Formula Approach

April 13, 2006

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When valuing a business interest as part of a buy-sell agreement, calculations of book value and fair market value may not always be the best options.

Because of the inherent unfairness of a purchase at book value, and the additional cost, time and complexity involved in a purchase at fair market value, some business owners rely on a formula approach designed to approximate fair market value without a formal appraisal.

One option is a purchase at book value, plus an arbitrary percentage (e.g. 5 percent). The arbitrary percentage is supposed to approximate the withdrawing owner's share of the entity's goodwill and of the appreciation in the entity's recorded assets.

Similarly, capitalization of earnings at a fixed percentage is sometimes used to approximate the fair market value of the withdrawing owner's interest. In this method, the entity's average annual net earnings for a period (e.g., the prior three years) are divided by the stated percentage to yield the presumed fair market value for all of the entity's assets, including its goodwill. By subtracting the entity's liabilities from this amount, the fair market value of the entity is derived

For example, if the annual earnings have averaged $90,000, and the capitalization rate is 10 percent, the presumed value of the assets is $900,000. If the liabilities total $600,000, the value of the entity is presumed to be $300,000.

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A new business is unlikely to generate significant goodwill or appreciation of its recorded assets in its first year of operations. Further, during the first year of operations, relationships among the owners could be especially unstable.

Thus, if fair market value is to be used, one approach is to specify that, during the one-year period after the buy-sell agreement is signed, fair market value is presumed to be equal to book value.

This eliminates the expense of an appraisal, which in any event would probably yield a result that approximated book value.

Finally, the buy-sell agreement can apply different methods to fix the purchase price, depending on the circumstances. For example, the agreement might fix a lower amount (e.g., book value) as the price if the owner files a personal bankruptcy action, but a higher value (e.g., book value plus 5 percent, or appraised fair market value) in other circumstances.

The strategy in this example is designed to prevent a significant payout to a bankrupt owner (which would only pass to the owner's creditors) or to convince the bankruptcy trustee to abandon the owner's property interest in the business. This strategy is open to challenge, so advanced strategies, such as this one, should only be employed with the advice of an attorney.