Buy-Sell Agreement – Will the Valuation Provision Work?

Businesses with multiple owners typically operate under the terms of a buy-sell agreement. If there are multiple owners of a business, they should have a buy-sell agreement. It’s prudent business practice for the following reasons:

• Can protect what might be the most significant asset – one’s business ownership interest
• Creates a market for a closely held interest
• Provides a framework for dealing with owner disputes and when unanticipated events happen
• Can force shareholders to deal with funding and liquidity issues
• Allows shareholders to control who they are in business with
• Can facilitate estate planning objectives

The Struggles of a Buy-Sell Agreement

There is a catch with buy-sell agreements… in our experience, most don’t work or won’t work as intended. The reasons why typically include one or more of the following:

• The agreement has become dated. Some agreements contain a “stated value” for the business which the owners have agreed upon. This value is not updated as time passes and may not have been reasonable in the first place.
• The agreement may have a section addressing the Valuation of an ownership interest, but the language is not clear; this leaves room for interpretation or has a valuation provision that is inappropriate or unreasonable.
• Critical elements of the agreement have been overlooked or left out, such as a sufficiently detailed valuation provision, a listing of all applicable “trigger events,” or funding provisions for the purchase of the ownership interest.

A buy-sell agreement is usually drawn up and ratified when a business begins. It’s filed away and often forgotten. Over time the business, its ownership, its purpose, and operations can change. The buy-sell agreement is rarely amended to include changes addressing these issues.

Setting Up an Agreement for Success

The valuation wording in the agreement is important and will be the roadmap behind the determination of the value of the business. An agreement with proper consideration of business valuation should answer the following questions:

• Does the valuation provision indicate the standard of value (fair market value, investment value, or other value) and level of value (controlling, marketable minority, non-marketable minority) that should be used?
• Has a standard effective date for the valuation been established (based upon the most recent month, quarter, or year-end financial information)?
• Have the qualifications of Appraisers and Appraisal Standards to be followed been defined?
• Does the agreement contain a formula or other provision (such as ownership agreed-upon value) to determine the value of the company? If it does, has it been reviewed to determine if it is appropriate?

If the agreement does not address these critical elements, it leaves the valuation “up to the interpretation” of the preparer and risks a valuation which arrives at an unanticipated value.

Consideration of Triggering Events

Once the above critical elements of a buy-sell agreement have been sorted, the matter of triggering events should then be evaluated. One should consider the following, as the absence of these elements can render an agreement unworkable:

• Does the agreement contain all of the triggering events that it should?
  • Death is listed in most buy-sell agreements, but what happens if a shareholder quits, is fired, retires, divorces, becomes disabled, or files for bankruptcy?
• Does the agreement include a provision for how a purchase is to be funded?
  • If the buy-out provision is to be funded by life-insurance proceeds, has the agreement considered the Connelly v. United States ruling (see a previous article discussing this ruling)?

When a triggering event occurs, one side naturally wants to receive the most money for its ownership interest and the other side wants to pay the least. Ideally, the price paid for an ownership interest will be fair to both parties. Unless the issues identified are properly addressed, there is a significant risk that the price will not be fair to one of the parties involved. A business owner can’t know which side of a transaction they will be on. Is it a desirable thought that one’s family could receive less for their ownership interest than it otherwise would just because the buy-sell agreement was not properly vetted? Alternatively, would anyone like to be the remaining shareholder in a business that is strapped with an obligation to buy out a former shareholder at a price that is too high?

There is good news. The issues can be fixed with competent legal counsel and a valuation professional that understands the issues. Our Business Valuation team has extensive experience with buy-sell agreements and designing tailored valuation provisions that work. Should you have questions regarding your buy-sell agreement contact Partner T. Eric Blocher CPA, ASA, CVA.

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