The Importance of a Relevant Buy-Sell Agreement
Manager, CMA, CPA, CVA
26 July 2022
In recent years, there has been a notable increase in the number of times I have been retained to consult on buy-outs of exiting shareholders. I have been on both sides of the equation, representing both the buying and the selling shareholders in these different cases. The most common problem I have encountered is either that there was no buy-sell agreement in place or the buy-sell agreement was so old and outdated it was no longer relevant and did not result in a fair and equitable transaction.
In some cases, parties were amicable and ready to negotiate, while in other cases parties proved to be more contentious which resulted in additional incurred expenses. In all cases, it dragged out longer than any party would have wanted it to. With proper planning and review of the company’s buy-sell agreement, time, money, and much aggravation could have been saved.
The death or disability of an owner, a shareholder dispute, and other life changes can lead to the need for a company or its shareholders to purchase an exiting owner’s share in the business. A proper buy-sell agreement should clearly stipulate the terms and process in which an exiting owner’s share is valued and purchased by the company or remaining shareholders.
Buy-sell agreements typically exist in one of the following forms:
The remaining shareholders agree to purchase the interest of the exiting shareholder.
Entity-purchase (stock redemption) agreement The company agrees to purchase the interest of the exiting shareholder. The shares go into the company’s treasury stock, which may be available for sale at a later date.
The exiting shareholder offers his ownership interest to the remaining shareholders first. If the shareholders decline the purchase, then the company will redeem the shares.
Once owners have agreed on what type of plan to put into place, arguably the most important question becomes – how should the ownership interest be valued? There are a few typical approaches to valuation in a buy-sell agreement:
Agreed-upon value (fixed price) agreement
An agreed-upon value agreement will stipulate the value of the company as of a certain date. While this may be very clear and simple, it is generally not practical as the valuation of a company is not static.
The book value of a company is the historical cost of assets less liabilities as reported in its financial statements. The book value method does not consider asset appreciation or the goodwill of the company and therefore is likely to result in a value that is less than fair market value. For this reason, it is generally advised to avoid using the book value when valuing a profitable operating company.
A formula agreement is typically based on an industry rule of thumb. For example, auto dealerships are often valued within the industry using the “Blue Sky Approach”, a hybrid of the net asset and income approaches, which adds the estimated dealership goodwill (based on earnings) to the net asset value.
Rules of thumb will indicate generally accepted industry multiples of revenue and/or earnings to apply to the subject company. If using an industry rule of thumb, its often best to select an earnings multiple rather than a revenue multiple. Revenue multiples tend to be less reliable since they don’t consider cost management, profitability, and cash flow available to shareholders. Two companies can have identical revenues, with very different bottom lines.
When applying a rule of thumb, it’s important that the selected formula is well understood. It’s not uncommon to have to adjust the value for working capital, interest-bearing debt, etc. When applying an earnings multiple, owners should consider whether there is a need to adjust the company’s financials for discretionary expenses, or adjust expenses such as officers’ compensation and related party rent to fair market value. Any adjustments needed should be clearly defined in the agreement and providing an example or illustration in such cases may be helpful.
Fair Market Value
The IRS defines “fair market value” as “the price at which property would exchange 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 reasonable knowledge of relevant facts.” Determining fair market value is difficult, and often engaging a valuation professional is necessary. While it may seem like the most expensive approach, the use of a business appraiser will result in an impartial conclusion of value and can save time and money if conflicts arise.
Whichever type of agreement is in place, it is advisable that business owners review their buy-sell agreements and the stipulations for determining value to verify that the agreement is still relevant and appropriate. If a company needs a buy-sell agreement or needs to update their agreement, hiring a business appraiser as a consultant can result in a relevant agreement that will mitigate cost, frustration, and wasted time in the future.