FACT: A large number of buy-sell agreements are outdated or poorly drafted. They are in essence “ticking time bombs”. A Buy-Sell is an agreement or contract (a) by and between a company and its owners or (b) by and between owners that provides for the continuation of a business upon an owner-related catastrophic event such as death. The agreement controls the valuation and disposition of business interests. So if one owner dies before the others, the agreement instructs the deceased’s estate to sell the deceased’s business interest back at a predetermined price to the company or other owners. Partners and stockholders of a closed (non-public) corporation often use Buy-Sells. All private companies with multiple owners, however, must have Buy-Sells drafted by attorneys.
Advantages of having a Buy-Sell:
- Legally enforceable
- Predetermined value
- Interest immediately and automatically transfers to owners or company
Disadvantages of not having a Buy-Sell:
- Loss of income to surviving family
- Loss of income to other owners
- Asset reduction from forced liquidation
- Delayed estate transfer
- Interest immediately and automatically transfers to surviving family
- Price Fixation
When preparing Buy-Sells, many owners think like buyers and assume they will outlive the other owners; therefore, Buy-Sell valuation formulas are often understated. Since an owner’s death, disability, termination or resignation is inevitable, owners must review their agreements at least annually. Owners must also periodically assess their agreements to be sure they still make sense. If an Agreement is outdated or the owners no longer agree to it, it may become unenforceable.
Many owners are “fixated on their companies” value. So it is not surprising that many owners encourage biased valuation approaches and ignore information that lead to a specific value. Owners must not interfere or pressure a business valuation analyst into a specific value. The analyst should prove (or disprove) an owner’s value opinion and help an him understand whether his value opinions are based on reality or perception.
Buy-Sells are like insurance because it protects a family from unforeseen problems, such as an untimely death or a business partnership “gone bad”. Though most companies buy insurance, few take the time to prepare Buy-Sells. And even if they have an agreement, the details of the valuation-related issues may not be adequate. It is no wonder that valuation is the main issue affecting most Buy-Sells.
A Buy-Sell review is less in scope than a full valuation, which is a determination of value. The Buy-Sell specifies how value is to be determined. A full valuation is not required since no transaction is pending. Instead, limited calculations providing a “rough” estimate of value is used to validate the agreement and illustrate their impact to the owners. Sometimes, not a single number is crunched. The cost of a review is remarkably less than of a full valuation, but the benefits will be a clearer and better-understood agreement. With a Buy-Sell review, therefore, the risk of a “ticking time bomb” will be reduced.
The following checklist has some Buy-Sell review points, in the form of questions, which owners should answer when drafting or revising an Agreement. From a valuation analyst’s perspective (not a legal perspective), the following questions could reveal symptoms of a technically defective agreement:
- Does the agreement specify and define the standards of value that are often isunderstood such as fair market value, fair value, market value or some other standard of value?
- Does the agreement specify the appropriate level of value for each owner’s interest, such as minority non-marketable or controlling marketable? Most Agreements do not distinguish between levels of value, failing to specify whether control and marketability discounts and premiums apply.
- Does the agreement specify a valuation formula or method? Are all the formula’s terms completely defined (for example, what is included in ‘seller’s discretionary cash flow’ or is ‘income’ before or after tax?). Most use formulas (for example, a number times earnings, book value or some other base) that are outdated and incompletely defined.
- Does the agreement include a valuation clause? Does it specify that a qualified valuation analyst perform the valuation? Does it also specify the certifications and credentials required by the analyst?>
- Does the agreement include alternative dispute resolution options such as arbitration and mediation by a specific arbitration or adjudication firm? Does it specify who will pay the arbitration costs?
- Does the agreement specify an “as of” valuation date for each triggering event (for example, the date of death in the event an owner dies)?
- Did an independent valuation analyst supply the method and is the method reasonable and defendable in court? Courts generally prefer professional outside appraisals because owners or managers may allow unrealistic expectations to influence their value estimates.
- Does the agreement provide guidelines for adjusting non-operating and nonrecurring items?
- Does the agreement “peg the value” for estate tax or marital dissolution purposes?
- Does the Agreement specify how it will be funded? Does it specify whether the seller receives the value of his or her interest in a lump sum or on installment? If on installment, does it specify the payment term, repayment schedule including principal and interest and the interest rate and its source?
Among the several methods for retaining ownership a deceased owner’s shares, liquidating company or personal assets or using cash flow from company earnings fund the ‘buy back’ are the least practical and the riskiest. Life insurance has an obvious business purpose in this circumstance. Any type of life insurance (whole, term or flexible) can be used to fund either of the two types of Agreements. A Cross Purchase Plan is used when owners purchase life insurance on each other. The owners are the policyholders and beneficiaries. Entity or Direct Plan is used when the company owns the policies on the owners and is the designated beneficiary for each contract participant. A closed corporation might purchase policies on the senior or majority shareholders, providing funds for the corporation to retain ownership.
Other than in Buy-Sell reviews or disputes, business valuations by a business valuation analyst are important in financial, tax and litigation matters.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.