Understanding Your Buy-Sell Agreement – Part 2
Written by Dalton Hopper, CVA, CFE
Recently, we kicked off a series discussing buy-sell agreements and what business owners and business advisors should know when it comes to valuation. In our last article, we outlined what a buy-sell agreement should contain. Now, let’s discuss some ways to define a business’ value within a buy-sell agreement.
One of the most crucial elements within a buy-sell agreement is determining how the business will be valued since there are many different options to consider.
- A fixed price valuation sets a pre-determined price for the company based on the buy-sell agreement. A fixed price provides comfort to both a potential buyer and seller since each can understand the value of the business or their interest in it; but this fixed price can quickly become outdated, especially in volatile economic times. To deal with economic volatility or other factors that might change the business valuation, a fixed price valuation can include an obligation for the business owners to update the fixed price annually, and contingency plans if a fixed price is not agreed upon for any year.
- A formula method of defining the business’ value sets a predetermined formula for valuing the business. Most often this is an earnings base, such as cash flow, net income, or EBITDA (earnings before interest, taxes, depreciation, and amortization) that is multiplied by a stated multiple. The formula method can clearly define how the business should be valued but still leaves uncertainty about how much the buyer will receive and how much a seller will pay since the business is in constant motion. Additionally, a formula method can ignore important items such as excess or deficient assets of the business.
- Finally, defining a methodology, such as fair market value or fair value, offers an analytical and adaptable approach to defining the value of the business but may leave room for significant interpretation and end up in litigation if one party does not like the result. In addition, the baggage that comes with these stated methodologies may not produce the intended result when drafting the buy-sell agreement. That’s why it is crucial to have a business valuation performed prior to any triggering event so issues can be discussed and resolved.
In addition to defining how the interest will be valued, the buy-sell agreement should address the application of discounts and premiums. For example, a 25% interest in a company can be viewed as a 25% pro rata share of the business, or as a 25% interest with applicable discounts, such as a discount for lack of control or lack of marketability. As you can see, there are many items to consider but, by putting these items on the agenda now, businesses can avoid the buy-sell agreement becoming the agenda later.
If you haven’t reviewed your buy-sell agreement lately or need help understanding how to best value your business, let us help and provide you with peace of mind. Contact your BMSS professional at (833) CPA-BMSS or visit our website at www.bmss.com.
The information provided in this series does not, and is not intended to, constitute legal advice; instead, all information and content in this series are for general informational and business purposes only. Please contact your attorney to obtain advice with respect to any particular legal matter, including a comprehensive discussion of other provisions that might be advisable in a buy-sell agreement.