Exit planning is a growing interest among business owners, and one important component of this process is the buy-sell agreement. But what do these agreements entail, and which term should you use?
What is a buy-sell agreement?
A buy-sell agreement is a legally binding agreement between owners of a business.
It’s designed to determine what happens if an owner dies, is forced to leave, or voluntarily leaves the business.
Who needs one?
Any business that has co-owners should have a buy-sell agreement in place.
What terms of the buy-sell agreement should be used?
One of the most challenging aspects of these agreements is determining the price at which the ownership interest will be exchanged. There are common terms related to business valuation that we commonly see in buy-sell agreements.
There’s no silver bullet that will be appropriate in all circumstances. Each term has its pros and cons.
Term 1: Fixed Price Agreement
What it is: Explicitly sets the purchase price to a fixed dollar amount. May include language that the price is to be periodically updated (e.g. annually).
Pros: Simple and inexpensive. Owners may choose to set a punitively low price as a strong disincentive for stock redemption.
Cons: May be materially different (higher or lower) from a market-based value. The fixed price may not be updated regularly which creates an opportunity for shareholder dispute or litigation.
Term 2: Agreed-Upon Formula
What it is: Specifies a formula to be used for determining the purchase price (e.g. equal to book value, or a multiple of EBITDA).
Pros: Easy to understand and use. Inexpensive. Gives owners some visibility as to the price at any point in time.
Cons: A static formula won’t represent a market value for the company at all times given ongoing changes in the economy, industry and company performance. It may also create the incentive to engineer financial results or creatively interpret the formula for the benefit of one side (e.g. accelerating expenses into the current year to purposely lower EBITDA).
Term 3: Single-Appraiser Agreement
What it is: A single appraiser conducts a business valuation to determine the purchase price. The buy-sell may also state that this individual must be a certified/credentialed business appraiser (e.g. has an ASA or CFA designation).
Pros: Using a credentialed expert provides a high level of credibility to the purchase price and may diffuse potential shareholder disputes. This individual may help reconcile shareholders by explaining how the conclusion was reached so owners can understand why that value is reasonable. Especially if it differs from their initial expectations.
Cons: More expensive. Doesn’t give owners real-time visibility into the purchase price. It may not be high quality if the appraiser isn’t properly credentialed and experienced.
Term 4: Multiple-Appraiser Agreement
What it is: Multiple appraisers are engaged to perform business valuations to determine the final purchase price. The buyer and seller each retain an expert. If they still can’t agree on the price, a third expert will be used. Again, certain professional credentials may be stipulated.
Pros: Very comprehensive analysis – the process may feel most fair to all parties.
Cons: Can be expensive and time-consuming. There’s no guarantee that appraisers will come to similar conclusions of value.
In the final analysis, if the owners want to ensure that their buyout value is a strong substitute for a market price (e.g. fair market value), then we would recommend using a qualified business appraiser; however, there can be situations where a market value may not be wanted or needed.
Business owners will need to assess their own situation and preferences before deciding which buy-sell terms would best suit all the owners of their business.
Have questions about buy-sell agreements? Let’s talk!