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Case Shows Power of Buy-Sell Agreements

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A recent court decision demonstrated the power of buy-sell agreements. Photo by Matthew Henry on Burst

A buy-sell provision can help ensure an orderly transaction when one shareholder wishes to leave a business. It can dictate the manner in which an owner’s interest changes hands, as well as the price.

The enforcement of one such provision was the point of contention when the shareholders of a family-owned automotive repair business in Nassau County recently faced off in court.

Tabs Motors of Valley Stream Corp. was owned by four siblings, each of whom held 50 shares of common stock. The siblings signed the shareholders agreement in December 2013, after allowing more than a year for consideration of its terms. The agreement featured a buy-sell provision that, among other things, would be triggered upon the filing of a motion to dissolve the company. 

Buy-sell agreements

Buy-sell provisions spell out the terms under which an owner’s share of a business may be reassigned when they leave the company. They often provide for some combination of redemption, in which the company is required to repurchase the interest, and cross-purchase, in which the remaining owners are permitted to buy it. Such provisions are often intended to prevent ownership from falling into the hands of outside parties. If designed properly, they can reduce the likelihood of controversy when a shareholder decides to leave the company.

Tabs Motors’ shareholders agreement (as cited in the decision) includes a buy-sell provision stating that “if any shareholder files a petition to dissolve the Corporation; … the Corporation firstly, and then the other Shareholders shall have the option to purchase all, but not part of the shares owned by such Shareholder.”

On October 29, 2019, two of the shareholders of Tabs Motors, Michael Louros and the Estate of Connie Collins, filed a petition for dissolution of the corporation. The filing triggered the buy-sell provision in the shareholders agreement. The corporation held a shareholder meeting on December 16, 2019, at which the two nonpetitioning shareholders voted to have the corporation exercise its option to purchase the shares held by the petitioners. The shareholders agreement excluded the petitioning shareholders from voting.

The closing was set for February 11, 2020. The purchase price was set by the shareholders agreement at $5,250 per share, nearly twice the value determined by an appraisal of the company in 2011, two years before the execution of the shareholders agreement.

In response to the petition for dissolution, Tabs Motors filed a counterclaim seeking to enforce the sale of the petitioners’ shares. Supreme Court Justice Robert Reed granted summary judgment in favor of Tabs Motors, ordering the sale of the interests. 

Justice Reed rejected the petitioners’ contention that the shareholders agreement was unconscionable, noting that it applied equally to any shareholder who petitioned for dissolution and that the parties had more than a year to review the agreement and receive counsel prior to signing. He rejected the claim that the valuation provided in the shareholders agreement was stale, pointing out that it was double the 2011 valuation and that it had been affirmed in 2018 in the probate of Connie Collins’ estate.

Finally, Justice Reed rejected the petitioners’ assertion that the other owners had breached their fiduciary duties, noting that even if the claims were legitimate, “they would not invalidate the buy-sell provision. The buy-sell provision is still enforceable.”

Parting thoughts

The ruling in Estate of Connie Collins v. Tabs Motors demonstrates the durability of buy-sell provisions written into owners agreements. That’s why it is vital to give due consideration to the wording of such agreements. For instance, language that calls for an appraisal in the event of a controversy can help ensure equitable treatment of all interests. For more information on buy-sell agreements or other valuation matters, please contact the trusted professionals at Advent.

The case is The Estate of Collins v. Tabs Motors of Valley Stream Corp. You can read the decision here. Read additional Advent blog posts on buy-sell agreements here and here.

Buy-Sell Agreements Vital in the Age of COVID

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A smartly crafted buy-sell agreement can spare you and your business from complications down the road. Photo by Marcelo Dias from Pexels

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.

Valuation Considerations

“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
  • 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.

Potential Pitfalls

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.

Outside Expertise

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. If you have any questions, the professionals at Advent Valuation Advisors are here to help.

For more information on buy-sell agreements, read our previous blog post here.

Buy-Sell Agreements: What You Should Know

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Photo by Thomas Drouault on Unsplash

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:

  1. Do you have a buy-sell agreement?
  2. Do you know what your buy-sell agreement says?
  3. 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.

Triggering Events

The agreement should define the transfer process for triggering events such as shareholder retirement, termination of employment, death, disability, sale, divorce and bankruptcy.

Pricing

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.

Funding

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.