Owners with the forethought to create and sign buy-sell agreements help facilitate voluntary and involuntary transfers between owners. But when it's time for a buyout, many owners discover that their agreements don't cover all the necessary details. Here are four key terms to consider when drafting or reviewing a buy-sell agreement.
One of the leading causes of disputes in owner buyouts is failure to provide valuation guidelines and define key terms, let alone provide for funding of the agreement!
For example, buy-sell agreements often state that the buyout price is the value of an interest in the business. But "value" can mean different things in different contexts, so the agreement needs to spell out whether the price should be based on fair market value, fair value, investment value or some other definition of value.
Just as important, every valuation is effective "as of” a certain point in time, and the valuation date can have a big impact on the result.
The agreement should specify whether the date used is the date of the triggering event, the last day of the company' s most recent fiscal year or some other date. Using a specific date rather than the date of the triggering event discourages owners from timing their departures to maximize a buyout price.
Even if a buy-sell agreement specifies a definition of value, the level of value - which can range from being a controlling interest to an illiquid, minority interest - can have an enormous impact on the outcome.
Parties to buy-sell agreements often assume that value is based on their pro-rata share of the value of the business as a whole. Depending upon the agreement this may or may not be true!
Without further clear instructions, a valuation specialist might adjust this value to reflect control premiums, minority interests or marketability discounts.
To avoid unintended consequences, the agreement should clearly specify which discounts or premiums, if any, apply. The parties might feel, for example, that a fair price is the fair market value of an owner's interest, without regard to discounts or premiums.
Beware: Sometimes discounts and premiums are imbedded in a valuation expert's methodology. So consider addressing in the buy-sell agreement which types of adjustments can be made when projecting the company's income stream.
Other issues to consider include time limits for completing the various valuation steps, appraiser qualifications and alternative dispute resolution (such as arbitration or mediation). The preferred method of resolving valuation problems inherent in buy-sell agreements is an agreement requiring owners to abide by independent findings if the agreement's terms trigger a valuation.
Independent professional valuation services increasingly are favored in buy-sell agreements because owners must agree on a valuation firm’s qualifications and independence. The resulting valuation under the agreement will be objective and independent of any individual owner's interests, making it fair to all owners.
A final consideration, especially if using a single appraiser, is when the appraiser will be selected. Many buy-sell agreements provide that the parties will select an appraiser after a triggering event occurs. But there are two significant drawbacks to this approach.
First, it may be difficult for the parties - who now have conflicting interests - to agree on someone. Second, even if both parties are comfortable with the appraiser, the outcome will be uncertain.
A more effective strategy is to select an appraiser at the time the agreement is signed. Ideally, the appraiser will perform a valuation at that time to set the initial buyout price and then revalue the business annually (or every two or three years).
As we indicated earlier, updates to the initial valuation report may be appropriate. This allows the parties to become comfortable with the appraiser's methods and conclusions and to get a handle on what the buyout price will be.
If a triggering event occurs, the buyout price could be based upon the most recent appraisal. But many agreements provide for a new appraisal if the most recent one is out of date (more than a year old, for example). In addition, a buy-sell agreement must be kept current to have any validity, so it's critical to review the agreement regularly and amend it, including any valuation provisions, as necessary.
Owners tend to put planning issues on the back burner, especially when they are young and healthy and owner relations are strong. But the more details that are put in place today, the easier it will be for owners to resolve issues when it's time for a buyout.
Importantly, once a buy-sell agreement is in place, it's important to periodically review the agreement, as conditions and business values tend to change over time.
What a Business Valuation should contain to become an action provoking instrument of value creation will be addressed in a future article.
It is important to understand a buy/sell agreement is not a static document that determines the conditions under which a transfer occurs or determines a valuation mechanism and is then placed on the shelf never to be looked at again. It represents a critical agreement, if the goal is to ensure a smooth transition should one of the scenarios occur during the life of the enterprise.