Surprise! Your Business Appraiser Just Disregarded Your Shareholder Debt

Your carefully drafted Shareholders Agreement addressed several buyout scenarios. After discussing a formula-based valuation, everyone decided to look to a valuation expert to appraise the business and set the value for the buyout.  The valuation process was left to the professional judgment of the appraiser.

But be aware that within the scope of that professional judgment the appraiser will look at the proper treatment of the company’s debt to shareholders.   Depending upon how that debt has been documented and treated over the years, the appraiser’s judgment may require that it be disregarded in valuing the business.

Appraisal industry literature in the past couple of years has increased awareness of this topic and hence the likelihood that an appraiser will decide that the debt should be disregarded.  Articles discuss a “multi-factor” approach to determining how to treat the debt by looking at a variety of factors.  Combining a “multi-factor” test with changing facts over time – like a few years of foregoing interest or principal payments on the debt – create a significant, and perhaps surprising variable in a valuation process.

The point of this article is not to explore the factors impacting how debt is characterized or how they should be applied, but to highlight the potential that these factors will increase the variation in appraisal outcomes – probably adding more variability to the process than the parties originally intended.

Imagine, for example, a scenario with four shareholders, two of whom contribute most of the money as debt.  Promissory notes are issued to the two lending shareholders, but interest is never paid.  A Shareholders Agreement is signed giving each shareholder the ability to sell his or her stock back to the company at “appraised value” if employment ends.    When the appraisal process is triggered, the business value based on cash flows is only half of the debt amount.  With the debt honored, the stock has no value.  But if the debt is disregarded, the equity is worth the business value.  There is the argument that the equity ownership interests need to be adjusted to reflect the implications of the debt being disregarded – presumably the shareholder should see his or her ownership interest percentage increased – but this creates a topic for dispute.

If your company has shareholder debt and a Shareholders Agreement (or a bylaw or other binding provision) calls for an appraisal process to value stock in certain situations, be sure to review this topic with your financial and legal advisors.

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