By Scott E. Evans, CPA, ABV, CFE, Managing Director
In our role as litigation support professionals, we are often asked to prepare valuations or various calculations based on the language in Buy/Sell agreements, operating agreements, and purchase agreements.
We find that these agreements often do not provide clear language as to how valuations or other calculations are to be performed. Below are some of the common problems we encounter:
Improper or Vague Accounting Terms
We run across vague terms like “profits” or “income” in Buy/Sell agreements. Often, the so called “profits” or “income” are to be used as inputs into various formulas in the agreement. However, these terms are vague and may not lead to the desired outcome. For example, are “profits” to be calculated on a cash or accrual basis? Should “profits” include owner’s compensation? What if owner’s compensation is under market? Should a market rate for owner’s salary then be determined? Should income taxes be deducted? Should interest on owner loans to the company be deducted? Should earnings from investments be included?
Accounting terms need to be properly defined, otherwise an accountant who is asked to prepare calculations consistent with the agreement will not have sufficient direction, and you may end up with unintended outcomes.
Improper Use of the Term GAAP
Frequently, we see the term GAAP (Generally Accepted Accounting Principles) used in Buy/Sell and similar agreements. Many attorneys use the term GAAP as shorthand for accurate financial statements. However, GAAP has a specific meaning that may not be applicable to many companies.
One of the biggest problems with requiring GAAP financials in an agreement, is that many companies likely have never actually prepared GAAP financial statements. Many small and medium sized businesses use cash basis accounting. Cash basis accounting does not comply with GAAP. Even if the company uses accrual accounting rather than cash basis accounting, the company may still not prepare GAAP financials. For example, many companies don’t prepare accurate year-end accruals in accordance with GAAP. Additionally, technically, financial statements prepared under GAAP are required to have footnotes – few small businesses prepare footnotes.
Therefore, when an agreement demands that financial statements be prepared in accordance with GAAP, and the company has never prepared GAAP financial statements, it can create a significant problem. Many companies would not be able to switch to GAAP financial statements economically and timely. Even if it was possible to prepare GAAP financial statements, the newly created GAAP financials would not be consistent with previously prepared financials, which can cause other problems.
Due to the high likelihood of problems arising from the improper use of the term GAAP, it is prudent to determine how the company keeps their books and then craft the requirements, in any agreement, accordingly.
Improper Use of the Term Fair Market Value
The term Fair Market Value (“FMV”) is often used in Buy/Sell agreements as the standard of value used to determine an owner’s interest in the company. The use of FMV is sometimes used as a default term, when Fair Value may be the more appropriate standard of value.
A FMV calculation of value generally requires discounts for lack of marketability and lack of control for ownership interests less than 50% of the company. Therefore, a valuation prepared using FMV will most likely result in a value, for the minority owner, significantly less than a valuation prepared using Fair Value. A Fair Value standard generally does not apply discounts for lack of marketability or lack of control. An alternative to specifying the application of Fair Value could be to require a value determined using FMV, but specifying that no discounts are to be applied.
Other factors, such as owner’s compensation, often need to be taken into consideration in valuing an owner’s interest in a company. Therefore, given the possibility of ending up with an unanticipated outcome, it is a good idea to consult with a valuation expert when crafting the methodology for valuing a business or an owner’s interest in a Buy/Sell or similar agreement.
Buy/Sell Agreements utilize accounting and valuation terms that should be carefully considered to achieve the objective of any Buy/Sell or similar agreement. Therefore, it would be wise to have an accountant familiar with business valuations take a look at your agreements to see if there are any issues or imprecise terms.