As most business owners will tell you, plenty of positive vibes are flowing at the inception of a new venture.  Whether it’s a couple of friends starting out on their own, an employer rewarding key employees with equity, or a family electing to pass the baton to the next generation, these occasions are exciting. As most seasoned business owners will tell you, this is also the best time to get in agreement on provisions and governing documents that will serve as guides when that excitement gives way to the day-to-day reality of running a business.

Among the most important of the topics addressed in the governing documents of a closely held business is how the parties will handle a future change in ownership. The reasons for ownership changes can be varied, but the possibility of change is always lurking.  Setting out how to handle the change in ownership can be done in a Company Agreement (also known as an Operating Agreement in some circles), but it is often done through a Buy-Sell Agreement among the owners.

In its simplest form, a Buy-Sell Agreement is merely an agreement between equity owners as to how the parties will handle a transfer of an owner’s interest in the company. The Buy-Sell Agreement will consider a multitude of issues, but perhaps the most important is the method of determining the value of a transferred interest. A lot of circumstances can be overcome when the parties get the value right and everyone walks away with what they consider a fair deal.  But get the money wrong, and things could go south in a hurry.

So how do business owners and their attorneys ensure an adequate method for valuing an ownership interest is included in the Buy-Sell Agreement?

Many use the Fair Market Value (FMV) standard as set out in IRS Revenue Ruling 59-60.

Revenue Ruling 59-60 defines the concept of FMV for appraising businesses and ownership interests for gift and estate tax purposes in closely held businesses having no market for their shares. In this approach to valuation, Section 3.01 of the ruling provides that “a sound valuation will be based upon all the relevant facts, but the elements of common sense, information judgment and, reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”  Section 3.03 observes, rather astutely, that the “valuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of appraisal.”

Section 4.01 of the ruling establishes eight “fundamental” factors that should be considered when determining the FMV of closely held business interests:

1. The business’s nature and the enterprise’s history from its inception.
2. The economic outlook in general and the condition and outlook of the specific industry in particular.
3. The book value of the stock and the financial condition of the business.
4. The earning capacity of the company.
5. The dividend-paying capacity.
6. Whether or not the enterprise has goodwill or other intangible value.
7. Sales of the stock and the size of the block of stock to be valued.
8. The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

In its discussion of the 7^th factor – sales of stock and the size of the block of stock to be valued – the ruling observes that “the size of the block of the stock itself is a relevant factor to be considered” and proceeds to embrace the now well-established use of control premiums, minority discounts, and marketability discounts in valuing closely held interests.

So, what does all this mean and why should you care?

If you are considering a Buy-Sell Agreement (or Company Agreement) that relies on Revenue Ruling 59-60 or some other methodology to determine the FMV of your ownership interest, ask whoever prepared it why that methodology was chosen and what it means to you.  If there is no methodology mentioned in the agreement, ask why not.  If you don’t get a satisfactory answer, keep asking until you do.

If you are a key employee considering an equity award, you need to know what discounts might apply when valuing your interest if facing an exit event.  If you are a second-generation owner of the family business with plans to buy out an uncle’s controlling interest, you need to be mindful of the slight variations in how the books are kept that can result in an artificially high outlook that could drive a significant control premium in favor of the selling uncle.

Regardless of the reason, if you are considering agreeing to address the transfer of ownership interests, or perhaps need one, reach out to an experienced professional to discuss.  There may be more at stake than you realize.

For an in-depth analysis of Revenue Ruling 59-60 and what it means in the real world, check out Z. Christopher Mercer’s e-book entitled “What Revenue Ruling 59-60 Says (and Does Not Say) About Fair Market Value; Analysis and Review of This Seminal Ruling from Business and Valuation Perspectives” (https://chrismercer.net/content/uploads/2022/04/What-RR-59-60-Says-About-Fair-Market-Value-E-Book-1.pdf).