Abstract: A solid buy-sell agreement can help closely held businesses avoid disruptions when a shareholder leaves the business. This article explains critical business valuation issues to address when drafting or reviewing a buy-sell, including the appropriate valuation method, level and standard of value, and valuation date. A sidebar highlights why it’s important to specify whether life insurance is an asset of the business or merely a funding mechanism.
How valuation expertise strengthens buy-sell agreements
A solid buy-sell agreement can help closely held businesses avoid disruptions when a shareholder leaves the business. Arguably, the most critical provisions in a buy-sell agreement are those that address valuation-related issues. Incomplete or outdated valuation provisions can lead to costly, bitter disputes that hurt both individual shareholders and the company.
Here are some business valuation issues to consider when drafting a buy-sell.
What’s the appropriate valuation method?
The valuation provision of a buy-sell agreement describes how a departing shareholder’s business interest will be priced for purchase by the company or the remaining shareholders. Three common methods of valuing an interest include:
- Prescribed formula. Some buy-sell agreements call for a simple formula to establish the amount of the buyout. For example, a buy-sell might specify that “shares will be purchased at four times earnings before interest and taxes (EBIT) for the previous 12 months.” Usually, a valuation professional will suggest an initial buyout formula.
A drawback to valuation formulas is that they typically apply to historical financial results (not projected results) and may not reflect a business’s current value in today’s marketplace. Moreover, it’s difficult to account in a formula for all factors that can affect earnings in any given year — including discretionary, unusual or one-off expenses.
Earnings-based formulas also may be subject to misinterpretation or manipulation. For instance, shareholders might over- or understate expenses in anticipation of a buyout. Or they may disagree about what’s included in (or excluded from) “earnings.”
- Fixed price. An agreement also might specify a fixed price reached through negotiation by the shareholders, often with the input of a business valuation expert. This approach fosters collaboration and discussion among shareholders at a time when they aren’t yet facing a triggering event.
Like a formula, the main appeal of a fixed price often is its perceived simplicity. But a fixed price may not reflect the business’s value at the time of a triggering event. And both formulas and fixed prices might require periodic adjustments due to external factors (such as the recent Tax Cuts and Jobs Act) that can affect a company’s value and capital structure in ways not contemplated when the agreement was drafted.
- Outside opinion from a business valuation professional. Alternatively, a buy-sell agreement could call for an agreed-upon process, usually a formal business valuation, to guide the buyout when a triggering event happens. Objective, timely business valuations are likely to take into consideration current circumstances, thereby producing more meaningful results.
The agreement might provide for the retention of a joint valuation expert or require that both sides hire their own experts. In the latter situation, a third expert might be needed if the experts’ opinions don’t fall within a certain range of each other. The buy-sell agreement should specify who’s required to pay the valuation fees (the buyer, the seller or the company).
What are the valuation parameters?
Other relevant parameters to consider in the valuation provision of a buy-sell agreement include the appropriate level and standard of value, as well as the valuation date.
There are basically three “levels” of value: 1) minority, marketable, 2) minority, nonmarketable, and 3) controlling. In turn, these levels can affect the methods, assumptions and adjustments the expert uses — and, therefore, the final value.
For example, if an expert uses publicly traded (minority, marketable) stock prices to value a private business interest on a minority, nonmarketable level, it may be appropriate to apply a discount to reflect the time and effort required to sell private stock vs. an actively traded stock. Conversely, if valuing a controlling interest, the expert might apply a control premium or make adjustments that only a controlling owner could do to optimize the company’s earnings.
Likewise, the buy-sell agreement should specifically define the “standard” of value to prevent disputes during the buyout process. A business valuation expert can provide definitions for a variety of relevant standards, including fair market value, fair value, book value and investment value. Different triggering events or departing shareholders may require different levels or standards of value.
It’s also critical to specify the valuation date in advance. After all, a business’s value can change overnight. Using the date of the triggering event could prompt shareholders to time their departures to maximize their buyouts. It could also create financial reporting headaches if the buyout happens in the middle of the reporting period. So, many owners opt to value the interest “as of” the last day of the most recent fiscal year.
When creating or reviewing a buy-sell agreement, there are no one-size-fits-all valuation provisions. The right choice depends on the shareholders’ objectives — and what’s right today might not be the right choice tomorrow.
Sidebar: Don’t forget the funding mechanism!
Many companies purchase life insurance to fund a buyout when a shareholder dies. The funding mechanism can directly affect a company’s value if it’s treated as a nonoperating asset that’s includable in the value of the business.
To avoid disputes, the buy-sell agreement should specify whether life insurance proceeds are an asset of the business or merely a funding mechanism for the buy-sell agreement. In some cases, it might be advantageous for the company to set up a separate trust to facilitate the funding mechanism.