Let’s say…Eli Jordan founded Jordan Family Farms. He now runs the business and each of his three children, Chris, Megan and Mark own a minority interest. Chris decides he has other opportunities and wants to remove himself from the family business. To do so, he must sell his interest. What should Chris expect to receive for his interest?
On one level, valuing an interest in a business should not be too complicated. It is the price a willing buyer is prepared to pay a willing seller for the interest. Two parties come together and negotiate a price. This “fair market value” concept is what we use wherever we can in the transactional world. Not that complicated, right?
…but Jordan Family Farms is a family business that needs to be kept within the family. This substantially limits the number of potential buyers. It means the potential buyers may have undue leverage because there is no one for them to compete with.
…but no one else in the Jordan family has the liquid resources to buy the interest. Even if everyone agreed that the interest in the business might be worth a certain amount, what difference does that make if none of the potential buyers can pay that price? Does that mean the interest is actually worth less as a result?
…but any buyer of the interest knows they will have this same problem if they try to sell down the road. Should there be a reduction in the price because the buyer knows they are signing up to the same concerns?
…but Eli Jordan runs the business and so any buyer knows they will be getting an increased economic interest, but they will never get to run the business or control it unless the Eli makes that decision. Should the price be reduced for that?
…but the whole reason for the sale in the first place is that Chris wants to be done with the family business. Should he be forced to bear the transaction costs associated with the sale? Or is that something both the buyer and Chris should bear? Or is that something the business should bear, given the family nature?
In some senses, this is a daunting set of factors to consider any time a family member wants to transfer an interest and it has certainly derailed many potential transactions. It might be best to think of these considerations in three general categories:
First, is the notion of fair market value or some adjusted version of fair market value even appropriate in the context of a specific sale? The most common reason parties will abandon any notion of fair market value is that the buyer just does not have the resources to pay a true fair market value. If that is the situation, it does not matter how good a case the seller can make. If a buyer cannot afford to pay the price, there is no transaction. If the parties are going to abandon the notion of fair market value, they will need to come up with other objective criteria to set the price, including book value of the assets, revenue of the business, EBITDA, etc. But, at the end of the day, the ceiling to the price will be set by the financial ability of the buyer.
Second, if the parties are going to proceed with some price based on a notion of fair market value, should they consider whether to apply discounts for lack of control or lack of marketability? The concept is that if a buyer is buying an interest that does not come with a proportional right to control the business or is going to be particularly difficult to sell because it is only a minority interest, maybe it is not appropriate to calculate the price as a direct percentage of the total value of the business. These discounts are commonly applied in closely held businesses, family-owned and otherwise, but they are the subject of real negotiation. It is worth considering whether or not they are appropriate in a given scenario.
Third, how should the parties handle transaction costs (which can sometimes be substantial)? There are certainly general market customs about how transaction costs are allocated in sales of businesses (each party usually pays their own) or investments in businesses (the business usually pays). But sometimes families feel that any family member selling their interest in the business is forcing the transaction on the family and should therefore pay the entirety of the transaction costs.
Family members face all these questions every time they consider buying or selling interests in their family-owned business, and very talented professionals have devoted their entire careers to working through these questions and helping families find answers that are correct and appropriate for each scenario. In addition to addressing the legal aspects of these questions, Davis Wright Tremaine works with many accounting, valuation and wealth management professionals on a regular basis and would be happy to make introductions for any of our family business clients and colleagues.
Drew Steen is a business transactions attorney at Davis Wright Tremaine, LLP. He represents both buy-side and sell-side clients in mergers and acquisitions, venture capital investments, joint ventures, equity co-investments and restructurings. He also serves as regular corporate counsel for several closely-held and family-owned companies. Drew can be reached via email at firstname.lastname@example.org or directly at 206.757.8081