September 01, 2010

Equity transactions between owners in closely held entities are often governed by shareholders’ agreements.1 One manner by which such agreements handle issues of valuation involves predetermined and agreed-upon valuation formulas. These formulas, as applied to some economic metric (e.g., revenue, net income, etc.) generate values which govern the buying and selling of past and/or prospective owners.

The recent Delaware Chancery Court decision of In re Sunbelt Beverage Corporation (“Sunbelt”) highlighted a problem associated with such formulas.2 Although the formulas discussed in Sunbelt derived from a purchase agreement with installment transactions over a three-year period rather than a shareholders’ agreement, the conclusions relate to both equally. The Court’s opinion correctly noted that formulas used to determine values, even if their associated valuation multiples were previously viable and applicable, can be rendered obsolete:

There is no bright-line rule relating to the maximum length of time that may occur between an earlier transaction and a cash-out merger before the Court discounts the weight of the earlier transaction as evidence of fair value . . . I conclude that three years is far too wide a gap between the two events.

In so determining, the Court reasoned that while a transaction may be recent, the negotiation and therefore the terms of the transaction were not. In this particular situation, the three-year lapse was sufficiently long to render the current transactions as invalid. This problem is not the sole difficulty presented by valuation formulas and underscores the issue of how shareholders’ agreements should be structured to handle equity transactions.

Problems with Valuation Formulas

The use of valuation formulas (“formulas”) in transactions of shareholder equity interests is not uncommon. Many privately held entities incorporate formulas into their shareholders’ agreements. The reason is as simple as the formulas themselves – they are often easy to calculate. However, formulas frequently fail to reflect fair market value due to two primary reasons.

The Problem of Timing

First, any formula, to the extent it reflects legitimate economic rationale, comports to market-based data as of a point in time. As previously noted, fixed formulas, while perhaps accurately reflecting fair market value at the point in time in which their associated agreements were executed, eventually become stale and obsolete.3 As all valuation multiples inherently reflect expectations of future return as adjusted for its associated level of risk, valuation multiples must change as a business’s risk and return profile changes.4

For example, a valuation multiple of enterprise value to earnings before interest, taxes, depreciation, and amortization (“EBITDA”) may be seven. All valuation multiples, by definition, are simply inverses of capitalization rates. Since all capitalization rates inherently blend together assumptions about risk (the discount rate) and return (the growth rate), then all valuation multiples also reflect such assumptions.5 As an example, a valuation multiple of seven equates to a capitalization rate of approximately 14% (equal to one divided by seven) which may reflect a discount rate of 20% and a growth rate of 6%.6

But future return may change as expectations of growth are altered. Likewise, the riskiness of a company may change with that of the industry in general or relative to competitors. For example, a manufacturer of DVD players may lose business as substitute products (e.g. on-demand video) increase in popularity or as competing DVD manufacturers realize cost savings by outsourcing production to low-cost countries.

This previously indicated 14% capitalization rate as related to a DVD manufacturer can be utilized as an example. Faced with increased risk (by substitute products) and less expected return (in profitability and/or sales), a potential buyer may now believe a discount rate of 24% and a growth rate of 4% is more appropriate. Accordingly, this generates a 20% capitalization rate which equals a valuation multiple of five. This corresponding and significant reduction in value will not be reflected with a fixed formula (having obviously stayed fixed at seven). In this example, the exiting shareholder would benefit at the expense of the new shareholder(s) or, in the case of the exiting shareholder’s redemption by the company, the other existing shareholders.

The Problem of Lacking Economic Rationale

Second, a formula may simply not reflect legitimate economic rationale. That is, the economic metric utilized in any formula should typically serve as a proxy for distributable cash flows. Distributable cash flow can be defined as cash flow which can be distributed to owners without impairing the operational viability of the business.7 Distributable cash flow can be measured discretely by adjusting expected EBITDA for non-cash expenses and their corresponding tax consequences, working capital requirements, and capital expenditures. Formulas typically utilize proxies for distributable cash flow such as EBITDA, revenue/sales, net income, etc. Sometimes even non-financial or accounting metrics are utilized, often when “rules of thumb” (e.g., the number of beds in the valuation of a nursing home) are employed. To the extent a formula does not reflect (either directly or as a proxy) future distributable cash flow, it will likely fail to produce an appropriate valuation, unless by coincidence.8

