Is Your Buy-Sell Agreement an Accident Waiting to Happen?

When entrepreneurs come together to begin a business, they are bombarded with legal filings and agreements drafted by their counsel that they rush to sign, often without considering the future ramifications. Many times, these agreements are standard templates not designed to capture any increase in company value as it grows and becomes profitable.

Thirty years ago, a business owner started a little company with a good friend and business associate. He put his heart and countless hours into it and spent weekends away from his family to help grow this business into a company worth over $100 million. Upon his death, and after the buy-out of the company, his wife received $1,000. Certainly, his share was worth significantly more than $1,000. How could this happen? In this true story, the $1,000 figure was set in stone 30 years ago. He had signed a poorly drafted buy-sell agreement.

What Is a Buy-Sell Agreement?

A buy-sell agreement identifies what you and your fellow co-owners would be entitled to receive for your ownership interests should a triggering event happen in the future. Triggering events can be as wide or narrow as you, your fellow owners and your lawyer determine. The most frequently included events are death, disability, retirement and bankruptcy. When a triggering event occurs, the buy-sell agreement will dictate the value, in terms of dollars, that the owner or his designated beneficiaries are entitled to receive.

Potential Pitfalls

Many times, an agreement simply spells out the value of the company without capturing future growth. Other times, the owners agree to stipulate a value at fixed points in time but become too busy to do so, and never put it in writing.

Buy-sell agreements may contain vague terms or incorrect references that can be open to interpretation or subject to various applications. For example, many spell out that an owner’s interest will be his pro-rata share of “book value.” However, to what does book value refer? Does it mean book value per the company’s accounting methods, tax returns, in accordance with accounting rules and regulations, or something else entirely?

An agreement might specify a formula to use in deriving the value of an ownership interest, such as five times net income. Again, is it net income in accordance with generally accepted accounting principles, per the tax returns, or on a cash basis? Should the net income include or exclude the owner’s compensation? What if the company had an unusually bad year, with the most recent net income results failing to be an accurate indicator of the company’s success? These issues and vague terminology become an issue at a time of a trigger event when the parties are already emotionally distressed.

How to Improve Your Buy-Sell Agreement

We recommend to our clients without a buy-sell agreement to have one drafted and those with one to add a valuation process within the buy-sell agreement. The process would stipulate that an appraisal expert performs an initial valuation of the company. This gives owners an opportunity to become familiar with the process and address any issues, questions or vagaries before they become a problem.

Details can be determined, and questions answered such as, should typical valuation discounts be considered, such as for lack of marketability, or should certain financial expenses be added back as unnecessary to the normal operations for a business? By undergoing an initial valuation, all parties understand what is and is not involved and potential sticking points can be addressed. Upon delivery of a final valuation report, the owners can stipulate that the valuation would be in-force for a specific number of years should there be a triggering event. We would recommend not exceeding two to three years as anything past that would cause the valuation to be stale.

By continuing to update the values that the owners agree upon, any appreciation in value from the success of a company would be captured and could be properly distributed. Having the business routinely appraised can facilitate other goals, such as ensuring adequate funding via life insurance is in place should a buy-out be necessary or helping the owners with their estate planning objectives.

As a valuation expert, I have heard horror stories like the one mentioned earlier, with designees receiving pennies on the dollar for their interests because of a poorly worded buy-sell, one that has long been outdated, or because an agreement was thrown in a drawer and never revised as the company became more successful.

Once a triggering event happens, the agreement is the overriding indicator of a value for an owner’s interest, especially if matters become more contentious and the involved parties get inside a courtroom.

Contact our Business Valuation team for more information and to discuss a buy-sell agreement for your business.

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