Companies should not only have a plan outlining how they conduct business, but also covering what happens if one of the owners leaves the company. A buy-sell agreement outlines who may purchase an owner’s shares, how the value of the shares will be determined, and the terms of a purchase. It’s important for any business with more than one shareholder to have a buy-sell agreement as a critical element to succession planning and to ensure continuity when a shareholder leaves.
“Buy-sell agreements ensure that shareholders are treated fairly when they leave a business, and that they will ‘know the rules of the game before they play’ — i.e., know when and how their shares will be bought out when they leave, how the company will deal with other shareholders leaving, etc.,” says Brian Bornino, CBA, CFA, CPA/ABV, director of valuation services at GBQ Consulting LLC. “It is crucial to have an agreement in place before a triggering event, since these events often cause disputes and friction, which can make the process very problematic.”
Smart Business spoke with Bornino about what you need to understand about buy-sell agreements and why valuation plays a critical role in administering these agreements.
What are some key items business leaders need to understand about buy-sell agreements?
- You have to have one.
- Regularly, shareholders should ‘play out’ the agreement to see what would happen if someone left so there are no surprises.
- Review the agreement occasionally.
- Shareholders should consider funding future buyouts triggered by the buy-sell agreement with life insurance.
- Valuation is perhaps the most critical part of a buy-sell agreement, and independent valuations are highly advisable for administering these agreements.
How does valuation come into play with buy-sell agreements?
Valuation is probably the most critical part of a buy-sell agreement. Knowing how to value the shares of a departing shareholder is critical — and is often a huge ‘unknown’ for shareholders. While some agreements establish a formula, there are many flaws with formulas and they often produce unintended and irrational results. Formulas should never be used if the shareholders’ intentions are to buy shareholders out at fair market value; rather, independent valuations should be performed. A simple formula cannot encompass all of the complex factors that are involved in a proper business valuation.
There are many different ways that valuations are used in buy-sell agreements. Sometimes a value is established annually. Sometimes a value is only established when there is a triggering event. In these cases, sometimes ‘each side’ gets a valuation and there might even be a third ‘tie-breaker’ valuation if the two valuations are not sufficiently close.
The best practice is to have valuations completed regularly and communicated to all shareholders — and to do this before a triggering event. Although there are costs associated with this approach, the benefits far outweigh the costs since valuation is, by far, the most common element of disputes with buy-sell agreements. Shareholders will appreciate knowing the value before there is a triggering event, as it provides comfort and certainty.
Also, knowing the value of the shares allows the company to plan for repurchases and perhaps fund them with life insurance. Additionally, it is much easier to value a company before a triggering event, because shareholders are getting along and generally agree on the business’s future prospects, which are important to a valuation. After a triggering event, valuation becomes much more difficult because shareholders begin ‘jockeying for position’ and advocating higher or lower values based on their own best interest. In these cases, the valuator has to sort through both sides of the story — i.e., two completely different sets of projections regarding the business’s prospects — and do their best to come up with a reasonable answer. Not to mention, as a shareholder’s ownership interest in their business is often their most valuable asset, doesn’t it make sense to know what it is worth before the shareholder leaves?
How can you ensure that you have a well-crafted agreement?
Have the agreement reviewed by both an attorney and a business valuation expert. Many agreements are deficient, particularly with regard to the valuation language. Valuation formulas should almost always be avoided. Also, the valuation language should be clear as to whether valuation discounts apply, as this is often the source of confusion and disputes.
Valuation discounts apply when assessing the fair market value of a noncontrolling ownership interest in a privately held company. Since these discounts can be quite large — often 20 to 40 percent — it is important for everyone to understand whether these discounts should be applied to the company’s value when determining the value of the shares pursuant to the agreement. If the agreement is silent on whether discounts apply, disputes can arise.
Ultimately, it is important for all shareholders to understand what happens when shares are to be purchased, and all advisers should be on the same page as the shareholders.
What are the risks and benefits associated with buy-sell agreements?
The biggest risk is not having one. Other risks are having a nebulous, confusing agreement, an ill-conceived approach to valuing shares, such as a valuation formula, or having to sell a business when a shareholder leaves.
The benefits include shareholder comfort and certainty, the ability to plan for repurchases and business continuity.
Buy-sell agreements are truly an example of when an ounce of prevention is worth a pound of cure. It is much easier to ‘do it right’ ahead of time than deal with costly and disruptive disputes later.
Brian Bornino, CBA, CFA, CPA/ABV, is director of valuation services at GBQ Consulting LLC. Reach him at (614) 947-5212 or firstname.lastname@example.org