A buy-sell agreement can be key in helping avoid disputes over ownership rights, control, and the value of a company when an owner leaves the business. The agreement gives the company or remaining owners the right, or obligation, to buy a departing owner’s interest after a “triggering event” occurs, such as death, disability, divorce, termination of employment, or some other event. Whether the buy-sell is triggered voluntarily or involuntarily, it’s critical for owners to protect their financial interests with an agreement that’s legally enforceable and comprehensive.
Comprehensive buy-sell agreements explicitly define the appropriate standard and basis of value to apply to owners’ interests. For example, an agreement might prescribe “fair market value” as defined in Revenue Ruling 59-60. For minority interests, fair market value implies a minority, nonmarketable basis of value. Conversely, an agreement might use the term “fair value” and define it to refer to each owner’s pro rata share of the entire company’s controlling, marketable value.
Other important valuation parameters include the appropriate “as of” date and payout mechanisms. Funds might be generated from life insurance proceeds, bank loans or seller financing. If exiting owners (or their estates) will be paid over time, it’s important to specify duration, interest rates and variable-rate market indices.
Some buy-sell agreements prescribe valuation formulas to avoid the time and expense of hiring valuators. Unfortunately, these formulas may be oversimplified or outdated.
Consider an agreement that stipulates the company is worth four times annual earnings. What does the term “earnings” really mean? One valuator might assume it refers to accounting net income and another might use pretax earnings, adjusted for depreciation and amortization, interest expense, nonrecurring items, and quasi-business expenses. Different interpretations can lead to substantial variance in opinions.
Imagine that the hypothetical company has been reserving cash to purchase land adjacent to its plant for future expansion. The prescribed rule of thumb doesn’t account for excess working capital and, therefore, is likely to undervalue the business. Conversely, if the company has significant contingent liabilities — for example, environmental cleanup or pending lawsuits — the formula might overvalue the business.
Suppose an owner dies on February 10, 2017. Would the valuator rely on 2015 audited financial statements, unaudited internal records for the trailing 12 months, or the 2016 audited financial statements (which might not be available until April 2017)?
Thorough buy-sell agreements specify how to determine financial statement dates and the requisite level of assurance (compilation, review or audit). If controlling owners engage in financial misstatement or deny minority shareholders’ access to facilities or financial information, agreements also might call for forensic accountants.
Remaining shareholders seldom are in a hurry to buy back shares, but exiting shareholders — or their surviving family members — have a financial incentive to cash out quickly.
Valuation often takes longer than owners anticipate, especially if the buy-sell agreement calls for multiple experts or valuation disputes arise. Predetermined timelines can establish reasonable expectations and help ensure buyouts are completed in a timely — but not rushed — manner.
It’s essential to ensure the valuation under your agreement is well reasoned and supportable and to update the agreement periodically as circumstances change. With foresight and the help of an experienced valuator, you’ll come out ahead.