The formula utilized in the Sunbelt decision, in addition to being stale and obsolete (“three years is far too wide a gap”) also appears to have suffered from a lack of underlying economic rationale:

Even a brief examination of that specific nature leads me to believe that the . . . Formula should not be used to determine fair value in this proceeding. First, the . . . Formula relies too heavily on the book value of Sunbelt, provides a premium reliant solely on the company’s net income in the two years preceding any Formula-based transaction . . .

In this circumstance, the Court found that financial measures such as book value and historical net income bore no relation to future cash flows, and hence value.

Other Shareholder Agreement Valuation Options

If fixed formulas fail to provide an appropriate solution in structuring shareholders’ agreements, what other options exist, and what are their relative merits? Other options for determining value in shareholders’ agreements include structured negotiations and third-party valuations.

Structured Negotiations

Many shareholders’ agreements require determinations of value by the shareholders themselves through structured negotiations. Such structured negotiations consist of two forms: agreed-upon-values and put/call processes.9

Agreed-upon-values typically require shareholders to state a value (agreed to by the parties) on an annual basis. Such a determination forces shareholders into a (hopefully) healthy discussion about a company’s prospects. More importantly, annually (or periodically) agreeing on values helps prevent the passage of time to create drastically different opinions of value. Counteracting this benefit, however, is the sheer impracticality of such discussions and determinations. Theoretically the mandate should work, but in reality shareholders, in the midst of operating and financing concerns, forgo such discussion in favor of more pressing needs. Additionally, if parties fail to agree upon values, resolution requires other means. Agreed-upon-values, therefore, cannot ensure a determination of value, but can be beneficial when combined (as a first option) with other valuation options.

Put/call processes do ensure a determination of value. Such processes convey duality upon an offer. That is, one party’s offer to buy shares, if rejected, allows the declining party to purchase the equity interest of the shareholder making the initial offer at the offered price per shared. For example, Shareholder A owns one-third of a company’s 30,000 shares of common stock while Shareholder B owns the remaining two-thirds. If Shareholder A offered to buy Shareholder B’s equity interest at $100 per share, Shareholder B, in declining the offer, would be forced to buy (and Shareholder A would be forced to sell) Shareholder A’s equity interest for $1 million. As any offer to purchase shares inherently includes a disincentive to propose an above fair market value price, the put/call process also creates a disincentive for the initial offering shareholder (Shareholder A) to propose a price less than fair market value – lest the declining shareholder (Shareholder B) implement a counterproposal upon the same terms.

Many view the outcome of this process as akin to a fair market value transaction. It should be noted, however, that such a transaction may or may not reflect fair market value which, by definition, involves a specific equity interest by hypothetical parties. Potentially in contrast, the put/call process typically involves different equity interests held by specific parties, which may differ from that of the marketplace.

A potential disadvantage of this process may result from disproportionate ownership interests, varying shareholder financial strength, and dissimilar access to company information. To extend the example discussed above, if Shareholder B possessed insignificant net worth beyond that of the equity ownership, Shareholder B may need to accept Shareholder A’s offer. Secure in such knowledge, Shareholder A would be incentivized to offer a low per-share value. Even if both shareholders possessed equal net worth beyond that of the business, Shareholder A (using the $100 per share offer price) faces a $2 million acquisition versus that of only $1 million for Shareholder B. Differences in knowledge about a company’s prospects (for example, if Shareholder A is a passive owner while Shareholder B acts as Chief Executive Officer) may also skew a shareholders’ opinion of value. To continue this example, Shareholder B, in possessing better knowledge about future risks faced by the company, may readily accept the “overvalued” $100 per share price.

