Last month, I described the key provisions of buy/sell agreements, which allow families to restrict business ownership to people with whom they choose to be partners. If a current shareholder intentionally or unintentionally transfers stock to a non-permitted person, the agreement specifies how the stock may be returned to appropriate hands.

It is the equivalent of a prenuptial agreement, since it sets the terms of a business divorce should the undesirable event ever occur in the future. However, despite the noble objectives, many families have trouble discussing and agreeing to some of the most critical terms.

Perhaps the toughest provision of all is valuation. Since the triggering event may not occur for many years or even decades, it is wise to set a mechanism that will self-adjust based upon changing conditions.

There are numerous ways to set the pricing mechanism, but they can be divided into several categories.

Book Value

Book value is the difference between assets and liabilities on the balance sheet. A multiple or fraction of book value probably is the most common valuation approach. It is simple, easily understood and easily calculated.

Unfortunately, book value only coincidentally equals a business fair market value. In fact, book value probably is the least accurate way to estimate fair market value because it:

  • Can be manipulated through choice of accounting methods.
  • Reflects historical asset cost, not current asset value.
  • Reflects past earnings, not future earnings potential.

The latter point is particularly important for most family businesses. For example, assume two businesses, each with a book value of $1 million. The first business is expected to generate annual profit of $500,000, while the second only $10,000. Do you think both are worth $1 million? If you do, give me a call. I have a nice bridge for sale.

Periodic Revisions

Some families punt on the valuation question by agreeing to meet periodically to set a new stock price. This approach allows the family to adjust the value for changes in business conditions.

Sounds reasonable, but there are some significant cons (not referring to family members who disagree with you the next time shareholders meet to set the value), including:

  • As long as no one wants or needs to sell, it is easy to agree on a new value. However, if someone is considering a sale, you can bet that the next meeting will become a major negotiation. That defeats the buy/sell objective of avoiding negotiations when tensions are high and interests diverge.
  • In my experience, families just don’t seem to get around to doing it. Since the most recent value sticks until the parties agree to change it, the price tends to get rather stale.


An independent appraisal is, at least theoretically, the most accurate way to determine fair market value. Why? A good appraiser considers not only history, but also current asset value and future earnings potential. Granted, appraisers are not astrologers, but at least they consider facts and trends at the time of the transaction.

There are a number of cons (not referring to appraisers who disagree with your view of value), including:

  • The shareholders don’t know what their stock value is from time-to-time unless the company periodically incurs the cost of an appraisal.
  • Appraisals are somewhat subjective. Qualified appraisers may come up with different values. However, appraisers usually fall within a reasonable range if they are truly independent, unbiased and given the same information. Pay attention to buy/sell provisions concerning appraiser selection and the appraisal process.
  • A major potential point of contention is discounts for lack of marketability and control. Perhaps the family should agree to the size of these discounts and not leave it to the appraiser’s discretion. The agreement can instruct the appraiser accordingly.

An appraiser friend says he knows he has found fair value when both sides are mad at him! That speaks volumes. It might be better for family members to be mad at the appraiser than each other!


For operating businesses, appraisers usually place great weight on multiples of earnings and/or cash flow. The multiples are based on price-to-earnings and similar ratios of comparable public companies. To avoid appraisal costs, you could use these types of formulas in your buy/sell to approximate fair market value.

An informed approach to selecting formulas is to ask an appraiser to describe the primary mechanics he would use to value your business. Those mechanics become formulas specified in your buy/sell agreement.

Downsides include:

  • Formulas don’t do too well at peaks and valleys of business cycles. For example, using a multiple of the average of the past three years earnings could yield a high value, even though conditions indicate the beginning of a downturn. Conversely, formulas would tend to undervalue a business that is starting a business upturn.
  • Results can be affected (some might say, manipulated) by tinkering with the underlying components. For example, if you want to lower the company’s earnings-based value, pay yourself a bigger salary. An objective appraiser would adjust out the effects of such unusual items. A formula-based agreement can spell-out adjustments, but might not adequately anticipate subsequent creative management or changing business conditions.
  • Formulas should be changed when there is a major change in the type of business or the assets owned by it. The bigger issue is whether the shareholders will agree to the change at that time.

The Real Problem

Picking a valuation technique would be easy except for one little bitty question. WHO GETS BOUGHT OUT FIRST AND WHO HAS TO PAY FOR IT? Actually, I guess that’s two questions.

If you think you’ll be the first to sell, you’ll argue for a valuation approach that will yield a high value. If you want the business to remain in the family forever, you want a low value to discourage family members from selling. As the debate over pricing gets more heated, other issues are brought to the surface. The entire process turns into a quagmire and grinds to a halt.

That raises another question for family business leadership. Do we really even want to let this genie out of the bottle? Maybe we should just not bother with a buy/sell agreement. It’s like that darn prenuptial agreement. We’re really happy together now. Why risk messing up our relationship by talking about what will happen if we ever need to split up?

Stay tuned. The saga continues next month.

Ross Nager is Senior Managing Director of Sentinel Trust Company in Houston, Texas