For many of our clients, their investment in their business is the most significant financial asset they own. Many are baby boomers (individuals born between 1946 and 1964) who have reached or are approaching the transition from working to retirement. As that transition occurs, their small or medium-sized businesses will be sold or otherwise passed on to the next generation of owners.
It is often during these times of transition that the importance of buy-sell agreements becomes evident. Buy-sell agreements spell out the terms for transferring an interest in a business upon the death or departure of an owner. The time to create such an agreement is not during a transition, but rather at the start, when all of the owners are involved and an orderly transition can be planned. In our role as appraisers, we have seen many clients who either don’t have a buy-sell agreement or whose agreement simply doesn’t work as the shareholders expected.
As a shareholder, ask yourself three questions:
- Do you have a buy-sell agreement?
- Do you know what your buy-sell agreement says?
- How is your buy-sell agreement funded?
Even in companies that have agreements in place, we often find that they are not current, have a price determination that isn’t fair or workable for all parties, or lack funding arrangements for events that trigger a transfer. These situations can result in protracted litigation or even the demise of the business. If you have a buy-sell agreement, it may be time to review it.
The four most common ways that business owners exit their privately held businesses are a sale to a third-party, gifting ownership interests to family members, selling to employees and liquidating. Buy-sell agreements can provide guidance in all of these situations. Read your agreement to see if the language delivers the results you desire in each situation.
A review of your agreement should focus on three key areas: triggering events, pricing and funding.
The agreement should define the transfer process for triggering events such as shareholder retirement, termination of employment, death, disability, sale, divorce and bankruptcy.
Transaction prices in buy-sell agreements are usually defined by a fixed price, a pricing formula or an appraisal.
Fixed prices are easy to understand and easy to set initially, but may be difficult to reset as time passes and interests diverge. The provisions are rarely updated, and inequities are likely to result.
Formula-based pricing provides a mechanism to update the value based on various metrics in the business. However, a formula selected at a point in time rarely provide reasonable and realistic valuations over time. Changes in companies, industries and the local and global economies may impact the true value of an enterprise relative to any set formula. And formulas may be subject to multiple interpretations.
If appraisals are used, all parties will understand the valuation process from the start, and they’ll know what to expect when a triggering event occurs. Appraisers can incorporate key business drivers and risks into the determined value. Periodic appraisals provide a mechanism for keeping a buy-sell agreement up to date, so that all parties know the current value of the business and their interests. An updated valuation provides valuable information for business and personal financial planning, as well.
We recommend clients consider appraisals of their businesses. Though this comes at an additional expense, owners should make the small investment to understand what their business is worth with an annual or periodic valuation. They will potentially save much more in litigation or exit costs later.
The buy-sell agreement should spell out how transactions will be funded in situations where the company buys shares back from shareholders. Management’s plan should spell out several key points:
- Who will buy the shares? Other shareholders, the company or a combination?
- Should the company hold life insurance to fund share purchases if an owner dies?
- What are the terms of the transaction (down payment, interest rate, security)?
- Are there any restrictions on share payments under the company’s loan agreements?
We have seen a variety of other deficiencies in buy-sell agreements. Some lack the signatures of current shareholders. Others have not been updated for several years. In others, the level of value is not identified.
As you can see, there are a number of issues which, if handled poorly, could result in your buy-sell agreement creating as many problems as it solves. Used properly, the buy-sell agreement is a great tool to provide guidance for all kinds of triggering events that affect shareholders. We encourage you to discuss these matters with shareholders and your attorney. If you are in need of a current appraisal, please call us.