- Seller’s business expertise in the industry and general ability to compete
- Seller’s intent to compete
- Seller’s economic resources
- Seller’s contacts and relationships with customers, suppliers, and other business contacts
- Seller’s age and health
- Seller’s intent to reside in the geographic area
- Barriers to entry that would limit the seller’s ability to compete
- Probability and timing of seller competing
- Probability that competition will harm the company
- Potential damage to the company due to the seller’s competition
- Ability of the company to prevent a customer from leaving
- Buyer’s interest in eliminating competition
- Duration and geographic scope of the (typical) CNTC
- Enforceability of the CNTC under State law
An Ounce of Prevention is Worth a Pound of Cure
I can’t tell you how many times I’ve heard from business owners and their spouses that a key person became disabled or died and left an operating closely-held business in turmoil. What, no Buy-Sell Agreement? Ask anyone who has been selling and appraising business for a number of years and they will tell you this sort of thing is common. All businesses with more than one shareholder should have a Buy-Sell Agreement (“BSA”) in place. Even when companies have BSAs, they are poorly written, causing divisive and expensive issues down the road. All multi-owner businesses need a well-written BSA to transfer shares in a fair and efficient manner when a shareholder dies, becomes incapacitated, is involved in a marital dissolution, quits or is fired, retires, or the company enters bankruptcy (aka,”Trigger Events”).
Exit Strategies’ accredited appraisers perform numerous business valuations each year, and because this work requires us to review corporate documents, we can say with some authority that many privately-held companies have problematic Buy-Sell Agreements from business, funding and valuation perspectives. When we come across B-S Agreements (pun intended), most often the owners didn’t want to invest the money to do it properly, or they just didn’t understand how import it was to have a viable BSA in place at the outset. Unfortunately, those who experience costly litigation, internal disputes, business erosion and family problems learn a painful lesson later on.
Shareholders have three choices when deciding on how shares will be priced when one of the aforementioned trigger events occurs:
- Fixed Price: Shareholders agree on a set price. Unfortunately, the price is likely years out of date and the shareholders usually have not agreed on a way to update the price.
- Price Formula: Shareholders agree on a formula to calculate future pricing. Chances are, no one has calculated it lately and because of changes in the company, economic and industry conditions over time, the formula price may be higher or lower than fair market value at the time of the trigger event. Also, it’s often seen where the shareholders haven’t agreed on ways to make necessary/appropriate adjustments to the formula.
- Valuation Process: Shareholders agree on a process employing one or more appraisers to determine the value of shares using guidelines specified in the BSA. There are two types of process BSAa: Multiple Appraiser and Single Appraiser. Multiple appraiser agreements call for the selection of two or more appraisers to develop one, two, or three appraisals whose conclusions form the basis for the final price. If that process sounds time consuming, cumbersome and expensive, IT IS!! It can also be divisive. Single appraiser agreements call for the selection of one appraiser whose valuation sets the final price. The choices are to a) select the appraiser and value upon a trigger event; b) select the single appraiser now and value at the trigger event; or c) select the single appraiser now, value now, and of course value again when a trigger event occurs.
Our Recommendation is to SELECT ONE APPRAISER NOW and VALUE NOW
- Select Now – If the shareholders creating the buy-sell agreement name the appraiser at the time of the agreement, all parties have a voice and can sign off on the selection. Early on, when everyone’s interests are aligned, this is a relatively easy decision to make. Doing it after a trigger event, when interests have diverged, is very difficult.
- Value Now – Once selected, the chosen appraiser provides a baseline valuation, which is a fantastic way to put all shareholders on the same (price) page. We often provide a draft report, and give everyone time to provide comments for consideration before the report is finalized.
Reasons why selecting a single appraiser now and appraising now is the best choice for closely-held companies when creating a Buy-Sell Agreement:
- The selected appraiser is viewed as independent by everyone
- Because the appraiser must interpret the BSA language related to valuation when conducting the initial appraisal, any issues regarding lack of clarity or inconsistency with the owners’ intentions can be resolved up front
- The valuation process is observed by all shareholders at the outset, so they all know what will happen when a trigger event occurs (no surprises)
- The concluded value establishes a baseline price (no surprises)
- The selected appraiser maintains independence with respect to process and renders future valuations consistent with the BSA terms and prior reports
- Subsequent appraisals, either annually or at trigger events, should be less time consuming and less expensive
- Parties will likely gain confidence in the process
- Parties will always know the current value for the Buy-Sell agreement, which is helpful for personal or estate planning purposes
- The initial valuation gives the shareholders a roadmap to increasing value if that is their objective.
- The appraiser’s knowledge of the company and industry grows over time, enhancing confidence for all parties
- Creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares
Valuation is a key piece of any shareholder buy-sell agreement. If you need help with the business valuation provisions of your buy-sell agreement, or need a valuation for a trigger event, feel free to Email Bob Altieri or call him at 916-905-5706.
The three types of Buy-Sell Agreements (BSA) are defined by the relationship between the parties to the agreement, i.e., the individual owners and their business entity.
Cross-Purchase Agreements are agreements between and among the owners of a business entity that requires the other owner(s) to purchase the interests of owner who has triggered the BSA. Cross-purchase agreements have common elements, including:
- Funded by life insurance owned by business owners on the lives of other owners.
- As the number of owners and the market value of the business rises, they can become unworkable.
- Typically individual owners are required to finance ownership shares not related to a death and they may not have that ability.
