The concept of the value of an owner-managed business is best understood considering the perspective of the marketplace. Fundamental to the understanding of business value is that the value will change depending upon the marketplace - more precisely, value will change with the circumstances that create the nature of the market.
Buyers who are involved with the business will not pay for the "know-how" or "good will" of a business that a buyer outside the business would consider purchasing. Generally, an inside sale (where the market consists of buyers involved with the business) will not have as high a purchase price as an outside sale (where the market consists of buyers not involved with the business). The term "fair value" is used in legislation and court decisions to indicate the value of business interests between owners of a business. The term "fair market value" is used to indicate the value of a business to those purchasing the business and not involved in the business. Fair value, the value between business owners, results in computation of an overall business value that is less than a presumed fair market value. A minority interest in a closely-held business will be highly devalued for lack of control by a market consisting of buyers not involved with the business, while a market consisting of buyers involved with the business might place a premium on an interest that when acquired would merge with an existing interest to become a majority interest.
Owners will have as a goal the increased value of the business, but when it comes to measuring the value of the business and then incorporating the value concepts into an owner's agreement which contains buy-sell provisions, the concepts often become convoluted. It can get worse because there are more complications, those involving terms of sale and circumstances motivating the sale.
There is an old saying among negotiators: "If you give me my terms, I will give you your price." Simply put, if all the proceeds of the sale are not paid immediately then the time involved before payment will decrease the present value of the sale. If the purchaser is not going to pay the entire purchase price immediately, the time factor involved in the payment discounts the value of the price. If purchasing owners do not have the funds to buy out another owner, it is still preferable to have a sale with payment of part of the purchase price deferred. (Usually this means that the future success of the business will determine whether the selling owner is paid.)
If the owner selling the business interest is dead, there are circumstances that create the nature of the market which will cause potential buyers to offer less. If the owner selling the business interest is disabled, there are circumstances that create the nature of the market that may cause a discounting of the price a buyer will offer. If the owner is selling because of a dispute with other owners, especially if the departing owner is going to compete with the business, there are circumstances that create the nature of the market which will cause the discounting of the value of the business interest. Note that none of these circumstances potentially affect the essential worth of the business interest over time - they are market causes for a decrease in purchase price for a certain transaction.
Owners want to enter into buy-sell agreements to avoid the potential result of circumstances that create the nature of the market - that death, disability, separation from the business, or a number of other events could cause a diminution in the value received for their business interest. Where there is an effective agreement, the owners of a business form the market place and agree to buy one another's interests in the event of certain triggers initiating a purchase and sale of interest. However, owners generally do not enter into effective agreements because they underestimate the complexity of the determination of a price in a given circumstance.
One of the most frequent mistakes in buy-sell agreements is confusing fair market value with fair value. By definition, a buy-sell agreement deals with fair value (between co-owners) not fair market value (applicable to a purchase of the business by one not an owner). If the basis for value discussion is some concept of fair market value (derived from an appraisal or a comparison transaction price) during the course of a transaction when enlightenment occurs, there will be an attempt to break the agreement. As an example, where two owners each own equal shares and agree to purchase the others interest at the first death of an owner, there will be a purchase for fair value of a one-half interest that will result in the surviving owner having all of the business valued at fair market value. This situation is often described as a windfall and has been the subject of much litigation, but a careful analysis results in an understanding that there is no windfall and that the purchase and sale was for an appropriate price. If this understanding is not properly documented for the benefit of the parties, related parties, and affected parties (as well as their lawyers), litigation is likely to undermine the efficacy of the buy-sell transaction.
Similarly, where the triggers for the transaction vary, some will try to apply the same value, ignoring the concept that the market reacts to circumstance. When buy-sell agreements offer different prices and terms given different triggers and the rationale for this treatment is not appropriately documented, the consulted lawyers, parties, related parties, and affected parties often advise and initiate litigation.
Generally attempts to simplify this complexity with a formula are also problematic, because conditions will change more quickly than will the formula.
When owners consider a buy-sell agreement and desire an effective agreement, the understanding of value must be approached with appreciation of its complexity. The owners should agree on fair market value and then understand that fair value will be the basis of their agreement. For each trigger of anticipated, potential circumstance, there must be a consideration of the price and terms of each transaction reflecting the marketplace issues. The agreement should specify the rationale and procedure for each transaction. Stakeholders (spouses, potential owners, and key personnel) should be advised to the agreement and understand the relative concepts of fair market value and fair value.