There is one certainty in business – ownership relationships are not permanent.
Transfers of interests are inevitable, and businesses must plan in advance to ensure operations are not interrupted when interests are transferred. But privately held businesses do not have a ready market for owners to transfer interests in the business. An effectively designed and written buy-sell agreement can prevent unwarranted stress and financial issues at the trigger event.
Buy-sell agreements are commonly used to address transfers by identifying when or what events prompt a buyout, identifying how a buyout will be funded, and identifying the timing of a buyout. These events are commonly referred to as triggering events and can be classified as voluntary (retirement, disagreement) or involuntary (death, disability, bankruptcy, insanity, violation of governing documents).
The valuation clause in a buy-sell agreement is one of the key provisions in the agreement and must be carefully drafted to avoid surprises or disputes. A buy-sell agreement should contain a valuation clause that sets forth a procedure to definitively establish the price to be paid when a triggering event occurs. Disputes between owners will arise if a buy-sell agreement fails to include a procedure to definitively establish the value of the business.
Oftentimes, agreements are established with good intentions but limited knowledge. Agreements are signed, stored away, and collect dust until the day they are needed. A valuation clause in a buy-sell agreement that was not carefully considered, or updated with changing conditions, can become a “ticking-time bomb” that at a minimum can lead to feelings of animosity – and at worst, years of costly litigation.
Fixed Price Agreements, Formula Agreements and Process Agreements represent the most commonly used methods to establish the value of a business under a buy-sell agreement.
Fixed Price Agreements
A fixed price agreement states the value of the business on the date the agreement is signed. While this agreement is easy to understand, fixed price agreements essentially become obsolete by the time the ink dries. Business and market conditions are ever-changing, but the value of a business is not automatically adjusted with a fixed price agreement. Disputes often arise when a business has grown substantially over time and the fixed price agreement value is no longer remotely close to the true market value.
Formula Agreements are easy to understand and relatively simple to apply. These agreements blend accounting information and valuation multiples to establish a value for the business. The valuation multiple in a formula agreement presents the same issues as a fixed price agreement since the multiple does not change with changes in business and market conditions. Unlike a fixed price agreement, the accounting information used in a formula agreement does change as a business operates. Crafting a precise definition of the accounting information that will be used is imperative, and challenging. For example, if the formula is four times “net income,” the owners could manipulate the value to whatever they desire (e.g. by issuing bonuses to the owners). To prevent manipulation, net income must be precisely defined and address issues such as net income before/after tax or net income before owner’s compensation.
Process Agreements detail how the business will be valued in the future. These agreements call for a valuation process in order to determine the value of a business, but there is generally no prescribed formula in the agreement. There is sometimes an appraiser named in the agreement, but most of the time a process is established to identify a qualified appraiser in the future. This process usually outlines using one appraiser, using two appraisers, or using multiple appraisers.
Which Do You Choose?
The anticipated business operations and funds available for planning typically dictate which formula a business will use to establish value.
Fixed Price valuation clauses are the easiest to administer, but the value may not be remotely close to the true market value.
Formula Agreement valuation clauses can provide a close approximation to true market value but must be carefully drafted and reviewed regularly.
Process Agreement valuation clauses will lead to the best estimate of market value but are the costliest valuation clause to administer.
Knowing these terms, it is important to consult with an experienced attorney and valuation professional to ensure all valuation elements of the buy-sell agreement are adequately addressed at the outset of a business venture while the owners are on favorable terms.
Preparing for the inevitable should be common sense, but it is one of the more neglected aspects of financial planning.
About the authors:
Dustin Scott is a manager with the CPA firm of McGregor & Company, LLP in the firm’s Columbia office. His practice primarily focuses on business valuation, tax planning, tax preparation and tax compliance.
Jeff Allen is a partner at Burr Forman McNair whose practice focuses on corporate and tax matters. He has been a SCACPA speaker on the topic of International Tax Updates.