Third-Party Valuations

Third-party valuations possess some clear advantages over structured negotiations. Frequently, to save on costs and to limit the process, a single binding or non-binding third-party valuation is performed by an expert who works on behalf of both parties. Shareholders, however, will often fail to agree on which valuation expert should provide the single valuation. For this reason, the process of choosing a valuation expert should be well structured and clearly defined as it relates to both the selection method (e.g., naming a particular firm within the document, allowing each party to choose an expert who in turn select on a single expert from another firm, etc.) and qualifications (e.g., independence, a minimum level of experience, etc.).

Assuming the shareholders choose a valuation expert with the appropriate level of expertise, a third-party valuation should provide an accurate and well-reasoned value. In non-binding situations, the conclusion of value (whether in the form of a report or provided in a presentation) hopefully proves compelling to all parties. Pivotal to a persuasive conclusion, in addition to being well reasoned and supported by market-based evidence, is the opportunity for each party to participate in the valuation process by providing thoughts, opinions, and commentary.

Frequently, shareholders’ agreements requiring third-party valuations do not entail the hiring of a single valuation expert, but rather oblige each party to hire their own valuation expert. In these situations, shareholders’ agreements must contain provisions on reconciling differences between the valuations. Oftentimes, if the differences are not material (e.g., within 10% of each other as measured from one of the valuations), then a value may be concluded which equals the difference between the two.

If the differences are material, a number of mechanisms which typically involve additional valuations exist to resolve the impasse. While these processes may settle disagreements of value, hiring additional valuation experts to perform additional valuations increases costs and lengthens the process. As an alternative, an effective solution involves the hiring of an additional expert to choose one of the original valuations as the binding valuation. In addition to saving the cost and time of an additional valuation, this stipulation helps deter valuation experts from taking extreme positions or posturing for their clients (either intentionally or subconsciously).

The likelihood of two third-party valuations differing significantly in their conclusions of value can be minimized by well defined and consistent valuation terminology within the shareholders’ agreement. Proper definitions will, at a minimum, detail the level of value (i.e., whether or not discounts for lack of control and lack of marketability should be incorporated), valuation date, and standard of value (i.e., value according to whose outlook – e.g., a hypothetical buyer or the actual shareholder party to the agreement?).


While a primary purpose of shareholders’ agreements is often the facilitation of equity transactions, poorly drafted agreements can hinder these transactions and generate significant costs for the parties involved. Too often, the incorporation of formulas for this purpose, in lieu of either structured negotiations or third-party valuations, creates long-term and expensive shareholder disputes. A properly drafted shareholder agreement should present options that allow for changing facts and circumstances associated with the company and its shareholders. In addition, careful attention should be given to properly defining the standard of value to minimize the potential for misinterpretation that could result in widely divergent valuations conclusions.

1 For purposes of this article, no distinction is made between the legal entity involved (e.g., partnership, corporation, etc.) and therefore the name of its corresponding agreement. Similarly, no distinction is made between shareholders’ agreements, buy/sell agreements, or any other agreements by existing shareholders governing the terms and conditions under which equity interests may transact. For both situations, the term “shareholders’ agreements” has been utilized.

2 In Re Sunbelt Beverage Corp. Shareholder Litigation, Consol. C.A. No. 16089-CC, Chandler, C. (Del. Ch. Jan 5, 2010).

3 For purposes of this article, the term “fixed formula” refers to a specific numerical value (e.g., six times EBITDA) rather than a specific formula (e.g., enterprise value to EBITDA).
EBITDA is a commonly utilized economic metric in determining value.

4 Ultimately, return equals distributable cash flow (a.k.a. free cash flow). For purposes of this discussion, distributable cash flow is defined as cash which can be distributed without impairing the operational viability of the business.

5 Growth rates incorporated into capitalization rates equal growth rates into perpetuity.

6 A capitalization rates equals a discount rate less the growth rate.

7 There are two primary reasons why distributable cash flow ultimately determines value. First, discount rates are typically derived from actual sales of stock, and therefore reflect returns paid in cash. Hence it is appropriate to match cash-derived discount rates with cash returns. Secondly, only cash, unlike an accounting concept like net income, can actually be distributed.

8 A formula may not reflect future distributable cash flow either inherently or if the circumstances by which it had acted as a proxy change.

9 Put/call processes are known by a variety of names including “shotgun” or “magic bullet” provisions.