Buy/Sell Agreements: A Business Valuation Perspective
Guest Blogger: Donald Parker
Gryphon Valuation Consultants, Inc.
Buy/Sell Agreements provide a blueprint for the transfer of business interests, allowing business owners to control and protect their investment in an organized and prescribed manner. Think of the Buy/Sell Agreement as a prenuptial between business partners.
Buy/Sell Agreements address certain triggering events such as death, divorce and the departure of business owners and should be an integral part of every business planning process – ideally, very early in the process. A well-constructed Buy/Sell Agreement serves five crucial functions:
- Creates a ready-made market for a company’s shares or membership interests upon the occurrence of a triggering event or other predefined transfer scenario;
- Defines the price (value) at which the shares or membership interests will be transferred and the terms of the facilitating transaction (i.e., interest rate, payments, etc.);
- Ensures that any transaction is funded in a prearranged manner;
- Imposes transfer restrictions that protect the integrity of the ownership structure and business interests;
- Allows for succession and estate planning needs while mitigating possible conflicts.
Buy/Sell Agreements are often incorporated into a company’s operating or shareholder agreement. As a business valuation consultant, I have reviewed hundreds of such documents from the standpoint of how ownership interests were to be valued for purposes of facilitating their transfer. Unfortunately, I have discovered that not all Buy/Sell Agreements are created equal when it comes to defining how the value (or price) of business interests should be determined. The following discusses the most common approaches to determining value and explores the merits of each.
Generally, there are three ways that Buy/Sell Agreements address value. Price is either:
FIXED at the outset and then adjusted periodically;
Set by a FORMULA that “kicks in” when a triggering event occurs; or
Initially determined through an APPRAISAL process and updated at predetermined intervals and/or upon a triggering event.
FIXED-price agreements are generally easy to negotiate and involve little expense. However, they are often based on values that rarely reflect the actual fair and equitable value of a company’s shares or membership interests. Further, contrary to intentions, they are often not periodically updated. This is problematic because after a triggering event, the respective party’s interests are no longer aligned and in fact, may very well be dynamically opposed, meaning that agreeing on a fixed price after the fact is almost (if not absolutely) impossible.
Agreements based on a predefined FORMULA are generally easy to understand and, as with the fixed-price approach, are easy to negotiate and involve minimal expense. Nevertheless, formulas necessarily rely on variables. Over time, the variables that drive the value of a company can differ depending on changes within the company, the industry and the economy. A formula appropriate at one point in time may not be meaningful in the future.
Unlike the fixed-price and formula approaches, the APPRAISAL process incorporates all relevant information and conditions each time the determination of price is required. Further, an appraisal conducted by a qualified business appraiser ensures that an independent and objective opinion of value is rendered. Additionally, an initial appraisal allows for a “test drive” of the Buy/Sell Agreement before the occurrence of an actual triggering event. In this way, any “kinks” in the process can be addressed while the respective parties are still sitting on the same side of the table.
Factors Affecting the Appraisal Process
Any factor required by the appraisal process that is not specifically spelled out in the Buy/Sell Agreement will result in certain assumptions having to be made by the business appraiser. Leaving material facts open to interpretation can result in a very different determination of value than that originally intended.
The following five factors impact how price will be determined by the appraisal process. These factors should be explicitly defined within the language of the Buy/Sell Agreement.
1. Appraiser Qualifications
Without specifying any qualifying criteria, anyone could be called upon to determine the price of the Company’s shares or membership interests when a triggering event occurs. Therefore, it is important that the Buy/Sell Agreement require that the appraisal be performed only by an independent Qualified Appraiser. This person should hold a designation sponsored by a recognized appraisal organization and have the requisite appraisal training and experience. Examples of appraisal designations include ASA, AVA, CBA, CFA CPA/ABV and CVA. Credentialing and membership in a recognized appraisal organization ensures that the appraisal will be performed in accordance with the appropriate professional business appraisal standards.
2. Valuation Date
This is the effective date of the determination of value (price). This date dictates what relevant facts can and cannot be considered in the appraisal process. The choice is critical because it can determine whether or not the triggering event itself can be considered. In the case of an unanticipated loss of a key person, whether the valuation date is the month-end preceding or subsequent to the triggering event could have a dramatic impact on the determination of price. Further, even though certain events can be reasonably anticipated, their timing and probability of occurrence may not be known with any certainty.
3. Standard of Value
The term “Value” in and of itself is ambiguous. While it seems trivial, the difference between Fair Value and Fair Market Value can be considerable. Business appraisal is not a one-size-fits-all proposition – the desired standard of value is critical to a successful appraisal process. I have read many Buy/Sell Agreements that call for “book value.” The fact is that book value is not a standard of value, but rather an approach to value; and is not appropriate for all situations and certainly not for all types of businesses. I suggest that in most cases the Buy/Sell Agreement stipulate the standard of Fair Market Value and let the professional appraiser determine the most appropriate valuation approach.
4. Basis of Value
In the world of business appraisal, there is a quantifiable difference between a pro rata share of the value of a business and the value of a fractional interest in a business – especially if the fractional interest is less than a controlling interest (50% or less). While the mechanics of the appraisal process tend to get a bit technical, suffice it to say that it is important to indicate the basis of value to be used in determining the price of each respective party’s shares or membership interest.
5. Funding Mechanism
While the funding of the Buy/Sell Agreement doesn’t necessarily affect the appraisal process, there is some interrelationship between the two. Typical funding mechanisms include life insurance and/or promissory notes. Other options are cash (accumulated over a period of time) and external financing. The appraisal process can help determine which options are most affordable (fair & equitable) under any given set of specific terms. In respect to life insurance, the Buy/Sell Agreement should indicate whether any proceeds are treated as company assets (i.e. included in the value of the company). This decision can have a substantial impact on the determination of price.
Conclusion – Avoid Conflict and Confusion
As an added value to your practice, review your clients’ business planning needs. If you identify clients that do not have a Buy/Sell Agreement in place, advise them to put one in place now. For clients that have an existing agreement, review it with them today. In addition to a legal and tax review, engage a professional business valuation consultant to review the Buy/Sell Agreement to identify any potential valuation issues. Better yet, have your clients “test drive” their Buy/Sell Agreement by having their company appraised now. It will be much easier to address any valuation issues before an actual triggering event occurs than afterwards under potentially adverse circumstances.