Let’s take a look today at an essential business document, a buy sell agreement, and how it is used, and how valuations are established:
Overview: THE THREE QUESTIONS:
- Do you have a buy-sell agreement?
- Do you know what the buy-sell agreement provides? and
- How is the buy-sell funded, is there life insurance or some other means to fund it?
What Is It?: A buy-sell agreement is a business contract, a succession tool by and between the owners of a privately owned business for purchase of the equity interests. Trigger events of buy-sell events are usually due to: disputes, disability, death, divorce, bankruptcy, retirement, and discharge, among other reasons.
It is Not a Forms-Based Agreement: What makes a buy-sell difficult to draft, and which makes it not a forms-based agreement, is that there are potentially many opposing characteristics among the ownership of any entity. The differing characteristics include:
- age differential
- involvement (passive vs. active)
- investment asset (small v. large)
- personal guarantees (none v. substantial)
- outlook on business (optimistic v. pessimistic
The types of buy-sell agreements are: fixed price; formula; valuation processes; and shotgun.
The fixed price agreements are the ones that are simply placed on “Exhibit A” annexed to the governing LLC, Shareholder, or Partnership Agreement, with the written understanding that the price is to be updated each year. Those updates are rarely done. However, if the price is not updated, and the price is too low, you are essentially betting that your partner is the one who will exit the entity before you.
Another option is to have a formula agreement, which states a single formula to be applied as the metric, such as a multiple of EBITDA, or book value, or valuation as of the fiscal year immediately preceding valuation date.
A third option is to have a process buy sell, whereby the owners agree to let business appraisers set the price for the agreement if and when it is triggered. With this process, no one will know until the end of a lengthy and uncertain process what the outcome will be.
The value to be determined by the terms of a buy-sell agreement will provide for either multiple appraisers, or a single appraiser. However the parties desire to resolve the issue of the number of appraisers, what is paramount is that the Buy Sell Agreement should be understandable, predictable, likely to achieve reasonable resolutions, and helpful in the wealth management process or estate planning process.
A majority of buy sell agreements are not favorable to the buyer. If the buyer is the entity, then life insurance is typically purchased to fund the buy-sell.
