Buy-sell agreements: How to cover all the (valuation) bases

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Buy-sell agreements: How to cover all the (valuation) bases

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’s still valid and addresses all of the business valuation issues that may arise.

Which structure is right for the 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 need to be covered?

Emotions tend to run high when owners face a “triggering event,” such as the death of an owner, a divorce of married shareholders or a shareholder 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’s role is played by either the other owners or the business itself — and it’s in the buyer’s financial interest to pay as little as possible. A comprehensive buy-sell agreement takes away the guesswork and helps ensure that all parties are treated equitably.

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.

At a minimum, the buy-sell agreement needs to prescribe 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 business interest. The loss of a key person could affect the value of a business interest, so timing may be critical.

Act now

Business owners tend to put planning issues on the back burner, especially when they’re young and healthy and shareholder 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. And, once the buy-sell agreement is in place, it’s important to periodically review the agreement, as business values tend to change over time.