Out of the File Cabinet: The Ideal Time to Review Your Buy-Sell Agreement
Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).
If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.
True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.
For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.
The Ideal Time to Review Your Buy-Sell Agreement
The time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.
Things to Look for When Reviewing Your Buy-Sell Agreement
As you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.
Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.
Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.
Fixed Price Agreements Are Typically Never Updated
Fixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.
The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.
Formula Agreements Often Outgrow Their Formula
Formula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?
Valuation Process Agreements Are Often the Most Workable
Buy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.
There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.
We suggest a Single Appraiser – Select Now, Value Now process. For more information on this valuation process, see this article.
Six Things That Should Be Clear in Any Valuation Process Agreement
Regardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.
While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.
- Standard of value. The standard of value is the identification of the type of value to be used in a specific valuation engagement. The proper identification of the standard of value is the cornerstone of every valuation. Will value be based on “fair market value” or “fair value” or some other standard? The parties to the agreement should select that standard of value. If they do not, the appraisers will have to select it and the parties may not like their choices.
- Level of value. Will the value be based on a pro rata share of the value of the business or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process and to the shareholders of any business who are parties to its buy-sell agreement. If knowledgeable choices are not made by the parties to the agreement, someone else, i.e., the appraiser(s), will make it for them. The problem is that many agreements are written such that they are subject to differing interpretations regarding the appropriate level of value.
- The “as of” date. Every appraisal is grounded at a point in time. That time, referred to as the “as of date” or “valuation date”, provides the perspective, whether current or historical, from which appraisals are prepared. Unfortunately, some buy-sell agreements are not clear about the valuation date which should be used by appraisers. Because value changes over time, it is essential that the “as of” date be specified.
- Qualifications of the appraiser(s). If the parties do not decide on the kind of appraiser(s) they want to help for their buy-sell agreements, then, unfortunately, almost anyone can be named by either party to the agreement. Do you want a college professor who has never done an appraisal as the appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? How about a shareholder’s brother who has an MBA but has never valued a business before? The picture is clear. Buy-sell agreements must specify the qualifications of appraisers who may be called when trigger events happen.
- Appraisal standards to be followed. It is in the interest of all parties to ensure that selected appraiser(s) follow accepted business valuation standards. Some buy-sell agreements do this by naming the specific business appraisal standards that must be followed by the selected appraiser(s). Business appraisal standards provide minimum standards (criteria) to be followed by business appraisers in conducting and reporting their appraisals.
- Funding mechanisms. The funding mechanism is thought of separately from valuation yet is an important aspect of any buy-sell agreement. Why? Because life insurance is often purchased on the lives of one or more owners of companies having buy-sell agreements. Does the agreement tell the appraisers how the parties want the proceeds to be treated in their valuations? Appraisers will develop potentially widely divergent valuation conclusions depending on whether the life insurance is a funding vehicle (and not considered in reaching a value conclusion) or a corporate asset (and added to value prior to determining price for the agreement).
A Tool to Help in Reviewing Your Buy-Sell Agreement
Buy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.
Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.
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Recommended Valuation Process for Buy-Sell Agreements: Single Appraiser – Select Now, Value Now