Buy-Sell Agreements Help Business Owners Prepare for the Unexpected
When a business is owned by more than one person, it’s generally advisable for the owners to enter into a contractual agreement that prescribes what will happen if an owner dies, becomes disabled, retires or otherwise leaves the company.
Some market analysts predict that the COVID-19 crisis may trigger an increase in buyouts. For example, some struggling owners may decide to throw in the towel after months of teetering on the verge of bankruptcy. Or squabbling partners may disagree about the future of the business and decide to part ways.
So, now is a good time for owners to draft or update a buy-sell agreement. Here’s a look at common valuation issues and potential pitfalls to avoid.
“Buy-sells,” as they’re often called, may be standalone agreements or a provision within a broader agreement (such as a partners’ or shareholders’ agreement). To avoid misunderstandings and delays when redeeming a departing owner’s interest, a buy-sell should address the following key elements:
- Appropriate standard of value (such as fair market value or fair value),
- Definition of the standard of value,
- Exhaustive list of applicable valuation adjustments and discounts,
- Relevant method of quantifying valuation adjustments and discounts,
- Effective date of the valuation (for example, the year-end nearest the triggering event),
- Buyout terms (including who will buy the interest and how payments will be made), and
- Appraisal/redemption deadline (for example, within 30 or 90 days of the triggering event).
The buy-sell should also specify the parties’ preferred method of appraisal. Examples include a fixed price, a prescribed formula or the use of credentialed business valuation professionals.
In some cases, the owners agree to use the company’s CPA firm to perform an independent valuation of the departing owner’s interest. Other buy-sells require two outside appraisals: one for the buyer and another for the seller; the value of the departing owner’s interest is then determined by averaging the results of the two conclusions.
Ambiguous or outdated buy-sells can cause problems when it’s time for a buyout. For example, an agreement containing undefined valuation terminology — such as “earnings” or “value” — may be subject to different interpretations.
Likewise, the use of a prescribed formula that’s based on a simplistic industry rule of thumb might cause problems when a buyout happens several years after the agreement was executed. Industry and economic conditions may have changed, or the company’s product or service lines might have evolved.
For instance, some companies have pivoted during the COVID-19 crisis to:
- Take advantage of new market opportunities,
- Automate certain processes, or
- Minimize face-to-face interactions with customers.
Fixed valuation formulas that were valid before the pandemic may no longer be relevant in the new normal. This underscores the importance of creating a “living” buy-sell that’s reviewed and updated regularly to stay current.
One More Word of Caution
During a buyout, the buyer is typically either the company or the remaining owners. The seller is usually either the departing owner or the departing owner’s heirs. Because the buyer controls how financial results are reported after the seller leaves the business, the seller should be wary of the potential for financial misstatement.
Financial statements often are used to value the departing owner’s interest. So, the buyer has an incentive to understate revenue and assets or overstate expenses and liabilities. These manipulations can lower the buyout price, unless adjustments are made to the company’s financial statements.
There is no one-size-fits-all buy-sell agreement. The input of a business valuation professional when drafting or updating a buy-sell can help achieve the owners’ buyout objectives and reduce disputes when and if the agreement is triggered.
Sidebar: Funding the Agreement
Under a buy-sell agreement, the buyer must come up with cash to fund the buyout after the parties have agreed on the value of the departing owner’s business interest. Funding should be a forethought that’s addressed directly in the buy-sell, not an afterthought. Different funding mechanisms may be appropriate, depending on what’s triggering the buyout.
For example, if the departing owner has died or become disabled, life or disability insurance proceeds may be used for the buyout. In other situations, the buyer of the departing owner’s interest will need to find an alternate source of cash.
Sometimes, the buyer has enough cash to fund the buyout. If this isn’t the case, the buyer might need to take out a loan to help fund the transaction. Or the buy-sell might specify that the departing owner (or his or her heirs) will receive a stream of payments over several years, rather than a lump-sum buyout. This is a form of seller financing that can also help spread the capital gains tax hit over multiple tax years.
Please contact Doug Collins, CPA on 973-298-8500 for additional information or to discuss a specific situation.