Weak Valuation Terms Invite Disputes: How BFMV Helps Owners Clarify Them

Operating agreements are drafted and executed at the beginning of a working relationship among co-owners. During that early period, expectations about the future are typically optimistic, and goodwill and harmony prevail among the new owners. The agreement governs how the entity runs day-to-day, and somewhere within it, usually in a single section, sits the language that determines what an owner's interest is worth when they leave and how it will be paid.

Once the agreement is signed, its terms are rarely revisited. Owners return to it when someone begins to contemplate leaving, whether to retire, to pursue another opportunity, or because disagreements have become serious enough that an exit seems like the best option. They return to it as well when an owner faces termination, a moment that raises significant questions for that owner and for the business alike.

At that point, each owner reads the language through the lens of their own interests, and valuation terms that seemed clear in a spirit of goodwill become a source of confusion and, often, a source of leverage for whichever side benefits from the ambiguity. The better course is to clarify those terms now, while the owners still agree on what they were meant to accomplish. Clear valuation terms reduce the risk of disputes and protect the company and its owners.

A familiar situation

Consider a two-physician practice in which the senior physician plans to retire within the year and expects her junior partner, who joined the practice several years ago, to buy her interest. She is confident the operating agreement covers the valuation and the buyout process, and she has had no reason to reread it.

During a meeting with her CPA about tax planning for her retirement, the conversation turns to the buyout. The CPA asks how much she will receive and when, to plan for the tax consequences and model her liquidity needs, but the valuation terms she remembered as thorough now appear incomplete, perhaps no more than a single paragraph. She plans to raise the issue with her attorney and to seek an independent valuation perspective before the buyout discussions begin.

Her situation is common and not limited to two-owner practices. The same pattern appears in larger ownership groups and in practices of every specialty. It also appears with increasing frequency in management services organizations ("MSOs"), where physicians often hold ownership interests, sometimes alongside outside investors such as private equity firms.

Common shortcomings in valuation terms

When valuation terms are incomplete or imprecise, owners are often left uncertain about what the agreement requires, and that uncertainty can become a dispute. These shortcomings tend to take a few familiar forms:

• Most commonly, the valuation terminology is inconsistent with valuation standards, or different provisions of the agreement use conflicting terms. An agreement may, for example, refer to "fair market value" in one section and "fair value" in another, or call for an "appraised value" without defining the standard of value to be applied.

• A price or formula set at signing produces a figure that no one recognizes as fair today.

• The agreement does not specify who selects the appraiser, who pays for the appraisal, or what happens if multiple appraisals reach conflicting conclusions.

• No one is sure as to what date the business should be valued, or whether the departing owner's interest should be discounted.

• The departing owner cannot tell when the money will arrive, and the remaining owners cannot tell how they will pay it.

  
  

Any one of these can turn a planned transition into a dispute, and a dispute over value can divert management attention, consume resources, and strain relationships across the ownership group.

After reading your operating agreement, can you say unambiguously how it defines value, as of what date your interest would be valued, and when you would be paid? Would each of your co-owners give the same answers? If not, those terms are worth revisiting before they are needed.

The right time to clarify the terms

The best time to review and clarify valuation terms is when no exit is imminent: at an annual owners' meeting, when a new owner or investor joins, or when a potential exit first appears on the horizon rather than on the calendar. A review at that stage is inexpensive and cooperative. A review conducted once an exit is underway is neither, because by then the owners no longer negotiate in the same spirit.

An operating agreement written in a season of goodwill will eventually be read in a season of competing interests. Clarifying its valuation terms now costs far less than resolving the same questions in the middle of a buyout.

How BFMV can help

BFMV offers consultative services to review the valuation terms in your operating agreement with you to identify where they are unclear or incomplete, and recommend how they could be clarified where revisions are warranted. We regularly work alongside attorneys, CPAs, and other advisors, and we welcome inquiries from owners and from the professionals who advise them. To discuss the process or schedule a consultation, contact Victor Jarosiewicz, PhD, ASA, CFA, CAIA, at victor@buckheadfmv.com or (678) 987-8765.