Buy/Sell Agreement - A Critical Contract for Business Owners
If there is more than one owner in your organization, knowing about and having a buy/sell agreement is of paramount importance. Putting the details down on what should happen to the company should a partner leave, retire or pass away will avoid the headaches, costs and emotional stress that can surely ensue if not tackled from the beginning. It is one of the most important documents a partnered company should possess.
Even the strongest business relationships among partners can be tested by retirement, transition or some other form of transaction. A buy/sell agreement sets the parameters for any potential transaction which may take place. It also provides valuable guidance for those inevitable real life situations. It is absolutely necessary in order to avoid potential litigation upon the departure of an owner, as is often the case the leaving owner believes that his shares are worth more than the remaining owners believe they are worth.
A critical factor in a buy/sell agreement is the establishment of the standard of value to be used. One standard, Fair Market Value, is defined by the American Society of Appraisers as "the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and, the latter is not under any compulsion to sell, both parties having a reasonable knowledge of the relevant facts." What this means is that if you have minority shares, the fair market value may be impacted due to a lack of control and lack of marketability. Therefore, instead of your pro rata share of the total value of the organization, you would receive an amount that is substantially less.
A situation happened to one of my clients who had a buy/sell agreement which said fair market value was to be used. A minority owner left and was very surprised and upset to find that he was only to receive about half of what he thought he was going to receive because he was not aware of the minority and marketability discounts which are applicable in a fair market value valuation. Had he been aware of the definition, and potential impact, another valuation method may have been chosen.
Additional standards of value include:
- Fair Value - this would often be a straight proration of the total value of the entity. If
you wish to use a straight proration, this should be spelled out in detail as the definition
of Fair Value can vary from state to state.
- Investment Value - this is the value to a specific buyer, usually in the same industry,
who is willing to pay more for your company than its Fair Market Value because of synergies involved.
In addition to standards of value there are various valuation methods. One valuation approach I have seen in Buy/Sell Agreements is the book value or net asset value method. Instead of considering the intangible value, businesses owners often just refer to stated book value. This is normally a conservative value, since a profitable business will have an intangible value attributable to goodwill. Book value does not consider this intangible value. In addition to standard of value, another factor to consider is the possible "Triggering Events." Besides the death of an owner there may be other triggers. What happens if the owner becomes disabled, quits, is fired or retires? Many companies have key man insurance. Upon the death of an owner, the life insurance proceeds will go to the company. These proceeds are then used in the purchase of the deceased owner's interest. If the proceeds, which go to the corporation, are in excess of the required payout for the deceased owners shares, is this excess life insurance considered an additional asset of the business, or is it specifically excluded from the valuation? The buy/sell agreement should specify how the valuation will handle this factor.
There are many other factors that should be addressed in the buy/sell agreement. Who will perform the appraisal? We recommend that an appraiser have the necessary qualifications such as an ASA, ABV or CVA certifications. Will the valuation be done by a formula? If so, who will be deciding on the formula? Does it make sense? Or will you hire an appraiser to do the valuation? Will the valuation date be the date of the triggering event? Or will it be the closest year end to the triggering event? Will the valuation be based on prior tax returns? They may have been prepared on a cash basis. Consideration should be given to converting to accrual basis in order to determine an accurate value of the business. Will the buyer and the seller each have their own valuations? Will the final price be the average of these two valuations? If they are significantly different, will a third appraiser be hired who is agreed upon by both parties to decide the final value? How would the departing owner be paid out? Will there be a note? What will be the length of the note and what will be the interest rate? Will the interest accrue from the date of death, or other triggering event? Can the shares still vote until purchased or are they considered sold at the date of the triggering event? And if the entity is an "S" Corporation, there are even more valuation issues to consider. You should understand the options and decide how you wish them to be handled in the valuation.
As you can see, there are many factors to be considered when drafting a buy/sell agreement, and we have just touched on a few of them. If you do not have a buy/sell agreement, you should consider getting one. If you have one, it is good practice to have it reviewed from a business valuation perspective. Having a quality buy/sell agreement is a key to ensuring smoother transitions and transactions in the future. With one in place, everyone in your ownership group should sleep better at night.