Business owners may be lulled into thinking their companies are purring along the road to success. But those same businesses may run into roadblocks when unexpected events, such as death, disability or divorce, send them into uncharted territory. A well-reasoned buy-sell agreement can help businesses maintain control and ensure orderly ownership transfers.
Spell it out
Many buy-sell agreements are based on a formula or rule of thumb such as book value or some multiple of earnings or cash flows. Some base the price on the shareholders’ judgment of value. But these methods can lead to under- or overvaluation, or to conflicts among the shareholders. This is especially the case because business values may change over time.
The best approach is to provide for valuations by one or more independent appraisers, either periodically or at the time of a triggering event. Buy-sell agreements may call for a single or several appraisers. Some agreements, for example, provide for the buying and selling parties each to select an appraiser. If their valuations are within a specified percentage of each other, the average of the two sets the price. But if their valuations are too far apart, a third appraiser (often selected by the first two appraisers) chooses the “winning” valuation.
Alternatively, the third appraiser might perform a separate valuation, which then is averaged with the others. The possible arrangements are practically limitless as long as the agreement clearly spells them out.
Time it well
Another significant consideration 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 revaluate the business annually — or every two or three years. This allows the parties to become comfortable with the appraiser’s methods and conclusions, keep the valuation up to date and understand what the buyout price will be.
Define your terms
One of the leading causes of disputes in buy-sell agreements is their failure to provide valuation guidelines and define key terms such as:
Standard of value. A buy-sell agreement might 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 another standard.
Valuation date. All appraisals value a business or business interest as of a certain date, which 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.
Other issues to consider include time limits for completing various valuation steps, appraiser qualifications and alternative dispute resolution. The preferred method of resolving valuation problems inherent in buy-sell agreements is an agreement requiring shareholders to abide by independent findings if the agreement’s terms trigger a valuation. Some agreements also contain a binding arbitration clause.
In addition to maintaining corporate harmony, independent valuation can help shareholders avoid legal battles. Objectively derived company stock values stand up well under IRS and court examination.
Stay on the right road
Independent professional valuation services increasingly are favored in buy-sell agreements because shareholders must agree on a valuation firm’s qualifications and independence. The resulting valuation under the agreement will be objective and independent of any individual shareholder’s interests, and therefore fair to all shareholders.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.