1. Include a Valuation Method in the Governing Agreement Between Business Partners.
Before examining how valuation should be addressed in the governing document among the partners, it is important to state what may be obvious but is often overlooked in these agreements: actually include provisions that detail the method or procedure for determining valuation. On many occasions, the governing agreement will only go half way -- it will include a redemption and/or buy-out right but not include how to value the departing owner's interest. As you can imagine, this invariably leads to costly litigation over the proper valuation of the business. Avoid creating a problem by including the valuation method in the governing document.
2. There is no Single Valuation Method that is Appropriate for all Businesses.
The next question is what is the appropriate valuation method. The bottom line is there is no single correct answer, as it depends on a number of factors, including (i) the nature of the business, (ii) the operating history and status, and (iii) the perception of the partners. The nature of the business matters because, for example, you would not value a real estate holding company in the same way you would an online retailer. The operating history/status of the business is significant because it may not make sense to apply the same valuation method to a mature company with an established operating history and revenues to a pre-revenue start-up. Finally, there is the perception of the partners, which can create some of the biggest issues in determining valuation. For example, the partners of an early stage company may believe that even without any current revenues, they have a new technology or concept that will attract substantial investment and eventually substantial revenues, requiring the valuation to take into account their understanding of the potential market for their product.
3. What are the Possible Valuation Methods or Procedures?
So, if no single method of valuation applies, how is the issue then addressed in the governing document? The answer is really a matter of the partners agreeing on the appropriate method. In some cases, the agreement will actually state a formula for calculating the valuation: whether it is book value, a multiple of gross or net income, an income multiple that looks at historical earnings, or a calculation based on discounted cash flow. In other circumstances, the partners may recognize that they are cannot determine the appropriate methodology or feel it may need to adjust as the company develops, and instead would rather leave it to a third party to determine the valuation. If the parties decide that engaging a professional to determine the valuation upon the triggering event, then they must next decide who would be engaged: obvious choices include a CPA, investment bank, or a company specializing in business valuations. Assuming a professional is to be engaged, the next question is how is that person/firm chosen? One possibility is to specifically name them in the agreement, but what if they are no longer in business at the time the valuation is needed. The parties can instead state that they will mutually agree who should be retained at the time of the triggering event, but what if they don't agree? An alternative which is often utilized is to set a time by which the parties have to agree, barring which they each choose a person to conduct the valuation, and subject to the reasonableness of the issued valuation opinions the final valuation is the average. Or, the agreement can provide that each party chooses their expert and the two experts then choose a third, with average of the three constituting the final valuation. Recognize, however, that engaging three experts can be costly, and the parties need to set forth how the fees will be paid (likely, they each pay their own expert and share the cost of the third one).
Lastly, the governing agreement should include provisions about timing -- in other words, when the valuation must be completed if the methodology is set forth in the agreement or when the experts must be chosen and their valuation opinion issued. Without clear deadlines, the process can drag-on without a timely resolution.
Disclaimer: The above does not create any attorney-client relationship and is for informational purposes only. It is important to retain a knowledgeable business lawyer before entering into any business relationship .