Hidden Problems with the Price Formula in Your Buy-Sell Agreement, and Solutions

It is tempting to select a formula approach to pricing shares when business partners come and go. After all, a formula is easy for everyone to understand, and in theory at least, inexpensive to apply. If you’re satisfied with getting to a price, any price, then congratulations – job done. But the goal is to arrive at a price that is fair to all concerned. This article discusses some of the unforeseen problems with buy-sell pricing formulas that we as valuation experts encounter frequently.

As a quick introduction, buy-sell agreements usually employ one of three basic approaches to pricing shares upon buy-sell trigger events (when a shareholder retires, dies, becomes disabled, etc.):

  1. Fixed Price: Shareholders agree on a price per share and agree to periodically revisit that price.
  2. Formula: Shareholders agree on a formula to calculate share price. Examples include: book value; adjusted book value; 4 times trailing 3 years average EBITDA, etc.
  3. Independent Valuation: Shareholders agree on a professional business appraiser to determine fair market value (or another appropriate standard of value).

The pricing method prescribed in your company’s operating agreement, by-laws, or shareholder, buy-sell or stock restriction agreement, as the case may be, is important to the success of your next buy-sell transaction. So, what are these hidden problems with the formula method?

Businesses evolve, and formulas are static

No single formula will consistently produce a fair market value result year in and year out. It is common, for example, for companies to move from a project-based model to a recurring revenue model over time. The latter sell for higher multiples, yet the multiple stated in the buy-sell agreement still reflects the old business model. In this scenario, the buyer wins and the seller loses. Formulas don’t capture changes in the business, and eventually become irrelevant. Shareholders usually have every intention of updating pricing formulas, but in practice buy-sell agreements get filed away and forgotten about, and their formulas become stale. As years go by and shareholders’ interests diverge (some become buyers and some become sellers), renegotiating a formula to bring it in line with market value becomes increasingly difficult.

Value is forward looking, and formulas aren’t

One of the central tenets of valuation is that the value of an operating business is based on expected future financial returns, considering risk and market conditions at a point in time. Valuation is therefore a forward-looking concept. Past performance may be a strong indicator of what to expect going forward, or it may not. Let’s say a manufacturing company has invested heavily in new product development for the past three years or has just added significant equipment to increase production capacity. A multiple of earnings formula would grossly under-value the shares in this case. In our work testing buy-sell formulas and providing benchmark valuations, we find that prices determined by formulas often bear little resemblance to fair market value.

Formulas are seldom 100% replicable

I’ve seen three reasonable financial experts apply the same price formula to a company and arrive at three different answers because there were at least three ways to interpret the formula. Rarely do we see pricing formulas that are totally unambiguous. When the formula was created, no one was sweating the details. Years later, when buyers and sellers emerge, a formula that leaves room for interpretation will almost certainly result in a dispute. While seemingly straightforward, a pricing formula that is not designed by a seasoned valuation professional is very likely not 100% replicable.

Formulas can create the wrong incentives

An earnings formula creates a disincentive for a managing shareholder to invest in operations toward the end of his or her reign. If he or she expects to be paid a multiple of EBIT, they might hold back from making investments that fuel growth or allow the company to remain competitive. The exiting shareholder receive more per share, while reducing future cash flows, which reduces actual value. Conversely, an unscrupulous controlling shareholder who knows that other shareholders are nearing retirement, could overspend for a few years to reduce EBITDA and therefore the buyout price. It does happen.

Bottom line; pricing formulas often yield results that are not true economic values. They produce winners and losers, which leads to hard feelings, disputes, and sometimes litigation, which becomes shockingly expensive, time-consuming and disruptive; and destroys shareholder value for all concerned.

All of the above shortcomings can be overcome by having a valuation-based buy-sell agreement and appointing a qualified and experienced business appraiser. However, if you insist on using a formula, I recommend that you at least hire a valuation expert to do a benchmark valuation of your company and design a formula that is more accurate, more replicable, and more robust. Then have that appraiser update the valuation and test and revisit the formula every three years or so.

If you would like to have your buy-sell agreement objectively reviewed from valuation, economic, fairness and practical business perspectives, please give us a call. Al Statz, ASA, CBA, can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Twenty Reasons to Know the Value of Your Company

Private company owners and shareholders seek independent business valuations at various times for various reasons. Here are twenty situations in which you may want to obtain a business valuation:

  1. An owner has passed away and a valuation is required to settle the estate per IRS regulations
  2. An owner is getting divorced and needs to have the company or their fractional interest valued to settle the marital estate
  3. An owner wants to gift shares to his or her heirs
  4. Business acquisition financing
  5. Owners need an independent opinion of value to comply with provisions of the company’s shareholder or buy-sell agreement
  6. A management buyout (MBO): the business can be valued on behalf of the current owners, or management or both
  7. When considering selling, merging with another company, or acquiring a company – an objective opinion of value can play an important role in setting expectations and having a successful negotiation
  8. One or more owners are developing a retirement plan and need to establish a preliminary value of their shares
  9. The business is often the largest asset in an entrepreneur’s investment portfolio – understanding its value is essential to any good personal financial plan
  10. Owner(s) wants to enhance business value – a current valuation establishes a baseline and identifies opportunities for value enhancement
  11. Owners are creating a buy-sell agreement or purchasing life insurance
  12. Owners want to part ways and need an independent valuation to determine the share price, because they can’t agree on price or their buy-sell agreement requires it
  13. The company is recapitalizing
  14. The company is converting from a C corporation to an S corporation
  15. The company (public or private) has acquired another company and needs to allocate the purchase price to all the tangible and intangible assets for financial reporting purposes in accordance with ASC 805
  16. The company has an employee stock ownership plan (ESOP) or incentive stock options
  17. The company has goodwill on its balance sheet and needs to test it for impairment in accordance with Generally Accepted Accounting Principles (GAAP)
  18. The company has stock-based compensation and needs to comply with IRC 409A and ASC 718
  19. The court, or one or more owners needs an independent valuation in support of litigation, or to avoid litigation
  20. The owners decide a capital call is required and one of the owners has become insolvent, triggering a buy-sell

Click here for more information on the different uses of business valuations.