Entity-Purchase Agreements require the business entity (corporation, partnership or LLC) to purchase the owners’ interest when a trigger event occurs. The entity must then define or provide the funding to complete the transaction. The actual funding may come from the purchase of life insurance, financing from a third party or the selling owner(s), cash in the business, or some combination thereof.
Hybrid Agreements give the entity the “right of first refusal” to purchase the interests in when a trigger event happens. Should the entity decline to buy the interests, it may offer the shares to the other owners according to their current ownership percentage or to selected owners. If the entity has refused to purchase the interests initially and the other owners elect not to purchase the interests, the entity is required to purchase the interests. Funding for the purchase is often via a combination of self-financing by the business, notes payable from selling owners, and life insurance.
Proper business valuation is essential for Buy-Sell Agreements to operate the way they were intended. For more information about business valuation as an element of Buy-Sell Agreements, please contact Jim Leonhard at 916-800-2716 or firstname.lastname@example.org.
Well-written Buy-Sell Agreements enable orderly share transfers upon the occurrence of certain events during the life of a business. They also prevent litigation that can quickly create a lose-lose situation for business owners. This article presents a list of 27 trigger events and common issues addressed in buy-sell agreements. For fun each item on the list begins with “D”. Buy-sell issues are unpleasant to think about; which is why owners often put off addressing them and why we call them Dismal D’s. However, it’s only good business to have a plan in place that protects company and shareholder interests when these events occur. And they will occur.
The Buy-Sell Agreement Dismal D List
- Departure (quits or leaves)
- Disinterest (mentally but not physically leaves)
- Discharge (fired)
- Deadlock (major disagreement)
- Distress (within the business)
- Default (personal bankruptcy)
- Disqualification (licensing, regulatory, etc.)
- Disclose (confidentiality)
- Donation (donate or gift stock)
- Do not compete
- Dual entities (e.g. holding and operating)
- Drag-along rights
- Distribution policy
- Dividends and Distributions after a trigger
- Dispute resolution
- Death benefits (life insurance)
- Down payment and debt (buyout financing)
- Determination of value (fixed price, formula, or independent valuation)
- Defining elements of any valuation engagement
- Discounts (for minority interests)
- Different discounts (depending on trigger type)
- Dueling appraisers
Items #1-14 are common trigger events. Items #15-27 are common issues to be negotiated and addressed in the BSA. Items #22-27 are nearest and dearest to our hearts as business valuation experts. Arguably, valuation is the most important (and argued over) aspect of buy-sell transactions.
The above list is intended to be a starting point for consideration by shareholders. They should work with their partners, attorney, CPA and business appraiser to understand and address all of these issues. “Daunting D List” may be a better description!
Not only is it critical to have a BSA (yes, many businesses don’t have one), but it’s also vital that the BSA be kept up to date. Owners come and go. Shareholders’ personal, family and financial circumstances change over time. Likewise, businesses are not static and economic and industry conditions, services offered, customers, management depth competition are in a constant state of flux – all key factors in valuation.
Business valuation plays a central role in buy-sell transactions and buy-sell agreements. Contact one of Exit Strategies’ senior advisors with any questions or for a no obligation, no cost and confidential consultation.
Buy-Sell agreements (BSA’s) are an essential, and often overlooked, element in allowing shareholders to realize the value of their investment in a privately held company. The BSA’s purpose is to a) provide a market for ownership interests, b) establish the price and terms for these interests, c) specify a buy-sell process that is orderly and reasonable, and d) specify financing should a “trigger” event occur. There are several reasons this contract among owners can fail. Let’s briefly examine a few reasons why this can occur and it will become obvious why this document needs to “live and breathe” outside the confines of the corporate archives.
A BSA that is written upon entity formation, even if well-articulated, becomes less relevant as time marches on. This happens for myriad reasons ranging from changes in business conditions and value, or changes in an owners personal situation or objectives. Language in BSA’s is often not sufficiently precise and leaves too much room for interpretation that can result in shareholder disputes and costly litigation that dilutes value for all shareholders.
There are three types of BSA’s: fixed price; formula pricing; and valuation process. Business valuation is a function of economic conditions and business fundamentals. Of the three BSA types, only the valuation process is flexible enough to fully accommodate the range of changes that can occur in a business. Fixed price and formula driven valuations may be less expensive to execute, but they are simplistic and can omit key value determinants that ultimately can prove very costly.
There are a wide range of trigger events where an owner may quit, be fired, retire, die, be disabled, or get divorced to name only a few. Each trigger event can alter the personal objectives of one or more owners, impact the business, and may have both control and valuation implications for all concerned parties.
Template-driven BSA’s frequently either omit, or do not make a clear distinction on the standard of value to be used in calculating value. For example, the difference between using an investment value standard or a fair market value standard can be very large. If the standard is not clear in the BSA, a buyer would naturally assume the lower price implied in the fair market value standard, while a seller would assume the higher price found in the investment value. Hence, if the BSA does not clearly address this issue, conflict and costly litigation is a likely outcome. Similarly, the level of value also has valuation implications that create potential for conflict if not clearly addressed in the BSA, because the difference between a controlling interest and a minority interests can be substantial.
As is now readily apparent, a well-defined and current BSA is important to accurately allocate value and keep the peace! Key elements of the BSA should seem reasonable to all owners BEFORE a trigger event (before the parties know if they will be a buyer or a seller), when it is easier to reach consensus. AFTER a trigger event this becomes difficult since there is an inherent conflict between a buyer and a seller.
Business valuation plays a central role in Buy-Sell Agreements. For more information about Exit Strategies’ BSA-related services contact one of our senior business appraisers.
- Relatively quick and easy to calculate
- Inexpensive to apply