The toughest part of drafting any shareholders' agreement is figuring out how to value the company when a "triggering event" (somebody dies, divorces, withdraws from the business, etc.) occurs and a shareholder must be bought out.

There are six basic approaches:

Nominal Value. Some shareholders' agreements attempt to penalize withdrawing shareholders who leave the company by valuing their shares for a nominal amount such as $1. Nominal valuation clauses are customary in "bad shareholder" scenarios such as:

— a shareholder who quits the company and takes a job with a competitor in the same industry;

— a shareholder whose employment is terminated "for cause" (he did something bad that hurt the company); and

— a shareholder's shares are taken from him involuntarily by court order (for example, in a divorce proceeding), and the new shareholder is hostile to the company's founders.

Courts don't like nominal valuation clauses, and rightly so. Even though a shareholder did something bad, the other shareholders shouldn't get an unearned "windfall" because of it. If you want a "nominal valuation" clause in your shareholders' agreement, make sure a lawyer drafts it carefully so there are no "loopholes" a judge can wiggle through to get around it.

Book Value. In a "book value" or "liquidation value" clause, you put a price on each tangible and intangible asset the company owns — usually it's whatever the company paid for each asset, less depreciation — and add them up. This is a helpful way to value a company that's going out of business, but it's a terrible way to value a "going concern" because it doesn't take into account the "goodwill" the business has built up over the years.

Earnings Formula. This is the most common way of valuing "going concern" businesses. Basically, you look at the company's profits (before taking into account taxes and compensation paid to the business' owners) for the past two to three years, add them up and then divide by the number of years to reach the current value. Sometimes, this "arithmetic average" of the company's profits is multiplied by a number from two to five, based on the average actual selling prices of other similar businesses in the same geographic area.

The only problem with an "earnings formula" valuation is that it assumes that a company's earnings are fairly steady. If a company has had several terrific years but a lousy one this year, an "earnings formula" valuation may result in an inflated valuation of the company going forward.

Likewise, if a company has had several lousy years in a row but a great one this year, an "earnings formula" valuation may result in an artificially low valuation of the company's future prospects.

Outside Appraisal. If there is a single individual outside the company that all owners trust — such as an accountant or lawyer — you may provide that he or she will determine the valuation of the company. I would advise that you get the individual's consent first, as some lawyers and accountants are nervous about playing this role (rightly so, in my opinion, as no matter how you value the company, you end up alienating one side or the other). Also, consider what will happen if that individual dies or retires.

"Three Stooges" Appraisal. In a "Three Stooges" valuation, the withdrawing shareholder picks one appraiser, and the remaining shareholders pick a second appraiser. The two appraisers meet, go over the company's books, and if they can't reach agreement on a value within a specified period of time (usually 30 days), the two appraisers appoint a third appraiser who plays "Judge Judy" and determines the value.

While this looks extremely fair on paper, in practice it can be . . . well, kinda like a Three Stooges movie. Either the appraisers can't get together on time, or they refuse to talk to each other, or they can't decide on a third appraiser . . . the process sometimes drags on for weeks and months while the business owners keep pressuring their experts to get the job done. If you do decide on a "Three Stooges appraisal," put in language that if the two appraisers' valuations are less than 10 percent apart (or better yet, 20 percent or 30 percent), the arithmetic average of the two appraisals will be the company's value.

Certificate of Agreed Value. When all else fails, there's the "certificate of agreed value" — the owners pick a number out of thin air and sign a certificate stating "this is what we think the company's value is." Great, except that as a company grows, people forget about this certificate. So when a "triggering event" occurs under the shareholders' agreement, the withdrawing shareholder is stuck with an outdated value that hasn't been brought current.

If you do one of these, be sure to include a provision that it "self-destructs" at the end of one year. And make sure another valuation clause in the agreement "kicks in" at that point.

Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and former host of the PBS television series 'Money Hunt'. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

COPYRIGHT 2008 CLIFFORD R. ENNICO.

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