actually was the same value at which “arm’s-length” transactions occurred; thus, representing fair market value under the traditional definition.

Finally, USPAP discusses whether the quality of an appraiser’s work is complete, accurate, relevant, appropriate and reasonable. When considering agreements and the emphasis, if any that should be afforded to them, it is wise to consider these factors, otherwise it could result in an opinion of value that is not credible. 

Most importantly, appraisal standards mandate that the value conclusion be the result of the appraisers judgment – deciding between the appropriateness of a formulaic value, as specified in some agreement, and other, market-based approaches is exactly the type of thing contemplated by these standards.



[1] Generally speaking a non-control ownership is considered to be less than 50% of the outstanding equity, however before a determination can be made it is necessary to know the entire distribution of ownership. There are times when less than a 50% equity ownership can still result in possessing rights that result in effectively controlling the direction and policies of the business enterprise. The distinction between control and non-control is important because agreements between a controlling owner and the Company can always be revised at any time, whereas an agreement with a non-controlling owner may not be as readily amendable.

[2] Uniform Standards of Professional Appraisal Practice, Standard Rule 9-2(e)(iii), USPAP 2014-2015 Edition, The Appraisal Foundation.

[3] Statement on Standards for Valuation Services No.1, AICPA, paragraphs 27 and 28.

[4] American Society of Appraisers, ASA Business Valuation Standards, BVS-VI Reaching a Conclusion of Value.

[5] Revenue ruling 59-60, 1959-1 CB 237. Revenue Ruling 59-60 requires the relationships of the parties be considered.

[6] Standards of Value Theory and Applications, Second Edition, Jay E. Fishman, Shannon P. Pratt, and WIlliam J. Morrison, Wiley Finance, 2013.

[7] Some refer to this as “fair value” rather than equitable value.”

[8] Judith E. Bernier vs. Stephen A. Bernier, 449 Mass. 774 (2007) (“Bernier I”).

[9] Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578 (1975)

[10]  Extraordinary circumstances have yet to be explicitly defined by the Courts.

[11] Fair market value is defined in Revenue Ruling 59-60 as the amount at which the business interest would change hands between a willing buyer and a willing seller when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.

[12] Several notable cases include Bright, Andrews, Newhouse and Watts, to name a few.

[13] Henry J. Knott, TC Memo 1988-120, Code Sec(s) 2512.

[14] The threshold did not apply if the Company were sold or if the owner retired for good reasons (defined in the agreement). It only applied if the owner voluntarily retired without good reason at the valuation date, which he didn’t.

[15] In Adams, an investment manager was considered to have a 14-year remaining work (to age 62). His expected cash flows during this 14-year period were converted to present value using a discounted cash flows methodology. Mr. Adams was also expected to receive 10 years of retirement income at the conclusion of his work life. These expected cash flows were also converted to present value. (Adams v. Adams, 459 Mass. 380-381 (2011)).

[16] The reduction in the value of the Company is actually the present value of the threshold calculated in the year in which the threshold might be incurred.  For example, if the threshold is $5 million and the cost of capital is 20% and the threshold is expected to be triggered ten years from now (assumed voluntary retirement date), then the reduction in the value of the Company, as of today, would be about $808,000 ($5,000,000/((1+0.20)^10)); which is nowhere near $5 million. This situation is complicated further in that not all types of departures from the Company trigger this threshold calculation. In fact, most do not; thereby, the effect of this threshold must necessarily reduce today’s value even less than the $808,000.

[17] The Company is very profitable and long-term growth is expected, and is included in capitalizing the terminal year cash flows using the income approach. Every year the owner stays and collects his proportionate share of the excess income (in excess of compensation) the more value inures to the owner. This is the essence of the income approach, in general, and in the capitalization of income method, in particular. To ignore cash flows collected annually by the owner results in an undervaluation of his interest.

[18] Paraphrased from The Lawyer’s Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony, (American Bar Association), Second Edition, written by Shannon Pratt and Alina Niculita, Chapter 4 and footnote 6, which cites Pabst Brewing Co. V Comm’r, T.C. Memo, 1996-506 (1996).

[19] The practice did set aside needed working capital requirements before paying out all remaining available cash in the form of compensation.

Stephen J. Bravo is President and founder of Apogee Business Valuations, Inc. The firm performs business appraisals for purposes such as income taxes, estate & gift taxes, arbitration, shareholder litigation, divorce, mergers & acquisitions, and reviewing the quality of another appraisers work.

Mr. Bravo is an Accredited Senior Appraiser (ASA) of the American Society of Appraisers, Business Valuation. He is an Accredited Business Valuator (ABV) with the AICPA, and is a Certified Business Appraiser (CBV) with The Institute of Business Appraisers, Inc.  Mr. Bravo is a Certified Public Accountant, a Certified Financial Planner (Institute of Certified Financial Planners), a Personal Financial Specialist (American Institute of Certified Public Accountants), and Notary Public. He has a Master of Science in Taxation from Bentley College and his Bachelor of Science in Business Administration from Suffolk University.

Mr. Bravo is a technical editor of many business valuation books written entirely, or in part, by Dr. Shannon Pratt and Roger Grabowski, such as Valuing A Business, Cost of Capital, Business Valuation Body of Knowledge, Market Approach to Valuing Businesses, Business Valuation Discounts and Premiums, and Standards of Value: Theory and Applications.

He is a former editor of Business Valuation Review published by the ASA, and Business Appraisal Practice published by the IBA. Mr. Bravo is on the Panel of Experts published by Financial Valuation & Litigation Experts.