Facing uncertainty is part of living life—even more so if you own a business. One way to reduce the unknowns in your future is to develop a buy-sell agreement.
A buy-sell agreement is designed to provide clarity around who can buy your business, what happens to your business if you were to die or become disabled, and for how much your business will be sold.
When it comes to the sale of your business, the valuation concept—i.e., the way in which the sale price is determined—under a buy-sell agreement typically takes one of three forms:
- Fixed price
- Outside appraisal
Here’s what you should know about each.
As the term implies, a fixed-price agreement specifies how much the security (stock, partnership interest, etc.) will be sold for. For example, an agreement could call for the stock to be redeemed for
$100 per share.
While simple to enact, a fixed-price agreement has a few pitfalls. First, if the price is unreasonably high or low, the agreement may be set aside by the courts. Second, there must be a bona-fide business purpose for the agreement. This concern is usually satisfied, especially when the parties to the agreement are unrelated.
Most important, if the agreement is not reviewed regularly, a price that once was fair may be very under or overstated compared to the company’s current fair market value.
Although formula agreements lay out the approach that will be used in valuing the company, they prevent the price from being known until the time of sale or redemption. However, this type of agreement allows for the company’s price to fluctuate as it grows or contracts. It also provides agreement as to how the value will be determined.
Examples of formulas used in buy-sell agreements include the following:
- Discounted future earnings or cash flow
- Capitalization of earnings or cash flow
- Capitalization of dividends or dividend-paying capacity
- Adjusted net asset value
- Book value
Any of the above formulas, as well as other methods, can be used in a buy-sell agreement; however, it is vital that all the parties understand the agreed upon method.
An outside appraisal provides for objectivity and a reasonable basis for determining the company’s current market value at the date of sale. Unfortunately, however, it does not diminish the uncertainty of how to determine its value.
Disputes can still arise over which appraiser to use, and the value the appraiser eventually determines. Additionally, the value is not known for planning purposes until the appraisal is completed. For these reasons, we recommend that the agreement should specify the valuation method to be used—and not simply leave this to an outside appraiser.
Reduce the uncertainty in your business’ future.
Determining which valuation concept to use is critical when developing your buy-sell agreement. Nevertheless, this is only a small part of the process. If you have questions about laying out a buy-sell agreement for your business, we can help. Contact your JAK + Co. advisor today.