I have been researching for any issues relating to my father selling his family business to my brother well below FMV to be able to pass the company on for future generations.
The business was not properly appraised due to the nature of the business being an S – Corp? At the time of the sale tremendous pressure was applied arguing the fear of a buy sell agreement needing to be broken as the agreed price was set too low with the previous partners.
During the sale, an offer was made from a large corporation for around $10-11 million dollars. My brother purchased the company outright for $5 million of which $1 million was to be paid over the course of 10 years. Inventory was paid in full and there was around a $1 million in the checking account to help him survive.
After less than 5 years, the business was sold for $20 million. Nothing was done to make such a drastic increase in value other than the buyer wanting desperately to own the company. Legal deadlines approached making the purchase price escalate in order to secure the sale.
I am trying to find out what went wrong with the way this should have been handled during the initial sale to my brother. I have discussed this in detail and found that a stipulation should have been entered into the contact. In the event of a sale over a predetermined amount of years a portion of the profit from the sale revert back to my father. My fathers expectations were not met in the sale. The price was intended for future generations and in my opinion, money should be paid back to may father.
Is there such a stipulation, and is it common practice?
Any advice concerning this would be greatly appreciated.
PLEASE NOTE: I have invited my colleague, Michael Camerota, a business intermediary with Touchstone Advisors, to be my guest respondent to this letter:
You raise a number of issues, which affect family, legal, valuation and other. Allow me to deal with at least the following four issues:
- How and why was the business valued at only $5 million for a sale to your brother?
- Why would a large corporation make an offer of $10 million around the same time as the sale to your brother and why would another company pay $20 million just five years later?
- Why was the business sold to your brother with all of its inventory at no additional cost and with $1 million in the checking account?
- In a sale among family members, how common is it to have a stipulation providing that in the event of a second sale during a predetermined period, a portion of the purchase price be returned to the Seller.
Below are my responses:
The first thing to understand is that the same business may be appraised to be worth very different values depending upon both the purpose of the appraisal and the standards used in the appraisal. For example, in a divorce situation, the husband’s appraiser would likely value his business for substantially less than the wife’s appraiser in a situation where she is looking to be paid some percentage of its value. Similarly, the same appraiser might arrive at three different values for the same business if the purpose of each appraisal was.
- An appraisal for estate tax purposes in which the higher the value the more taxes to be paid;
- An appraisal for a buy-sell agreement where neither partner knows which one will die first; or
- An appraisal to provide to a particular buyer interested in purchasing the business.
In this situation, your father may simply have wanted to sell the business to your brother at a discount; perhaps in return for his help in building the business over the years. I can’t know from the situation presented. In the alternative, if there was a buy – sell agreement, your father may not have wanted to sell to your brother at a price higher than he agreed to sell to his previous partners and may even have been prohibited from doing so.
The point is that especially in family situations, it is not uncommon for a sales price to be on the “low” (or even “high”) side due to extenuating circumstances and feelings.
In the case of valuations for estate and gift tax, divorce, and buy- sell agreements, the standard usually required and generally used is a detailed set of rules set forth in IRS Revenue Ruling 59-60 which lay out how such a valuation is to be performed. These rules assume a “hypothetical” buyer and seller, under no compulsion to act, having full knowledge of the facts, and paying all cash for the business. In the case of the two buyers willing to pay substantially more for the business, the “fair market value” standard as defined in Revenue Ruling 50-60 simply does not apply. The buyers you mention:
- Likely had both synergistic and strategic reasons for purchasing the business: it was worth much more to them than to any “hypothetical buyer”.
- Were likely under some “compulsion” to buy (note your statement that the last buyer “wanted the company desperately” and that “legal deadlines approached making the price escalate”) and
- Likely structured the purchase with some cash, some debt and perhaps an earnout;
- Almost certainly required the seller to execute a non-compete agreement, which is not taken into consideration when computing “fair market value”.
Businesses of the size you present are almost always sold with the inventory included. They are also usually sold with both accounts receivable and accounts payable included and sometimes with the cash necessary to operate the business. These items can be viewed as the “gas in the tank” that go with the business and without which the business could not operate. One can argue that $1 million in cash was excessive in this particular case but the fact that some cash was left in the business does not trouble me.
A stipulation such as the one your refer to would perhaps have been appropriate in this situation, depending upon the intentions of your father which appear to be unknowable at this point. Nevertheless, in my experience, such stipulations are not at all common in transfers among family members.
Michael W. Camerota, JD, M&AMI, Touchstone Advisors, Enfield, CT 06082