Buy-sell agreements protect business owners from unexpected events, such as disability or divorce, or a shareholder’s death. They are also helpful when owners disagree and want to buy out a difficult partner, or want to sell their interests. Unfortunately, valuation issues often take the backseat to legal issues, leading to irreconcilable differences when the agreement comes into play.
An accurate valuation is essential, whether owners are deciding on a buyout price, planning for future buyout terms, or purchasing insurance coverage. Here are a few valuation issues to flesh out completely while shareholder relations remain amicable and no one is under duress to buy or sell.
Definition of value
It is important to fully define value in the context of the buy-sell agreement, because “value” often means different things to different people. Here in our Texas office, we hear shareholders who want to measure the “fair market value” of their interests, that is, the price that the universe of hypothetical buyers and sellers would agree to pay for a business interest.
However, that’s not always the appropriate standard of value. For example, noncontrolling owners may feel entitled to their pro rata share of the entire company’s value on a controlling basis in a buyout.
The definition of value may even vary depending on what event triggers the buy-sell agreement or the size of the ownership interest. A well-thought-out agreement will identify these nuances. For example, under the agreement’s terms, a shareholder who loses his or her professional license due to unethical behavior may be entitled to less than one who’s retiring. Or the owner of a controlling interest may receive a smaller discount for lack of marketability than a minority shareholder.
There are even times when the involved parties disagree about the appropriate valuation date. Valuations are valid as of a specific point in time, and conclusions can vary significantly in a volatile economy, or if major business decisions made by a controlling owner alter the value of the business.
There are three methods used by valuators to value a closely held business: asset-based or cost approach; market approach or income approach.
The asset-based (or cost) approach estimates the value of equity by subtracting liabilities from the combined fair market value of assets. The market approach compares the subject company to similar businesses sold on the public markets and in private deals. The income approach determines value from expected future economic benefits.
Appraisals help owners to understand which methods are the most appropriate for their business, so it’s a good idea to make obtaining regular appraisals necessary within the buy-sell agreements. That way, no one is surprised when it’s time for a buyout, and fewer disagreements are likely to ensue. Regular appraisals also give owners a general idea of what their interest is worth, which may narrow the gap between the buyer’s and seller’s expectations.
Some detailed buy-sell agreements address which adjustments to the company’s cash flow and its preliminary value are appropriate. For instance, an agreement may specify that owners compensation will be adjusted to match a predetermined industry benchmark. Or it may prescribe a discount for lack of marketability of, say, 15% or 30%.
Appraisals of business value
It’s typical for the company and the exiting shareholder to each hire separate experts to value the business, but sometimes the buy-sell agreement names a specific joint appraiser who the owners agree is competent and unbiased. This strategy can help minimize costs and disputes later on.
It is also important to consider and include who will pay appraisal fees, how long the appraisal process will take, and which documents the controlling shareholder will provide to the appraisers. The buy-sell agreement may even include a provision that allows valuators to perform site visits and interview management to help with discovery, if the parties wind up in court.
A valuation generates a cash-equivalent price in today’s dollars, but sometimes owners prefer installment payments for tax or cash flow purposes. A buy-sell agreement should address whether shareholders will receive a lump-sum or a series of installment payments over a prescribed time period. In installment sales, the parties also may stipulate an interest rate to apply over the buyout term.
When drafting the buy-sell agreement, many Texas business owners wonder how they’ll finance future buyouts. Insurance often works well, but some businesses maintain reserves to finance buyouts from operating cash flow. Borrowing funds when the agreement is executed can slow down the buyout process, which may cause stress for family members when a business owner dies without an adequate amount of liquid assets.
As the business evolves, a buy-sell agreement should change along with it. Otherwise, the agreement may become obsolete over time. Owners also may accidentaly invalidate their own agreement by failing to update it or adhere to its terms.
For example, a buy-sell agreement needs to be updated if shares are sold to a new owner or an existing owner voluntarily or involuntarily leaves the company. If buyouts are funded by life insurance, policies need to be periodically reviewed to determine whether more (or less) coverage is needed.
Plan for regular valuations
As owners write and amend their buy-sell agreements, it’s critical that the value of the business remain central to these activities. Often management chooses to have regular valuations to ensure that everyone knows what their interests are worth, and to avoid surprises in stressful times.