All closely held businesses should have buy-sell agreements. If designed properly, these agreements help ensure a smooth ownership transition if an owner dies or leaves the business. They can also provide an owner’s surviving family members with the liquidity they need to pay estate taxes and other expenses.
Perhaps the most critical aspect of a buy-sell agreement is its valuation provision. This establishes the price (and thus the methodology for determining the same) for which the company or remaining owners are permitted, or required, to buy back a departing owner’s interest. Any ambiguity in the agreement’s pricing terms — or misunderstandings about what they mean — can lead to unpleasant surprises when the buy-sell agreement is triggered.
3 approaches to setting a price
In general, there are three ways to set the price: 1) an independent appraisal, 2) a formula, such as book value or a multiple of earnings, and 3) negotiation by the parties. All buy-sell agreements use one or a combination of these approaches, and each approach has its pros and cons.
Independent appraisals generally produce the best results. They account for the special characteristics that distinguish a particular business from others in its industry. They also ensure that the price reflects an interest’s value at the time it’s transferred. An appraisal is the best way to ensure that all parties are treated fairly. The downside of this approach is that it’s the most expensive.
Valuation formulas are inexpensive and easy to use, but they fail to reflect changes in a company’s value over time. Book value, for example, might be a good indicator of value when a company is founded, but often it becomes less accurate over time because it fails to account for earnings, goodwill or the current fair market value of the company’s assets. (See the sidebar “Book value undervalues interest by millions.”)
Formulas based on multiples of earnings or cash flow also may be unreliable. For one thing, multiples are derived from industry averages, which may not accurately reflect the characteristics of the business being valued. Also, the values produced by these formulas tend to fluctuate, often underestimating value in good times and overestimating it in bad times. In essence, valuation multiple formulas can result in an undesirable outcome for one or more parties to the agreement.
Negotiated pricing can be effective, so long as the parties are able to agree. If they can’t, litigation may be the only option. One potential solution is to call for a negotiated price, but provide for an independent appraisal in the event the parties can’t agree.
To avoid litigation over a buy-sell agreement, it’s critical to choose terminology carefully and define key terms if necessary to eliminate ambiguity. For example, business owners often provide that the buyout price for an interest is its “value,” without specifying whether the term refers to fair market value, fair value, investment value, book value or some other standard.
It’s also important to specify the level of value, such as controlling interest or minority interest. Often, parties to buy-sell agreements assume that in the event of a buyout they’ll receive their pro-rata share of the business’s value as a whole. But if the agreement sets the price based on “fair market value,” the price may be discounted to reflect lack of control or marketability. If the parties intend for the buyout price to be fair market value without regard to discounts or premiums, the agreement should say so explicitly.
One issue that’s often overlooked is the valuation date. The value of a business can change dramatically over a short time, so the selection of a valuation date can have a big impact on the buyout price. Generally, it’s best to use a specific date, such as the last day of the company’s most recent fiscal year. If the date of the triggering event is used, owners may be able to time their departures in a manner that maximizes the price they’ll receive.
Get professional help
It’s always a good idea to consult a valuation professional when planning a buy-sell agreement. An expert can help you draft the valuation provision to help ensure that all parties are treated fairly, and also to make certain there are no surprises. Further, it’s imperative that the parties to the agreement periodically review it, since circumstances and issues may change over time.
Sidebar: Book value undervalues interest by millions
One case — the Estate of Cohen v. Booth Computers — illustrates the dangers of relying on book value to set a buyout price in a buy-sell agreement. The 2011 case involved a family partnership agreement. In the event of a partner’s death, it called for a buyout price of net book value plus $50,000.
After one partner died, the sole surviving partner implemented the buyout clause, which set the price at $178,000. The partner’s estate sued, alleging, among other things, that the buyout provision was “unconscionable” because the fair market value of the interest at the time was more than $11 million.
The court held that the buyout provision was enforceable, noting the term “book value” was unambiguous.
For more information, please contact Kent Pummel at [email protected].