Buy-sell agreements help protect small businesses with multiple owners if an owner dies, becomes disabled or chooses to leave the company. They should dictate who can buy the departing owner’s interest, when, how and for how much. It’s best if these contracts are created when a business is started, but they can always be entered into or changed later on.
It may seem unlikely that something will happen to one of the owners when a business is created, but sooner is better than later when it comes to buy-sells. When the unexpected does happen, it’s way better to be clear on the company’s next plan of action. Establishing a reasonable buyout plan while all the parties are still on amicable terms is a lot easier than when they are not. Disputing owners seldom agree on buyout price and terms.
The most helpful buy-sell agreement address more than legal and tax considerations. They also answer questions related to valuation issues. For example:
Hiring an Appraiser
How many appraisers should value the departing owner’s interest? Some owners prefer to use one joint appraiser or hire an appraiser under the company’s name. Often the buy-sells permit each owner to hire his or her own appraiser. If these two appraisers arrive at differing conclusions of value, the buy-sell may call for a third expert to resolve the difference.
Who pays the retainer and appraisal fees? The company may fund the retainer in the interest of time, but shareholders are often expected to reimburse the company for appraisal fees.
Is there a preferred appraiser? Some buy-sells name a specific firm to appraise a departing owner’s interest. It’s important to know this in advance, if an unexpected event suddenly triggers the buy-sell.
Definition of Value
What’s the appropriate standard of value? Fair market value is the most common standard of value. But, by using this term, the owner may then be bound by tax court precedent. Instead, some buy-sell agreements require buyouts to be based on fair value, which the agreement may define as the interest’s pro rata share of the business’s value on a controlling basis.
Are there any valuation discounts and adjustments that may apply? This is often the most contentious part when company owners disagree about the value. Comprehensive buy-sells iron out these details before disputes occur by specifying which discounts and which types of financial statement adjustments apply. They also may lay out a preset amount or methodology for quantifying discounts and adjustments.
[Note: The existence of a buy-sell agreement may, in turn, affect the magnitude of a company’s discount for lack of marketability. On one hand, a buy-sell provision effectively creates a “market” on which owners may sell their interests. This makes an interest more marketable. On the other hand, a buy-sell agreement may also restrict transfers of ownership interests to unrelated parties, which can make an interest less marketable.]
Do different standards of value apply to different triggering event or ownership blocks? Owners may, for example, decide that the death of an owner should mean a higher buyout price than the bankruptcy of an owner.
What is the appraisal timeline? The buy-sell agreement may prescribe a timeframe for valuing the business interest, in order to prevent the estate of a deceased owner from arguing that the remaining partners are unnecessarily dragging out the appraisal process.
What’s the “as of” date for the valuation? If an owner dies, the date of death or the alternate appraisal date (six months later) may be used. Different triggering events may warrant different “as of” (or effective) dates. In a volatile market, the different dates could mean significant changes in value.
What’s the correct format for reporting? Estate tax filings may require a comprehensive written appraisal report to satisfy the IRS’s adequate disclosure requirements. Written reports are also important if the owners are fighting over the buyout in court. A letter or verbal reporting format may be sufficient for amicable buyouts.
Are there any scope limitations? Usually, appraisers perform a full valuation for buy-sell purposes. But some shareholders opt to prescribe an industry rule of thumb or a specific appraisal method to expedite the appraisal process. These are unlikely to survive courtroom or IRS scrutiny.
How will the buyout occur? Sometimes the company buys the departing owner’s interest; other times the remaining owner(s) purchase the departing owner’s interest. For voluntary departures, things like noncompete contracts, earnouts, and consulting agreements need to be considered. A valuator can help owners understand the typical deal terms in the company’s industry, which may vary over time depending on the market conditions.
Will installment sales require interest payments? Appraisers determine a cash-equivalent price, but sometimes owners prefer buyouts to occur over time for tax and cash flow purposes. If interest is charged, the buy-sell may prescribe a reasonable interest rate.
Will buyouts be funded by key person life insurance policies? Life insurance proceeds are free of federal income tax, as long as the surviving owner was the original purchaser of the policy on the deceased owner. This can get complicated if there are more than two owners, and a valuation professional can make sure that each owner’s cumulative life insurance coverage is sufficient to buy out his or her interest.
These questions provide a sampling of the relevant valuation issues that come up during shareholder buyouts. Obviously, these agreements, and the valuation’s affect on them, are complicated and need to be handled by a professional valuator. Because market conditions change over time, it’s important to review these questions regularly to determine whether the agreement needs to be updated. For more information about the role of valuations in buy-sell agreements, consult with Filler & Associates.