A buy-sell agreement should work like a safety net. You want it on hand for when—or if—you’ll need it. In most cases, you don’t need it until long after you first created it, making it quite likely that some conditions will be different, whether your business has grown in value or partners’ responsibilities have changed. Before you need your safety net, it’s wise to take it out periodically and check for holes.
Has your safety net got any holes?
Yes, if any of the following apply:
- Operating agreements are out of date
- Buy-sell agreements haven’t been followed historically
- Shareholder agreements include out-of-date formulas
- Agreements refer to valuing shares “per attachment A”…and attachment A was never finalized (or attached)
How do you fix the problem? Through a better understanding of how to define “value” in buy-sell agreements.
What is value?
To define “value,” you need to first ask, “Value to whom”? How you perceive value does not always agree with what your partner/spouse/shareholder has in mind. For example, business owners usually have a number of different perspectives on their investment based upon the needs of the situation. This may lead them to see value very differently from another owner in the same company.
Definitions of value: Current definitions and implications on “the number”
Fair Market Value is a stable and well-recognized valuation standard. The definition in common use was crafted by the IRS in 1959 and is based upon a hypothetical, arm’s length transaction between willing parties.
“Fair value” has an accounting meaning and a statutory (legal) meaning. The meanings are, of course, different. The statutory meaning can (and does) vary based on location or the context of the legal action. The accounting definition of fair value is based on the “exit price” of a transaction, somewhat akin to what a runner-up would have paid in an auction.
“Book value” is a historic construct, an accounting definition. Only by chance would it have any relevance to the market value of a company.
There are many additional nuances—ratable value, fair market value of an interest—that can have major implications on the value. For instance, the difference between 20% of a company on a pro-rata basis (20% of the enterprise value) and the value of a 20% interest in that same company could be significant (50% or more) or inconsequential. How would you know? It would depend on the facts and circumstances of the company in question.
Which definition should be used in a buy-sell agreement? It depends on what the owners are trying to accomplish with the agreement.
So, what is a buy-sell agreement meant to do?
- Require agreement between shareholders as to the process surrounding the exit of one or more owners
- Frame transactions that may occur in the future with other shareholders, with the corporation, or with outsiders
- Define the triggering events or conditions
- Determine the transfer price and/or process for pricing
- Discuss the funding mechanism and terms
- Generate consensus on how different transactions will be handled prior to their occurrence
In the best-case scenario, you set-up an agreement on the front-end when everyone is getting along and assured that good things will happen in this new venture as opposed to trying to figure it out when you are under pressure. (See our related article on this topic, “Avoid a Bitter End for Your Business.”)
Think like a firefighter—Perform periodic safety checks
Make any corrections and agree on all definitions now so that issues do not come up when you are under the pressure of a sale or separation from a partner. When planning for the future, you want to prepare for the worst and hope for the best.
While not overly complicated, this process can be tricky, so it’s wise to call in the experts. Contact your legal advisor, or talk to Seth Webber or Art Marshall in BerryDunn’s Business Valuation Group for input as to how the language of the agreement translates into actual numbers should an event actually trigger the agreement.