When business partners form a company, they often focus on growth, strategy, and operations. It is also important to plan for what happens when an owner leaves. Ownership transitions happen for many reasons including retirement, death, disability, disputes between owners, divorce, financial distress, termination of employment or an owner simply wanting to exit the business. If an agreement does not clearly define how the company will be valued, disagreements can quickly escalate into costly litigation.
For this reason, most well-drafted shareholder agreements (also known as buy-sell agreements) and operating agreements include provisions establishing how the business will be valued if an ownership interest must be bought or sold. This article explains the most common valuation approaches used in business agreements and the advantages and disadvantages of each.
A business valuation clause determines the price at which an ownership interest will be bought or sold when a triggering event occurs. Common triggering events include death of an owner, disability of an owner, retirement or voluntary withdrawal, termination of employment of an owner, bankruptcy or creditor claims against an owner, divorce involving an owner, deadlock between owners, forced buy-sell provisions or sale of the company. Without a clear valuation method, disputes may arise over questions such as:
- What is the company actually worth?
- How should intangible assets be valued?
- Should future growth be considered?
- Should a minority owner receive a discount?
Courts often must appoint valuation experts in these disputes, which can cost tens of thousands of dollars or more. Proper planning in governing documents helps avoid this uncertainty and potentially cost and time associated with battles over valuation.
Common Methods for Valuing a Company in Business Agreements
There is no single “correct” valuation method. The appropriate approach depends on the size of the company, the industry, the number of owners, and the complexity of the business. Below are the most common approaches used in operating and shareholder agreements.
Fixed Value Method
Under a fixed value method, the owners agree in advance on a specific dollar value for the business. Typically, agreements provide for the business owners to agree annually to a current value. The value can be one the owners determine, or one by a third party such as their accountant or a valuation expert. The fixed value approach is attractive because it is simple, predictable, inexpensive and easy to administer.
The primary risk is that the value may become outdated or inaccurate if the owners do not regularly attend to the task of executing the agreed upon valuation document on an annual (or other regular) basis. Business values can change quickly due to growth or decline in revenue, economic changes, industry trends, loss of major customers or new intellectual property or product lines. In practice, many companies adopt a fixed value but fail to update it regularly, which can create unfair outcomes if an owner exits years later.
This method is often used by small family businesses, early-stage startups and closely held companies with few owners. However, it works best only when owners commit to periodic updates.
Formula-Based Valuation
A formula-based method calculates the company’s value using financial metrics, such as revenue or earnings. This is one of the most common approaches used in operating agreements because it provides predictability and objectivity. Some agreements value the business using a multiple of revenue. This method is common in businesses where revenue strongly correlates with value.
Another common formula uses EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA multiples are commonly used in manufacturing businesses, service companies, hospitality businesses and professional practices.
Some agreements rely on accounting values. This method reflects the company’s net asset value. However, book value often undervalues businesses that have significant goodwill or brand value. Formula methods are popular because they are objective and easy to calculate, reduce disputes between owners, avoid expensive appraisals and create predictable outcomes. However, formula approaches may not reflect true market value. Potential issues include unusual financial years, temporary economic disruptions, accounting decisions affecting EBITDA and failure to capture goodwill or brand value. For this reason, many agreements include a fallback appraisal process if the formula result is challenged.
Independent Appraisal Method
Under an appraisal method, the company is valued by an independent professional business appraiser. Common credentials include Accredited in Business Valuation (ABV), Certified Valuation Analyst (CVA), and Accredited Senior Appraiser (ASA). The valuation professional analyzes the company and issues a written valuation report. The appraisal method provides the most accurate market valuation, an independent and neutral process, and credibility if disputes arise. It is commonly used in larger companies or companies with significant intangible assets. The main drawback is cost and time. Professional business valuations can cost anywhere from $5,000 to $30,000 or more depending on the company. Additionally, the valuation process may take several weeks or months.
Multiple-Appraiser Method
Some agreements attempt to create a balanced valuation process by requiring multiple appraisers, most often three appraisers. A common approach works as follows: each owner selects an appraiser, the two appraisers select a third appraiser and the final value is determined by averaging the appraisals or selecting the median value. Another approach, sometimes called baseball arbitration, works differently. Each party’s appraiser submits a valuation number, and the arbitrator must choose one of the proposed values, not create a new one. This structure encourages both parties to present reasonable valuations. These approaches attempt to reduce bias, encourage fair valuations and discourage extreme valuation positions. The biggest disadvantage is that they can be expensive and complex because multiple experts may be involved.
Market Comparable Method
This approach values the business based on recent sales of similar companies. Appraisers examine comparable company acquisitions, industry transaction databases, and publicly available market data. Common data sources include DealStats, PitchBook, and IBBA transaction reports. This method reflects actual market conditions and real-world transaction values. The disadvantage is that comparable companies may differ significantly in size, profitability, geographic market and customer concentration. Therefore, professional judgment is required.
Discounted Cash Flow (DCF)
The Discounted Cash Flow method values a company based on expected future cash flows. The basic concept is:
Business Value = Present Value of Future Cash Flow
This requires estimating projected future revenue, expected expenses, growth rates, risk adjustments and discount rates. DCF can provide a very sophisticated valuation that reflects long-term earning potential. The disadvantage is that this method depends heavily on assumptions about the future, which can be highly subjective. For this reason, it is usually performed by professional valuation experts.
Hybrid Valuation Methods
Many agreements combine multiple approaches to create a balanced system. Examples include formula valuation with appraisal override, fixed value updated annually with appraisal fallback and EBITDA multiple unless challenged by an independent appraisal. Hybrid approaches often provide the best balance of certainty and fairness.
Additional Valuation Adjustments Often Addressed in Agreements
In addition to determining the company’s value, agreements may address valuation adjustments affecting specific ownership interests. These may include a “Minority Discount” that reflects the reduced value of a minority interest that lacks control over company decisions. They may also include a “Marketability Discount” that accounts for the difficulty of selling shares in a closely held private company. On the other hand, it can include a Control Premium where a controlling ownership interest may be valued higher than a minority interest. It can also involve Key Person Adjustments where businesses depend heavily on the reputation or skills of a specific individual. Agreements may address how this affects valuation.
A well-designed valuation clause should also address several practical issues such a triggering events that clearly define when valuation occurs. The agreement should specify whether value is determined on the date of the triggering event, at the end of the last fiscal year or on another defined date. Payment terms should be detailed in the agreement. Buyouts are often structured as lump-sum payments, installment payments and life-insurance funded buyouts. The agreement should also specify how valuation disputes will be resolved.
Final Thoughts for Business Owners
Valuation provisions are one of the most important — and most overlooked — parts of shareholder and operating agreements.
A well-designed valuation mechanism can prevent disputes between owners, reduce litigation risk, create predictable exit outcomes and preserve business continuity. The best approach depends on the nature of the business, the number of owners, and the level of complexity the owners are willing to accept. For many closely held companies, a formula valuation combined with an independent appraisal backup offers a practical balance of certainty and fairness.