Valuation Considerations in Buy-Sell Agreements

Every business with more than one owner needs a buy-sell agreement to handle voluntary and involuntary ownership transfers. A well-written buy-sell agreement will cover valuation considerations in addition to legal and tax matters. Buy-sell agreements should be put into place early and reviewed and updated regularly to ensure it’s still valid and addresses all the business valuation issues that may arise.

Emotions tend to run high when owners face a “triggering event,” such as the death of an owner, a divorce of married shareholders or a shareholder dispute. The departing owner (or his/her estate) suddenly is in the position of a seller who wants to maximize buyout proceeds. The buyer’s role is played by either the other owners or the business itself — and it’s in the buyer’s financial interest to pay as little as possible. A comprehensive buy-sell agreement takes away the guesswork and helps ensure that all parties are treated equitably.

Many outdated buy-sell agreements identify who can purchase shares of the company when a triggering event occurs but neglect to address how those shares will be priced. Oftentimes, a buy-sell agreement will suggest using a valuation multiple or a “rule of thumb” to determine value, but these methods may not be valid on the date of the triggering event. The best method for determining the appropriate value is to hire a qualified business valuation expert to estimate the fair market value of the shares as of an agreed-upon valuation date (most likely the date of the triggering event).

A valuation expert will consider conditions in place on the valuation date the may not otherwise be considered by a valuation formula written into the buy-sell agreement. Language included in buy-sell agreements should cause remaining shareholders to hire a third-party appraiser rather than force the use of certain valuation techniques that may not be relevant as of the valuation date.

In addition to forcing the valuation to be conducted by a third-party appraiser, a buy-sell agreement should also address the following valuation considerations to follow when the agreement is triggered:

• Standard of value (most likely “fair market value”),
• Pro-rata controlling interest versus minority interest,
• Whether valuation discounts will apply,
• Who will pay appraisal fees, and
• What the timeline will be for the valuation process.

Business owners tend to put planning issues on the back burner, especially when they’re young and healthy and shareholder relations are strong. However, the more details that are put in place today, the easier it will be for owners to resolve issues when it’s time for a buyout.