Does Your Business Need a Buy-Sell Agreement?

Does Your Business Need a Buy-Sell Agreement?

What Is Buy-Sell Agreement?

Buy-Sell Agreement, also known as a buyout agreement, give the company or other stockholders the option or obligation to purchase the interests of other owners under some specified circumstances called trigger events such as death, departure, or retirement, etc.

There are two basic types of buy-sell agreements: the stock-repurchase and cross-purchase agreements. Under a stock-repurchase agreement, the company agrees to purchase the interest of a departing owner. A cross-purchase agreement allows the remaining owners to purchase the departing owner’s stock.

When does a business need a buy-sell agreement?

Every co-owned business needs a buy-sell agreement when the business is formed or as soon as thereafter. The buy-sell agreement protects business owners when a co-owner wants to leave the company and it also protects the owner who is remaining in the business; furthermore, it helps the owners to agree on a way to value the company in advance in a buy-sell or buyout agreement. This gives owners the chance to discuss and vote on how a reasonable price for the company should be calculated. Buy-sell agreement reduces conflict when the time for a buyout comes.

What methods are used to set the price?

The process of determining the value of the business is directed by the buy-sell agreement and it could employ one of three methods to determine value. First, valuation process agreement, second, fixed-price agreement, and third, formula agreement. We highly recommend that you use the valuation process agreement by engaging an independent valuation analyst to determine the fair market value of your business because fixed-price and formula method agreements could either overvalue or undervalue the company. For example, under the formula agreement, say, you apply a multiple to five-year-average EBITDA such as five times the average EBITDA. What if the EBITDA value results either much lower value or even zero value because of the negative EBITDA in the previous years? The price under the fixed-price agreement method could have been outdated or have been set unreasonably high. You should keep in mind that the departing partner might be you or you might be the one who would buy out another partner. In either case, you do not want to receive less than the fair market value or pay above fair market value.

Furthermore, the IRC Section 2703 prevents a business owner from creating an artificially low value for estate tax purposes by providing for a purchase price in the Shareholders Agreement that was lower than the actual value; It also state that the value will be determined without regard to any option, agreement, or other right to acquire or use property at a price less than the fair market value of the property. Similarly, any restriction on the right to sell or use such property will also be disregarded; therefore, selecting an experience business valuation analyst who understands your business and the industry that you operate in can help you minimize conflict between business partners and regulation authorities and help you come up with a fair market value that is fair for both departing and remaining partners. The following section will discuss some of the benefits of retaining an experienced business valuation analyst, methods used to derive a fair market value and important items that should be included in the buy-sell agreement.

Valuation Process Agreement:

You and the other partner(s) agree to engage business valuation analysts to perform a valuation to set the price for buy-sell agreement periodically (preferably annually), so that the price in the agreement gets updated annually and the partners and shareholders know what will happen and what the price will be if and when the trigger event occurs. The valuation analyst analyzes the historical and current financial statements and evaluates the future financial outlooks of the company. The analyst also takes into account the present circumstances of the company and economic and industry condition at the trigger event or close to it. He or she then utilizes varies valuation methods and provides an independent and objective fair market value opinion. Although many valuation methods are used in practice, all such methods may be classified as variations of one of the three general approaches:

• The Income Approach
• Market Approach
• The Asset Approach

Each method may at times appear more theoretically justified in its use than others; however, the sustainability and appropriateness of a particular method or a combination of two or all three methods is entirely based on the relative circumstances and facts involved in each individual case.

The Income Approach:

Income approach estimates the value of a business by converting the future economic benefits to a single present value based on an investor’s required rate of return considering the risk associated with the investment. The future economic benefits are generally a stream of periodic cash flows, but it could be a lump sum payment in the future. The measure of earning power most frequently used is “net cash flow”, which represents the amount that an owner could take out of the business over time without jeopardizing it as a going concern

The Market Approach:

The market approach looks at company transactions within the same or similar industry and uses the earnings and revenue multiples from those transactions to determine the implied value of the subject company. There are three sources of comparable company transaction data

• Public company transactions
• Private company transactions
• Prior arm-length transaction of the subject company

The Asset Approach:

Asset approach involves an analysis of the economic worth of a company’s tangible and intangible recorded and unrecorded assets in excess of its outstanding liabilities; however, the most items on the balance sheet are recorded at historical cost, so it requires adjustments to assets and liabilities, so that they are presented on fair market value basis as of the valuation date.

What Should the Buy-sell Agreement Include?

An appropriately constructed buy-sell agreement should address several important items including:

• What events trigger the buyout
• How the buyout will be funded
• What valuation date will be used?
• What level of value to be used?
• What qualification of business valuation analysts will be engaged?

Trigger Events:

Trigger events are circumstances when the company or the remaining owners would buyout the departing owner at the price or to be determined price that is specified in the buy-sell agreement. Some of the trigger events could include.

• Death
• Departure
• Disability
• Divorce
• Bankruptcy
• Retirement

Funding Mechanism:

The buy-sell agreement could be funded through cash, promissory notes, cash and promissory note combinations, and life insurance. Specifying an optimal funding mechanism and ideal amount of funding help make the transition smoothly for both the departing and remaining partners and shareholders without harming the efficient operation of the business.

The Valuation or As Of Date:

There is no such a concept as “The Value”. Value is determined as of a specific point in time based on information known or reasonably knowable; therefore, specifying the valuation date clearly in the buy-sell agreement eliminates future dispute.

The Level of Value:

The level of control and minority value depends on the related characters of ownership. Discounts and premiums have significant effect on the ultimate value of the company and in turn on the level of ownership. Most privately-held company owners face two different types of discounts: discount for lack of control and discount for lack of marketability. Minority interest ownerships in a privately held business may be worth much less than their proportionate share of the business as a whole because of their limited control over the operation of the business. As a result, the value of minority shares is reduced due to lack of control. The lack of control characteristic makes the minority shares hard to sell, so the value is also reduced for lack of marketability. Theses discounts could total up to 50% or more from the proportionate shares of the value of the business as a whole.

Qualifications of Business Valuation Analysts:

The management should carefully consider the education, specialization and credential of a business valuation analyst. The dedicated Business Valuation group at Greenstein Rogoff Olsen & Company (GROCO) provides the expertise of a large big four firm with the hands on individualized service of a small local firm with regional prices. We are committed to provide our clients and their advisors with the highest services and support available. Our business valuation analysts are certified as accredited valuation analyst from the National Associate of Certified Valuation Analysts and have work experience with the big four accounting firms.

GROCO is a full-service certified public accounting firm, advising and assisting our clients with their accounting, tax, wealth preservation and business valuation needs.

Our business valuations group has preformed hundreds of valuations of privately held corporations and businesses totaling over $3 Billion in appraised values. This experience has spread over sixty-five different industries all geographical regions of the US and all stages of enterprise development, with particular emphasis on early stage companies in the Silicon Valley.

For more information contact Alan Olsen, Managing Partner, at aolsen@groco.com