Every business with multiple owners should have a buy-sell agreement.
Ideally, this document should be in place at a company’s inception, but it must at least be accounted for as soon as a business begins to gain value. It is easy for this crucially important document to slip down the priority list for business owners not particularly mindful of exit strategies. However, businesses all too often to their detriment operate with an outdated version of this agreement, or without one altogether.
This issue emphasizes the importance of companies having a business and/or a tax attorney with experience in buy-sell agreements to guide the owners in this effort. The cost of a buy-sell agreement is small compared to its benefits. The individual owner’s financial risk increases over time as the business gains value and as the owner’s compensation increases. Without a plan for future transition, the owners’ financial risk of loss is substantially greater than those with a carefully crafted agreement.
Closely held business owners should have a buy-sell agreement to ensure that the business remains in the hands of the current owners and that a market exists for a departing shareholder in the event of a triggering event. The big three triggering events are death, disability and retirement. Others include bankruptcy, divorce, deadlock, philosophical differences and owner disputes. A buy-sell agreement can help to avoid costly infighting by family members, co-owners and spouses. The agreement can also help keep the company in business to preserve goodwill, and avoid the substantial financial issues that can accompany major events, such as the death of an owner.
Buy-sell agreements are designed to provide a market for the shares of the departing shareholder, to protect the value of a significant asset, to meet estate planning objectives, to establish a price and terms for the shares and to establish a funding mechanism for a buyout. A critical component of any agreement is the process by which the price is determined. The manner in which this is accomplished is usually by establishing a fixed price, creating a formula valuation process, or having a professional appraiser value the shares at the triggering event.
Fixed Price Agreements
These agreements usually involve the shareholders agreeing upon a price per share and then periodically updating the price. On the surface, this method is not a bad idea, if the owners can agree on a price and rigorously employ a valid and reasonable valuation method. As valuators, we most often find that the price has not been updated, the original method was incorrect or the conditions of the business have shifted. In general, fixed price agreements result in a price which is too low or too high and in cases, where the process has not been followed for some years, the value may be grossly incorrect.
Formula Valuation Agreements
Formula valuation agreements are established by the owners to determine price. Typically, the formula will be some multiple of earnings, such as five times the average of the last three years. Often, the agreement specifies that the price will be determined by the company’s accounting firm. As valuators, we find that this method results in an unrealistic price, either too low or too high. Like a clock, the formula will only be correct twice each day. Changes within the economy, the industry and the market drive changes in multiples, which is why formulas often don’t work. Healthcare is hot today and coal mining is not. Five years ago, the opposite was true. We have seen “book value” as the formula or specified price. This may be very appropriate in an asset holding company, where the assets are periodically marked to market, but in an operating company, book value is almost always off the mark. As a further note, formulas do not consider the future of the business, good or bad.
Professional Appraisal Agreements
Upon the triggering event, a qualified appraisal firm is selected to value the business. The selection process can vary substantially from one company to another, but the owners should select an appraiser with appraisal credentials such as Accredited Senior Appraiser (ASA), Accredited in Business Valuation (ABV) or Certified Valuation Analyst (CVA). It is of the utmost importance that the standard of value be specified in an appraisal agreement. Typically, this will be the Fair Market Value standard, which is well understood by appraisers and the courts. Owners should then determine if the appraised value will be with or without discounts for minority (lack of control) and marketability (liquidity). The presence of rights of first refusal clauses, mandatory puts and calls can greatly influence the share price. Owners sometimes specify more than one appraiser/appraisal company and a reconciliation is then made. Other times, even a third appraiser may be specified to serve as a tie breaker.
Attorneys should note when drafting such agreements that the owners will not know what the value will be until the triggering event. A remedy would be to have the company professionally appraised regularly (every two or three years) and have all of the shareholders “buy-in” to the valuation methodology.
The valuation of closely- held companies is just as much an art as a science. Consider the company which just landed a large multi-year contract. No historical formula or fixed price agreement will capture that value for the departing shareholder. Without a buy-sell agreement and an appraisal process, the departing owner would likely be disadvantaged and possibly to the point of costly litigation. Attorneys should periodically review the terms of buy-out agreements with owners to determine if the original agreement continues to meet the changing needs of the business. Furthermore, a review of the buy-sell agreement can lead to other important discussions about the need for modifications, business succession planning, and other corporate matters.
For more information, please contact S. G. Brooke Tucker, ASA.