Buy-sell agreements exist in many, if not most, closely held businesses having substantial size and/or value. And they exist between corporate joint venture partners in many thousands of enterprises.
Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself. They establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners. In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner.
Buy-sell agreements (or put agreements in some cases) are more important than most business owners, shareholders and boards of directors realize. I’ve often said that buy-sell agreements are written under the assumption that the other partner is going to die first – and one of the partners is right!
Seeing two different buy-sell agreements recently put the topic at the top of my mind and triggered a couple of memories, as well.
We reviewed a buy-sell agreement that was perfectly fine on the day it was signed by a company’s two major shareholders – more than ten years ago. The agreement states that the parties will reset the value each year.
Since then, the company has more than tripled in size and value. However, the valuation in the buy-sell when it was signed remains in effect today because it was never updated.
This creates no significant problems – unless something adverse happens to one of the shareholders. In that case, one shareholder would benefit from a bargain purchase price and the other’s family would suffer a true economic loss. With this item now in the open, those shareholders are working to update the document as rapidly as possible.
Many business owners want to create a formula to establish the pricing if a buy-sell agreement is triggered. And quite a few buy-sell agreements have them, usually with disastrous long-term results. However, this is not uncommon because this is an inexpensive alternative to hiring a business appraiser. Almost anyone can put a few numbers into a formula, whether it calls for book value at the preceding fiscal year-end or 4.5 times a 3-4-5 year (pick one) average EBITDA – less debt, of course. (I’ve actually seen the exclusion of debt to determine equity value omitted as part of the formula!)
The questions is, will formula results be fair for both sides in all circumstances? No rigid formula can realistically determine the value of a business over time with changing company, industry, and economic conditions. That’s why many buy-sell agreements use an appraisal process.
Many buy-sell agreements are written where the valuation mechanism involves multiple appraisal firms. Variations go like this:
And there are probably other variations on this theme.
There are at least two versions of the single appraiser pricing mechanism.
It should be clear that the pricing mechanism in a buy-sell agreement can be important to the outcome of a purchase event when it is triggered.
Before concluding this discussion of pricing mechanisms, let’s note some of the other important issues that need to be addressed when formulating your buy-sell agreement:
What’s so hard about specifying these things? We understand that it is, indeed, difficult. Owners have a hard time talking about some of these issues with their fellow shareholders when they are creating their buy-sell agreements. It makes people think about things they don’t want to think about. But think about them we must.
The process of drafting a buy-sell agreement requires the parties to address important issues in balanced form at the outset. In doing so, they are forced to realize that each party could be a buyer – in the event of the death of a partner – or a seller. Actually, if one thinks about being a seller, it is actually his or her estate that will be the seller. This can be tough stuff to deal with.
Know this. If these defining elements, including the pricing mechanism, are unclear in your (or your clients’) buy-sell agreement(s), they will be the only thing you will be able to think about following a trigger event until the situation is resolved. Absent a clear agreement, this can take lots of money, lots of time, and create lots of hard feelings. Dealing with the issues under adverse circumstances will absolutely distract you from the business of running your business.
You probably don’t spend much time at night thinking about your (or your clients’) buy-sell agreement(s). Take our word for it, you shouldn’t. You should be thinking about your buy-sell agreement now, in the light of day, and working to get a clear agreement that works for you and your fellow shareholders or partners.
We never practice law, so these are not legal opinions. They are, instead, business opinions.
Remember this about buy-sell agreements – someone will buy and someone will sell. You just don’t know who that will be when you sign the agreement. Your agreement needs to work for you and your family whether you are the buyer or seller. And it needs to work for your partner(s) and their families (or their shareholders) whether they are the buyers or sellers.
This is important. Send this article to any of your friends who own businesses. They will benefit greatly from taking time to review their buy-sell agreements. And send this article to attorneys, accountants, or other advisers of businesses. They can bring great value to their clients by suggesting a review of their buy-sell agreements from legal and valuation viewpoints.
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