Buy-sell agreements protect business owners from unexpected events, such as a shareholder’s death, disability or divorce. They’re also useful when owners disagree and want to sell their interests — or buy out a difficult partner. Too often valuation issues take the backseat to legal issues, leading to irreconcilable differences when the agreement comes into play.
Whether owners are deciding on a current buyout price, purchasing insurance coverage for key shareholders or planning future buyout terms, an accurate valuation is imperative. Here are a few valuation issues to flesh out completely while shareholder relations remain amicable and no one is under duress to buy or sell.
Definition of value
“Value” means different things to different people. So, it’s important to fully define value in the context of the buy-sell agreement. Usually, shareholders want to measure the “fair market value” of their interests — that is, the price that the universe of hypothetical buyers and sellers would agree to pay for a business interest.
But that’s not always the appropriate standard of value. For example, noncontrolling owners may feel entitled to their pro rata share of the entire company’s value on a controlling basis in a buyout.
The definition of value may even vary depending on what event triggers the buy-sell agreement or the size of the ownership interest. A well-thought-out agreement will identify these nuances. For example, under the agreement’s terms, a shareholder who loses his or her professional license due to unethical behavior may be entitled to less than one who’s retiring. Or the owner of a controlling interest may receive a smaller discount for lack of marketability than a minority shareholder.
The parties also may disagree about the appropriate valuation date. Valuations are valid as of a specific point in time, and conclusions can vary significantly in a volatile economy or if major business decisions made by a controlling owner alter the value of the business.
Valuators use three methods to value a closely held business. The asset-based (or cost) approach estimates the value of equity by subtracting liabilities from the combined fair market value of assets. The market approach compares the subject company to similar businesses sold on the public markets and in private deals. The income approach determines value from expected future economic benefits.
Buy-sell agreements that require the company to obtain regular appraisals help the owners to understand which methods are the most appropriate for their business. That way, no one is surprised when it’s time for a buyout — and fewer disagreements are likely to ensue. Regular appraisals also give owners a general idea of what their interest is worth, which may narrow the gap between the buyer’s and seller’s expectations.
Some detailed buy-sell agreements address which adjustments to the company’s cash flow and its preliminary value are appropriate. For instance, an agreement may specify that owners compensation will be adjusted to match a predetermined industry benchmark. Or it may prescribe a discount for lack of marketability of, say, 15% or 30%.
Generally, the company and the exiting shareholder each hire separate experts to value the business. Or sometimes the buy-sell agreement names a specific joint appraiser who the owners agree is competent and unbiased. This strategy can help minimize costs and disputes later on.
Other important considerations include who will pay appraisal fees, how long the appraisal process will take and which documents the controlling shareholder will provide to the appraisers. The buy-sell agreement may even include a provision that allows valuators to perform site visits and interview management to help with discovery, if the parties wind up in court.
A valuation generates a cash-equivalent price in today’s dollars. But sometimes owners prefer installment payments for tax or cash flow purposes. A buy-sell agreement should address whether shareholders will receive a lump-sum or a series of installment payments over a prescribed time period. In installment sales, the parties also may stipulate an interest rate to apply over the buyout term.
When drafting the buy-sell agreement, many owners wonder how they’ll finance future buyouts. Often insurance is a smart answer, but some businesses maintain reserves to finance buyouts from operating cash flow. Borrowing funds when the agreement is executed can slow down the buyout process — which can cause stress for family members when a business owner dies without an adequate amount of liquid assets.
A buy-sell agreement is a living document that should change as the business evolves — if not, the agreement may become obsolete over time. Owners also may inadvertently invalidate their own agreement by failing to update it or adhere to its terms.
For example, a buy-sell agreement needs to be updated if shares are sold to a new owner or an existing owner leaves the company, either voluntarily or involuntarily. If buyouts are funded by life insurance, policies need to be periodically reviewed to determine whether more (or less) coverage is needed.
As owners write and revisit their buy-sell agreements, the value of the business needs to take center stage. Often management chooses to have regular valuations to ensure that everyone knows what their interests are worth — and to avoid surprises in stressful times.
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.