Buy-Sell Agreements Part I: Covering the (Valuation) Bases

Today’s article addresses not only the need for a planning document that addresses buy-outs, business divorce and estate planning but also some of the valuation issues that need to be considered.  The article is presented in two parts.

Part I: Covering the (Valuation) Bases

As the baseball season winds down, what better way to present a topic that all business owners need to consider: protecting one of their most important assets that is critical to meeting future financial goals for both the business and the family.

This article will address the need for a buy/sell agreement, what to consider in the creation of the document and why valuation related issues are extremely important in crafting an agreement that is both fair and equitable.

The Buy-Sell Agreement Imperative

Every business with more than one owner needs a buy-sell agreement to handle voluntary and involuntary ownership transfers. Additionally, it's important to update the agreement regularly to ensure it still meets the needs of the owners and addresses all the business valuation issues that may arise. In a separate article we will discuss strategies for single owner businesses so that they too can protect their financial future.

Which buy-out structure is right for my/our business?

Cross-purchase Agreements give the company's remaining owners the right to buy a departing owner's interest either in one lump sum or in installments, depending on how the agreement is written. The purchase may be funded by insurance, if triggered by an owner' s death or disability.

Alternatively, Redemption Agreements allow the company to purchase the departing owner’s interest. The value is effectively transferred to the remaining owners by reducing the number of outstanding shares. Redemption agreements also may be funded by insurance policies (in which the company is named as the beneficiary).

What valuation issues should be covered in the Agreement?

Emotions tend to run high when owners face a "triggering event," such as the death of an owner, a divorce of married owners or an owner dispute. The departing owner (or his or her estate) suddenly is in the position of a seller who wants to maximize buyout proceeds.

The buyer on the other hand, who is either the other owner(s) or the business itself, is looking to pay as little as possible. A buy/sell agreement takes away the guesswork to ensure that the buyer, the seller and the company are not injured in the process.

Valuation Issues

Some owners decide to have the business valued annually to minimize surprises when a buyout occurs. This is often preferable to using a static valuation formula in the buy-sell agreement, because the value of the interest is likely to change as the business grows and market conditions evolve.

It does not mean that a “full” valuation is performed every year, it means that a baseline valuation is conducted and updates are performed as needed, either annually or upon the occurrence of certain events, for example, new owners or a need to measure the results of business activities – new products, new markets, etc.

At a minimum, the buy-sell agreement needs to prescribe a valuation protocol to follow when the agreement is triggered, including:

  • How “value” will be defined,
  • Who will value the business?
  • Whether valuation discounts will apply,
  • Who will pay appraisal fees, and
  • What the timeline will be for the valuation process.

It's also important to discuss the appropriate “as of” date for valuing the company. The loss of a key person could affect the value of a business interest, so timing may be critical.

Part II of this article will cover specific issues relating to valuation that should be considered in the creation and updating of a Buy-Sell Agreements.

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