A buy-sell agreement is a critical tool for owners of closely held companies. It ensures an orderly ownership and management transition when an owner dies, becomes disabled or otherwise leaves the company. And it creates a market for departing owners’ shares, providing them and their families with liquidity and ensuring that the business stays in the family or other tight-knit ownership group.
For a buy-sell agreement to be effective, however, you need to review it periodically and, if necessary, modify its language to reflect changing circumstances. Of particular importance is scrutinizing the valuation provision, which establishes the purchase price for a departing owner’s shares.
Depending on the mechanism for valuing interests in the business, a valuation provision drafted years ago may understate or overstate the company’s value. This can lead to undesirable outcomes or disputes. And the risk is especially acute now, given the significant impact the COVID-19 pandemic has had on the financial performance — and, therefore, value — of many businesses.
Valuation provisions in buy-sell agreements typically use one or more of the following approaches:
Negotiation. At the time an owner leaves the company, the parties negotiate the buyout price. This approach has some advantages: It’s cost-effective and allows the parties to consider recent events in determining a fair price for the shares of the business. The risk, of course, is that the parties fail to negotiate in good faith, can’t reach an agreement and end up in court. One way to mitigate this risk is to provide for a negotiated price but bring in an independent appraiser if the parties are unable to agree within a certain time frame.
Appraisal. Valuation by one or more independent professional appraisers, like one of Landmark’s Certified Business Valuation Analysts, at or near the time of the buyout is usually the most accurate approach ― however, it can be costly. Some buy-sell agreements call for periodic appraisals (for example, once every year or two) and use the resulting price for any shares transferred between then and the next valuation date. Others require the parties to conduct an appraisal on the occurrence of a “triggering event,” such as an owner’s death or disability.
Be sure your agreement provides unambiguous valuation guidelines for appraisers. For instance, it should spell out the:
- Valuation standard (such as fair market value, fair value or investment value),
- Premise of value (for example, controlling interest or noncontrolling interest), and
- Valuation date.
Some agreements provide that the valuation date is the date of the triggering event, but this type of provision is susceptible to manipulation by an owner who, for example, times his or her resignation to maximize the buyout price. A better approach is to set the valuation date as the last day of an accounting period (for instance, the end of the most recent fiscal year or quarter).
Formula. Using a valuation formula tied to book value, earnings or other benchmarks has the advantage of simplicity and predictability. However, it’s also quite risky. Book value, for example, may reflect a company’s fair market value at formation, but it tends to significantly undervalue established companies with consistent track records of earnings.
Formulas based on earnings multiples may or may not be reliable indicators of value, depending on a company’s particular circumstances at the time of the valuation. One potential solution is to revisit the formula annually and adjust it to produce a price the parties view as fair.
Review your agreement
Valuation provisions that rely on independent appraisals typically don’t need to be reviewed as frequently as formula provisions. If your agreement calls for a negotiated buyout price, consider using a different method or providing for an independent appraisal in the event negotiations fail to prevent litigation.
Whatever approach or combination of approaches you and your fellow business owners decided on, review your buy-sell agreement regularly. Everyone will benefit from avoiding unpleasant surprises and ensuring the agreement will work as intended to yield a fair price for ownership shares. Contact us if you have questions about your buy-sell agreement.