Key Takeaways
A fixed valuation formula in a buy-sell agreement may become unreliable over time as a family business changes in size, profitability, debt, customer concentration, capital needs, and risk profile.
Shareholders should evaluate whether a formula still produces a reasonable result before a triggering event occurs, when buyers and sellers may have conflicting perspectives on value.
Directors can test the agreement by calculating the formula today, comparing it with a current independent valuation, and working with legal and valuation advisors if significant or unexplained differences emerge.
When a buy-sell agreement is drafted, a formula for determining the value of the family business can be appealing. Perhaps the agreement says the company is worth five times earnings. Everyone can understand the calculation, the result can be determined quickly, and there is no need to debate what the business is worth each time the agreement is triggered.
Simple, predictable, and objective. But what happens ten or fifteen years later? The company may have entered new markets, taken on debt, accumulated cash, or made significant acquisitions. The industry may also have changed around it. The formula in the buy-sell agreement may still be easy to calculate, but, will it still produce a reasonable result?
The Formula Was Simple When We Signed It. Is It Still Fair?
Families contemplating a valuation formula for their buy-sell agreement should carefully evaluate whether the consistency of the formula is ultimately a feature or a bug.
Consider a family business that adopts a buy-sell agreement when it generates $2 million of annual earnings. The shareholders agree that, for purposes of the agreement, the company will be valued at five times earnings. At the time, the formula may produce a result that everyone considers reasonable.
Ten years later, earnings have grown to $5 million, so the formula now produces a value of $25 million. The arithmetic is easy to verify, but the reasonableness of the conclusion is not. Perhaps the company has become more valuable because it has stronger management, recurring revenue, and better growth prospects, suggesting that the company has outgrown the 5x multiple. Or perhaps those higher earnings are now concentrated in a single customer and require significantly more working capital, which may suggest that the appropriate valuation multiple may actually be lower. Or, the company may have borrowed heavily, which wasn’t even contemplated by the parties at the time the buy-sell agreement was executed.
As this simple example shows, the consistency and simplicity of a formula provision may come at the price of future problems. A formula established today may be used to determine the price of a transaction many years in the future, and under circumstances the original shareholders could not reasonably anticipate.
Family businesses rarely stand still. The company that exists today may bear little resemblance to the one that existed when the buy-sell agreement was drafted. Product lines change, markets expand or contract, management teams develop, capital needs evolve, competitors emerge, debt is borrowed and repaid, cash accumulates, and acquisitions can transform the size and risk profile of the business. A formula will likely not capture those changes.
A Formula Will Likely Expose How Perspectives Change After a Triggering Event
Suppose a shareholder dies, retires, or otherwise triggers the buy-sell agreement. For the first time in years, everyone pulls out the document and calculates the formula. The selling shareholder may look at the resulting price and conclude that it bears little relationship to what the business is actually worth. The remaining shareholders may respond that the formula is exactly what everyone agreed to.
The circumstances surrounding a triggering event can be a difficult time to discover that shareholders have very different expectations about what the agreement was supposed to accomplish. Once a transaction is underway, the parties no longer approach the question from the same position. One side is selling and the other is buying. The time to determine whether a formula still makes sense is before anyone knows which side of that transaction they will be on.
Test the Formula Before You Need It
Directors do not need to wait for a triggering event to find out what the buy-sell agreement would do. Calculate the formula today, then compare the result with a current independent valuation of the company. A difference between the two does not automatically mean the formula is defective. The buy-sell agreement may intentionally define a price differently from what would apply in another valuation context. But a significant or unexplained difference should prompt a conversation about whether the agreement is still accomplishing what shareholders expect.
A few questions can help start that discussion:
When was the formula established, and when was it last reviewed? A calculation designed around the company ten years ago may deserve another look.
What has changed since then? Consider the company’s size, profitability, debt, cash, customer base, management, capital needs, industry, and growth prospects.
Have we calculated the formula recently? If not, shareholders may have no idea what price the agreement would produce today.
How does the result compare with a current valuation? Understanding the reason for any difference is more important than simply identifying that one exists.
Would shareholders consider the result reasonable regardless of whether they were the buyer or the seller? This can be a useful test of whether expectations remain aligned.
If these questions reveal a significant or unexplained discrepancy, directors should work with their company’s legal and valuation advisors to determine whether the pricing mechanism should be updated or replaced with an appraisal process that doesn’t rely on a formula.
Conclusion
Formula-based agreements are attractive because they appear to replace uncertainty with simplicity. However, a formula cannot anticipate every change that may occur in a family business after the buy-sell agreement is signed. Family business directors should understand what their buy-sell agreement says today and whether that result remains consistent with shareholder expectations. The worst time to discover misalignment is after the buy-sell agreement has already been triggered.