Buy-sell agreements protect businesses with multiple owners in the event that one of the owners dies, becomes disabled, or voluntarily decides to leave the company. The agreement should dictate who can buy the departing owner’s interest, when, how and for how much. Ideally, these contracts are set up when a business is launched, but they can always be entered into — or modified — later on.
That said, you do not want to put off doing a buy-sell. Comprehensive agreements provide stability when the unexpected occurs, and establish a reasonable buyout plan while the parties are still on friendly terms. Disputing owners seldom agree on buyout price and terms.
A comprehensive buy-sell agreement addresses many matters beyond the legal and tax considerations. It also answers questions related to valuation issues, such as:
Hiring the Appraiser
How many appraisers do you need? Some owners prefer to use a single joint appraiser or hire an appraiser under the company’s name to value the departing owner’s interest. Other buy-sells permit each owner to hire their own appraiser. If the appraisers arrive at very different conclusions of value — say 20 percent or more — the buy-sell may specify that a third expert be called upon to resolve the difference.
Who fronts the retainer and pays the appraisal fees? It’s not unusual for the company to fund the retainer in order to move the process along, but shareholders may be required to reimburse the company for appraisal fees.
Who should do the appraisal? Some buy-sells identify a specific valuator (or firm) to appraise a departing owner’s interest. Identifying appraisers in advance helps aid the valuation process if the buy-sell is triggered by an unexpected event.
Definition of Value
What is the appropriate standard of value? Fair market value — as defined by IRS Revenue Ruling 59-60 — is the most common standard of value. Note that by using this definition, the owners may be bound by tax court precedent when buying out a departing owner. As an alternative, some buy-sell agreements obligate a buyout to occur at “fair value,” which the agreement may define as the interest’s pro rata share of the business’s value on a controlling basis.
Do valuation discounts and adjustments apply? If parties to a lawsuit disagree about how much the business interest is worth, problems may result. Comprehensive buy-sells clarify details before arguments occur by specifying which discounts — marketability, control, swing vote, key person, etc. — and which types of financial statement adjustments — unusual, non-operating, related party payments, above- or below-market owners’ compensation, etc. — apply. They also may set a predetermined amount or methodology for quantifying discounts and changes.
[Note: The existence of a buy-sell agreement may impact the magnitude of a company’s discount for lack of marketability. On one hand, a buy-sell provision essentially creates a “market” on which owners can sell their interests. The interest becomes more marketable. On the other hand, if a buy-sell agreement restricts transfers of ownership interests to unrelated parties, an interest may be less marketable.]
Do different standards of value apply to different ownership blocks or triggering events? For instance, owners may determine that the death of an owner merits a higher buyout price than an owner declaring bankruptcy. Or a decision may be made that a 2 percent interest warrants a discount for lack of control, but a 30 percent does not.
How long can the appraisal take? When an owner dies, the estate may argue that the remaining owners are holding up the appraisal process to delay a buyout. The buy-sell agreement may detail a timeframe for establishing the value of the business interest.
What’s the “as of” date for the valuation? In an active market, the value of the appraisal may differ from one day to the next. If an owner dies, the date of death or the alternate appraisal date (six months later) may be specified. Different triggering events may merit different “as of” (or effective) dates.
How should reporting be done? Satisfying the IRS’s adequate disclosure requirements for an estate tax filing may require detailed written appraisal report. And if owners are fighting over the buyout in court, written reports will be necessary. But if the buyout is friendly, a letter or verbal report may be enough.
Are there any scope limitations? In most cases, appraisers do a full valuation for buy-sell purposes. But some shareholders choose to set specific appraisal method or industry rule of thumb to speed up the appraisal process. However, scope limitations result in an “indication of value” (as opposed to a “conclusion of value”) that is unlikely to survive courtroom or IRS scrutiny.
How will the buyout happen? In some cases, the remaining owner(s) purchase the departing owner’s interest; in others, the company buys it. If the departing owner is leaving voluntarily, a buy-sell agreement may call for a non-compete contract, earnouts, and/or ongoing consulting agreements. A valuator is an aid to help owners comprehend typical deal terms in the relevant industry, as they may change over time as market conditions change.
Will installment sales require interest payments? Appraisers determine a cash-equivalent price, but in some cases, owners prefer a buyout to occur over time for tax and cash flow purposes. If interest is charged, the buy-sell may detail a reasonable interest rate.
Will buyouts be funded by key person life insurance policies? Life insurance proceeds are free of federal income tax, providing the surviving owner was the original purchaser of the policy on the deceased owner. Things become more involved when there are more than two owners, as each owner must buy policies on all the other owners’ lives. A valuation professional can help make sure that each owner’s cumulative life insurance coverage is sufficient to buy out their interest.
These are just some of the relevant valuation questions that come up during shareholder buyouts. Since market conditions do change, it is important that these questions be reviewed regularly to ensure the company’s buy-sell agreement is accurate and current. A periodic appraisal update can also assist in gauging what owners interest are worth and avoiding surprising should a triggering event occur.