Badly Drafted Buy-Sell Agreement Results in Lengthy Litigation

Shareholders must properly address valuation implications and issues before entering into a Buy-Sell Agreement. The case described below illustrates how the failure to properly think through and document a comprehensive valuation methodology can result in protracted and expensive litigation.

Related Article: Addressing Valuation Issues Is Essential to an Effective Buy-Sell Agreement

Lynton Kotzin  

Dimaria v. Goor, 2012 U.S. Dist. LEXIS 21457 (Feb. 21, 2012)

In 1992, the two co-owners of a commercial transport business entered into a stock agreement to ensure the continuity of their closely held company. Pursuant to that agreement, if one of the owners died, the company would have the right to buy all of the decedent’s stock. If the company declined its option, then the surviving shareholder would be obligated to purchase the decedent’s stock. The decedent’s estate would be equally obligated to sell.

The agreement provided that the surviving shareholder would pay a price equal to the company’s “total value” divided by the number of shares. This value would be determined in one of two ways: If the two shareholders had executed a “Certificate of Agreed Value” within two years preceding the date of death, then that agreed value would dictate the purchase price. If not, then the defined “value” would equal the amount stated on the most recent Certificate of Agreed Value, which stated “plus (or minus) an amount which reflects the increase (or decrease) in the net worth of the corporation from the date of the most recent Certificate of Agreed Value to the end of the month immediately preceding the decedent’s death, as determined by the certified public accountant regularly employed by the corporation, applying generally accepted accounting principles.”

At the time (1992) that the co-owners executed the stock agreement, they also executed a Certificate of Agreed Value that valued the company at $2 million.

In 2006, one of the shareholders died. After inheriting his 50% interest, his wife demanded $1 million for her shares. The surviving shareholder refused, asserting that, by then, the business was merely a “payroll company” and was worthless. The wife sued the surviving shareholder for a variety of claims. The court eventually found that the company was obligated to repurchase the decedent shareholder’s interest. The surviving shareholder moved for summary judgment, accepting his repurchase obligation but claiming the company was worthless.

In support of his motion, the surviving shareholder provided testimony from the company’s CPA, who said that the “actual equity” of the company as of the valuation date (the shareholder’s death) was $5,800 – in effect, a zero value. At the same time, the CPA did not attempt to determine the net worth of the company as of 1992 (the date of the last Certificate of Agreed Value) or calculate the amount by which the company’s net value might have increased (or decreased) between 1992 and 2006.

The decedent’s wife argued that the shareholders’ agreement empowered the CPA to determine the change in the company’s net worth, but that the ultimate determination of its value must be made in accordance with the formula set forth in the repurchase provisions. Her CPA expert criticized the company’s accountant for failing to properly apply GAAP, which does not equate “value” with “net worth” or mandate the application of book value. Instead, he testified, GAAP defines “value” as the amount of money something is worth.

After considering both sides, the federal district court (E.D. N.Y.) held that the “plain language” and intent of the shareholders’ agreement foreclosed the surviving shareholder’s argument.

The surviving shareholder’s reasoning also inverted the “complex” formula contained in the buyout clause, the court said. The contract clearly envisioned the “value” to be the dependent variable, calculated by inputting the most recent agreed-upon value ($2 million) and the change in net worth since that time.

Although the court conceded that it could not, from the face of the agreement, determine which valuation method the parties intended to use, it did find that “the parties did not intend to use the ‘book value’ methodology” and that, pursuant to the contract, the company’s CPA must calculate the change in net worth between 1992 and the valuation date. “[The CPA] may not simply assume that the net worth was $2 million,” the court ruled.

Indeed, there was evidence that the company’s book value was not equal to $2 million in 1992; rather, the agreed-upon certificate simply reflected the value of the life insurance policies that the shareholders had purchased to fund any future forced-repurchase obligation. Because the company’s net worth may have been substantially less than $2 million in 1992, the court said, subtracting from $2 million the change in net worth between 1992 and 2006 could produce a positive value, “even if its 2006 net worth was a deficit.”

For these reasons, it denied the surviving shareholder’s motion to dismiss and ordered the parties to conduct a valuation of the company that complied with the court’s interpretation of the buyout clause.

© 2012. No part of this article may be reproduced or redistributed without the express written permission of the copyright holder. Although the information in this article is believed to be reliable, we do not guarantee its accuracy, and such information may be considered incomplete. This article is intended for information purposes only, and is not intended as financial, investment, legal or consulting advice.