Canada: Valuation Issues in a Buy-Sell Shotgun

Copyright 2010, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Real Estate Joint Ventures, October 2010

Dissimilar Interests

One issue arising in the negotiation of a real estate joint venture buy-sell gunshot is that of "dissimilar interests", for instance, if there were favourable or unfavourable financing attaching to the interest of one joint venture participant but not to that of the other, if the interest of one joint venture participant attracted a preferential rate of return, or if such interest carried with it the benefit of equity purchase options at a price less than fair market value. The buy-sell shotgun works well in the valuation of the respective interests of joint venture participants when those interests are similar in nature. Determining such valuation becomes more complex when the interests of the joint venture participants are different. Some mechanism is required in the joint venture agreement to value the various beneficial aspects attaching to the interest of one joint venture participant but not the other. Often, this is done through the appraisal mechanism.

Beneficial Financing

In certain joint venture arrangements, one joint venture participant provides the other with financing at beneficial rates. Such favourable financing enhances the value of the interest of the borrowing joint venture participant. If the interest of the borrowing joint venture participant is sold in a buy-sell shotgun, such joint venture participant would not be compensated for the value of its beneficial financing. On the other hand, if the financing was due on sale, the beneficial financing would be lost and no value should be attributed.

Preferential Returns

If one joint venture participant has charged its interest in favour of the other joint venture participant as security for payment of a preferential return for a specified period of time, the valuation of the preferential return may be very difficult to determine. One manner of dealing with this situation is simply to prohibit the use of the buy-sell shotgun during the preferential return period. However, this is not a terribly satisfying approach.

Assuming that the preferential return of 10% per annum on the purchase price for a five-year term was offered by one joint venture participant to an investor joint venture participant as an inducement to obtain an enhanced sale price on the sale of a 50% interest to the investor joint venture participant and that the project currently generated an 8% return, the interest of the investor joint venture participant would have an increased value due to the higher rate of return while, at the same time, the interest of the borrowing joint venture participant would have the benefit of the remaining 6% return, a depreciated value resulting from the depressed return for the five-year preference term. The problem is that no one can be certain what the return will be over time. One approach is to adopt a "wait and see" approach where, as a post-closing matter, the top-up continues to be there.

This does not operate as effectively if the shotgun is reversed. The selling joint venture participant will be reluctant to have the investor joint venture participant manage the project – and thereby directly affect the return – while still having to bankroll the preferential return when it is no longer in control of the project and determining the manner in which the project is to be operated.

Options

Options are another problem in the context of the buysell shotgun. In certain joint venture arrangements, one or more of the joint venture participants grant to the other an option, exercisable by written notice during a specified period of time to purchase an additional equity interest in the project for a stipulated price. The question then arises as to the manner in which the option is to be valued if the buy-sell shotgun is invoked prior to the exercise of the option. The optionee/ selling joint venture participant should be entitled to receive a payment from the optionor/purchaser joint venture participant after the date on which the option is exercised equal to the amount by which the fair market value of the interest to which the option applies exceeds the option price as of such date.

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