As if we need another case illustrating why fixed price buy-sell agreements should be avoided like the plague.
Before we get to the case: A fixed price buy-sell agreement is one in which co-owners of a business select a specific dollar amount, expressed either as enterprise or per-share value, for calculation of the future buyout price to be paid an exiting owner or his or her estate upon the happening of specified trigger events such as death, disability, retirement, or termination of employment. Such agreements can take the form of a stand-alone buy-sell agreement or may be included in a more comprehensive shareholders, operating, or partnership agreement.
Fixed price buy-sell agreements in theory offer two main advantages over pricing mechanisms that utilize formulas or appraisals at the time of the trigger event. One is certainty; everyone knows in advance the amount to be paid upon a trigger event. The other is avoidance of transactional costs; there’s no need to hire accounting or valuation professionals at the time of the trigger event and no need to hire lawyers to litigate differences that can arise with indeterminate pricing mechanisms such as those requiring business appraisals.
But when theory meets reality, reality usually triumphs. Company values can and often do change dramatically over time, for better or worse. And even though the typical fixed price buy-sell calls for periodic updates of the so-called certificate of value, it’s rarely done for any number of reasons ranging from benign neglect to inability to reach agreement on a new value among co-owners of different ages whose interests and exit horizons diverge over time. So when a buyout occurs long after a last agreed value has become out of sync with the company’s significantly higher value as of the trigger date, there’s a powerful financial and emotional incentive for the exiting owner or his or her estate representative to challenge the buyout in court, thereby defeating one of the main reasons to have a fixed price agreement in the first place.
I’ve previously featured on this blog several illustrative fixed price buy-sell lawsuits precipitated by stale or absent certificates of value, including Sullivan v Troser Management, Nimkoff v Central Park Plaza Associates, and DeMatteo v DeMatteo Salvage Co. The latest addition to this ill-fated family of cases is entitled Namerow v PediatriCare Associates, LLC, decided last November by a New Jersey Superior Court judge, in which the court enforced a fixed price buy-sell agreement among members of a medical practice where the original certificate of value hadn’t been updated for 16 years at the time of the plaintiff doctor’s retirement from the practice.
Before I say anything else about the case, let me point out that the fixed price provision in Namerow‘s operating agreement is far from the worst offender in the bunch; it includes an adjustment to any last-agreed value older than two years based on the increase or decrease in the firm’s “net worth . . . including collectible accounts receivable.” Here’s the full text of Section 10 of the operating agreement entered into in the year 2000:
The total value of the Company (“Company Value”) shall be the last dated amount set forth on the Certificate of Agreed Value, attached hereto as Exhibit G and made part hereto, executed by the Members. The Members shall exercise their best efforts to meet not less than once per year for the purpose of considering a new Value but their failure to meet or determine a value shall not invalidate the most recently executed Certificate of Agreed Value setting forth the Company Value then in effect. If the Parties fail to agree on a revaluation as described above for more than two (2) years, the Company Value shall be equal to the last agreed upon Value, adjusted to reflect the increase or decrease in the net worth of the Company, including collectible accounts receivable, since the last agreed upon Value. The value of a Member’s Interest (“Value”) shall mean the Company Value multiplied by the percentage interest held by said Member and being purchased hereunder, less any indebtedness that the Selling or Disabled Member, the Decedent, or a Member departing for any other reason contemplated hereunder may have to the Company or to the other Members, whichever the case may be.
The referenced Certificate of Agreed Value stated the “Value of the Company” to be $2.4 million. It was never updated. Also noteworthy is the omission of any provision delegating the responsibility for a determination of the net worth adjustment, e.g., to the practice’s outside accountant, much less providing that such person’s determination shall be conclusive and binding on the members.
Events Preceding the Court’s Appraisal
From an earlier decision in the case, we can glean that in 2009, for “business and financial planning” purposes, i.e., not in connection with a Section 10 buyout, the members of the practice engaged a business appraisal firm which used a fair market valuation methodology to arrive at a practice value of $4.25 million. We don’t know if the members discussed at the time updating their Certificate of Agreed Value. All we know is, they didn’t do so.
Fast forward to January 2016, when Dr. Namerow announced his intention to retire the following year. The other members thereafter commissioned two successive appraisals for the purpose of reaching a settlement with Dr. Namerow as to a voluntarily negotiated buy-out number for his 25% interest. Both appraisals used a fair market value standard. The first one, valuing the practice as of October 2016, came in at a range of values with a midpoint of $4.45 million, which Dr. Namerow rejected. The second one, valuing the practice as of December 2016, came in around $3.4 million, likewise rejected by Dr. Namerow who then hired an accounting firm to prepare a critique of the second valuation.
