Business valuation, which is a fluid and dynamic process, doesn’t lend itself to expression in a mechanical formula. But incorporating a valuation formula into a buy-sell agreement reduces costs by eliminating the need for regular appraisals by a valuation expert. The key is to find the right balance between the lower cost of a formula and the greater accuracy and fairness produced by a full valuation.

By definition, the subjective elements of the valuation process cannot be incorporated into a formula. When the build-up method is used to determine capitalization rates, for example, subjective inputs, such as the specific company risk premium and the business’s growth rate, usually aren’t susceptible to objective determination. This makes it difficult to structure a buy-sell valuation provision that’s flexible enough to adapt to the business’s changing circumstances.

Adding Flexibility

One potential compromise is to incorporate some measure of flexibility into the variables. A buy-sell formula can be designed to take into account some of the economic, industry, and even business-specific factors, making it possible to determine a reasonable capitalization rate under the build-up method.

The risk-free rate, the equity risk premium, and the small company risk premium are all quantifiable by reference to objective measures. But the specific company risk premium, which is intended to measure the additional risk assumed by a buyer who invests in a closely held company, takes into account strength of management, quality of the labor force, and certain strategic advantages.

The buy-sell formula may incorporate a range of values for the specific company risk premium (e.g., 1% to 6%). If, at the time of valuation, the company is performing poorly in comparison to its peers, a risk premium at the higher end of the range may be chosen. Conversely, if the company’s performance is strong, the risk premium would fall at the lower end of the range.

Similarly, if growth is slowing and the industry is a mature, cyclical business, a growth rate may be chosen that’s in line with the Consumer Price Index or some other standard measure of inflation. If the industry and business are performing strongly, it may be appropriate to choose a higher growth rate.

Of course, there must be a mechanism for choosing the appropriate risk premium and growth rate, such as selection by top management or by an independent business valuator.

Specify Standard of Value

Even if the buy-sell agreement doesn’t incorporate a formula, it should, at the very least, provide some guidance to the business valuator, including specifying the standard of value to be used and whether discounts for lack of control and/or lack of marketability should be applied. Ambiguity in these areas can invite disputes and litigation.