Ambiguous Buy-Sell Provision Can Really Hurt PDF Print E-mail
Ambiguous Buy-Sell Provision Can Really Hurt

Poorly drafted buy-sell agreements can lead to litigation and the possible dissolution of the business.  Just the opposite of what the business owners intended.  Buy-Sell agreements are common place in most closely held business whether they have been formed as a corporation, partnership or limited liability company.  Buy-Sell agreements typically deal with two trigger events between business owners.  They are either the disability or death of one of the business owners.  

In a recent state court action in Wisconsin, the appellate court affirmed the trial court's determination that the term "book value" in the document was sufficiently ambiguous to render the terms of a disability buy-sell agreement unenforceable.  Paul Hood discussed this case in a recent article and mentioned what to avoid and think about regarding valuing a business.  His comments are below.
 
FACTS: Jon and Bill, a dentist, were friends and decided to form and co-own a picture framing company.  Jon worked in the business full-time. In 1992, just a year before Bill discovered that he had Parkinson's Disease, the two men entered into a buy-sell agreement that provided in pertinent part as follows:

For transfers of all of a Shareholder's stock at his death, or upon his becoming disabled, the purchase price of a Shareholder's shares of stock shall be $350,000.00 or Book Value[,] whichever is greater, except if the Shareholders have determined by unanimous resolution passed subsequent to the date of this agreement that the purchase price shall be other than $350,000.00, then the most recent such resolution shall determine the purchase price. For transfers of all of a Shareholder's stock on threat of involuntary transfer, the purchase price of a Shareholder's shares of stock shall be the book value of said shares as of the end of the last fiscal year. (Emphasis added.)
 
In June 2001, Jon triggered the disability buy-sell provision and offered to pay Bill the sum of $431,400, which John represented was the corporation's "book value." Bill didn't think that amount was sufficient and requested and received the right to audit the corporation's books. Nevertheless, the parties parted as friends - and promptly sued each other.

The trial court held that the buy-sell agreement was enforceable despite the ambiguity and further that Jon was in fact disabled for purposes of the agreement. However, the trial court also held that Bill was entitled to judicial dissolution. Jon and Bill both appealed.
 
On appeal, the appellate court affirmed all of the trial court's holdings. The appellate court noted:
 
we conclude that the term "book value" as used in the Agreement is not indefinite but is ambiguous, and that the most reasonable construction of that term is that it refers to a computation using generally accepted accounting principles. We conclude further that the absence of information necessary to complete the GAAP analysis rendered the disability buyout provisions unenforceable because [the corporation's] book value as of March 31, 2001, could not be determined.
 
Valuation Lessons:  This buy-sell agreement used the term "book value," which almost never takes current value or goodwill into account. It made no attempt to define what the term "book value" meant. There are very few if any situations in which a naked use of the term "book value" should be used in a buy-sell agreement.
 
In this case, the trial court decided to graft GAAP onto the definition of "book value." However, this was not a foregone conclusion, and Bill originally fought its application since he argued that the agreement was totally unenforceable due to ambiguity. It is possible that the court would not have imported GAAP to its determination of the meaning of the term "book value."
 
Suppose the parties weren't using GAAP to begin with? The bottom line: if one is going to use some sort of valuation formula  or some variant of book value, strongly consider spelling out that GAAP is to apply and if there are to be departures from GAAP, consider spelling those out as well.
 
Use of the term "book value," even if defined in detail, is rarely advisable in a buy-sell agreement because it could be susceptible of manipulation. Book value does not factor in income-earning potential. Suppose that the business was a low capital business such as a service business.  The human capital component does not get factored in under a book value arrangement.
 
Even though it appears that Bill will get his wish and have the corporation dissolved, this will be a pyrrhic victory at best. On dissolution, he will probably not be compensated at all for the earning power or goodwill of the corporation and will face double taxation—at the corporate level and at the shareholder level.

 

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