In response, the other members had its appraiser prepare a new valuation using Section 10’s methodology, i.e., adjusting the last agreed value of $2.4 million by the increase or decrease in the practice’s “net worth,” resulting in a figure down from the prior $3.4 million valuation to about $3.25 million.
You can see what direction this is going. According to Dr. Namerow’s complaint, shortly after he officially retired in mid-2017, the remaining members threatened that if he didn’t accept the $3.4 million December 2016 fair market appraisal, they would utilize the net worth valuation methodology set forth in the operating agreement ($2.4 million) even though it had never been previously used in the 16 years the operating agreement had been in existence. They also allegedly threatened to reduce the amount to which Dr. Namerow was entitled by around $172,000 based upon alleged improper actions taken by him while still practicing.
Dr. Namerow filed suit in October 2017. His amended complaint included a claim that the parties’ course of conduct over the 16-year period following adoption of the operating agreement had modified it to require a fair market valuation of his membership interest in lieu of the methodology provided in Section 10.
In a late September 2018 opinion, the court dismissed that claim along with others in Dr. Namerow’s complaint, holding that Section 10 of the operating agreement unambiguously provides for a net worth adjustment to the 2000 Certificate of Agreed Value as the sole method for calculating Dr. Namerow’s buyout price.
The Court’s Appraisal Ruling
The court’s November 29, 2018 opinion summarizes the testimony and reports of Dr. Namerow’s and the defendants’ respective expert appraisers, the former concluding a practice value range between $5.6 million and $6.75 million and the latter between $2.8 million and $3.2 million.
In the court’s view, it was no contest.
Mincing no words, the court criticized Dr. Namerow’s expert for “manipulat[ing] the Company Value calculation for the benefit of the Plaintiff” by employing a “limited and vague” definition of net worth that put it on a par with “equity” value inclusive of “intangible assets” such as goodwill. The court spoke with disdain for the expert’s “blind” assumption that the $2.4 million value in the Certificate of Agreed Value “must have” included intangible value over and above the approximate $600,000 to $1 million net tangible assets on the books at that time, from which the expert then developed a ratio using doctor compensation, practice revenues, and purported intangible assets as of 2000 “which he then converts to an inflated figure for the year 2016.” The expert’s assumption, the court pronounced, “is nothing more than a self-serving conjecture of the Parties’ intent in 2000 designed to inflate the 2016 Company value.” Ouch!
In contrast, the court had no trouble adopting the defendants’ expert’s analysis and conclusion of value which started with the $2.4 million value in the Certificate of Agreed Value which he then adjusted for change in net worth “based upon the terms contained in the Operating Agreement.” As the court wrote:
Defendants’ Expert executed his valuation of PediatriCare under a very different assumption than that of Plaintiff’s Expert as to exactly what “total assets” encompasses. Specifically, it is Defendants’ Expert’s position that “net worth” is “the total amount of all assets minus all liabilities, as stated in the balance sheet.” In sum, Defendants’ Expert performed a net worth valuation based solely on assets and liabilities as recorded on the financial statement of the Company.
The court also noted with approval the defendants’ expert’s adjustment to net worth in the financial statement for “collectible accounts receivable” as provided in Section 10.
In the end, the court concluded a value of $3,223,116 using the high end of the defendants’ expert’s net worth range resulting in an award of $805,779 for Dr. Namerow’s 25% interest — less than the amount offered to Dr. Namerow two years before based on the December 2016 appraisal.
Despite its harsh words for Dr. Namerow’s expert’s analysis, the court expressed sympathy for the disadvantaged position in which Dr. Namerow found himself due to the parties’ failure to update the Certificate of Agreed Value, commenting:
This Court is mindful that Plaintiff, as the first member of PediatriCare to retire, may feel as though his efforts as one of the founding members and an established physician for thirty-eight years are being shortchanged, and this Court to some extent does not disagree. However, based on the language of the operating agreement and the lack of any updates to the Certificate of Agreed Value, the Court is left with little discretion but to apply the appropriate formula as was agreed upon in 2001.
Closing Thoughts: In the Namerow case, unlike some others I’ve written about, the pain of the un-updated Certificate of Agreed Value was mitigated to some extent by Section 10’s required adjustment for changes in net worth including accounts receivable. Still, Namerow underscores anew the crapshoot and potential unfairness inherent in fixed price buy-sell agreements where it cannot reasonably be expected that the owners will update the agreed value. Chris Mercer, one of the country’s top business appraisers and no fan of fixed price buy-sell agreements, has written extensively and persuasively on the subject. Finally, a hat tip to BVWire, the business valuation ezine to which everyone reading this should subscribe (it’s free!), for alerting me to the Namerow decision.