Contact one of Exit Strategies Group’s business valuation experts to discuss a potential business valuation need, confidentially and at no cost.

Buried in the Corporate Archives – a Valuation Case Study

A lot of our valuation work is done for the purpose of internal share transfers of private businesses, or buy-sell transactions. In doing this work, we often see that owners have overlooked or neglected to keep important documents up to date. One such document is the buy-sell agreement, which articulates important legal, tax, valuation and financing issues that are important to ensuring smooth share transfers and business continuity.

We recently evaluated a holding company with a fair market value of approximately $40 million dollars. Two shareholders each owned a 50% interest in the company, a C Corporation, and one wanted to sell their stake to the other. The client said during our initial conversations that there was no buy-sell agreement in place, so we proceeded with developing a Fair Market Value opinion of a 50% interest. Just to be safe we requested a copy of “any agreements governing  or restricting the sale of shares”.

Guess what? Just as we were wrapping up the valuation, the client came across a type-written copy of the corporate buy-sell agreement executed in 1982. The owners and officers had been unaware of its existence. Hence, it hadn’t been updated and they certainly weren’t aware of its terms and provisions. As we reviewed the agreement, we found that it prescribed that any transfer of company shares would be at book value. In this case, book value was less than $1 million dollars.

A buy-sell agreement is a legally enforceable contract.

In the 2011 New Jersey Appellate Court case of Estate of Cohen v. Booth Computers, the partnership (buy-sell) agreement stated that value would be “net book value, plus $50,000, on the most recent financial statement.” When Cohen passed away this formula generated a value of $178k. Cohen’s heirs had the business appraised for $11.5 million. The Court upheld the $178k value based on the terms of the partnership agreement!

For our client, this was a nightmare waiting to happen. Imagine what would have happened had our clients not had a great relationship — the seller could have received less than $1 million for a $40-million-dollar asset! Fortunately, the owners were committed to a fair deal and they agreed to set aside the buy-sell agreement.

To assure that your company shares will transfer for an appropriate price when your buy-sell agreement is triggered or to put a buy-sell agreement in place, contact a business appraiser who is experienced in valuing company shares for buy-sell transactions. When you bring in a seasoned business valuation expert early on to interpret the pricing mechanism and other terms of your existing buy-sell agreement, they can recommend changes that will ensure that the agreement will operate the way the shareholders intend. And the sooner the better. It’s an easy discussion while all shareholders interests are aligned. Later on, as shareholders becomes buyers and sellers, their interests diverge and in most cases making changes to these agreements become far more difficult.

For further information on buy-sell agreement business valuation or to discuss a potential need, confidentially, please one of our senior business appraisers.

Pricing Methodologies in Buy-Sell Agreements

When it comes to valuing a business for tax filings, M&A transactions, ESOP’s and most other purposes, business appraisers are usually free to use all of the methodologies in their arsenal.  But, when it comes to Buy-Sell Agreements that govern the sale or exchange of interests among closely-held business owners, many of these agreements specify a fixed amount or formula to price equity interests. Recently our firm analyzed the valuation and funding-related provisions used in thirteen buy-sell agreements that we encountered over the past several months.

Here’s a summary of the pricing approach taken in those agreements:

• 6 called for one or more independent valuations to determine share price (46%)
• 6 contained a predetermined price formula (46%)
• 1 used a fixed price (8%)

Despite the small sample, our findings were remarkably similar to a survey by forensics and valuation services firm Dixon Hughes Goodman LLP, which asked attorney’s what their preferred method was for valuations in BSA’s:

• 43% prefer a valuation
• 39% prefer to prescribe a formula
• 17% default to using a fixed price

Using a valuation process in a buy-sell agreement normally produces a value that is most fair to all parties, that stands up to scrutiny, is less likely to result in a dispute, and is less likely to be challenged by tax authorities.  On the other hand, the use of formulas and fixed prices introduces potential landmines that should be avoided under most circumstances.
Proper business valuation is one of the keys to making buy-sell transactions occur smoothly and cost-effectively. Jim Leonhard works out of Exit Strategies’ Roseville, California office. For more information feel free to Email Jim or call him at 916-800-2716. 

Funding Your Buy-Sell Transactions

Al StatzA properly structured Buy-Sell Agreement (BSA) ensures a market for owners’ equity when they leave the business, restricts the transfer of shares to unwanted parties, and lays out a set of rules and processes that mitigate the overall risk of uncertainty when a trigger event occurs. However, without having adequate funding mechanism(s) in place, a well-intentioned buy-sell agreement may not satisfy the shareholders needs when a trigger occurs.

In this post I’ll briefly outline the three most common funding sources that we find when reviewing buy-sell agreements for business valuation purposes.

  1. Life insurance is the safest bet in case of the death of a shareholder. The proceeds are paid out promptly, and if any additional payment is required one of the other methods can be used to facilitate full payment. Several tax and administrative issues need to be considered depending on whether the shareholders or the corporation owns the policies. The type of policy — term, variable or whole life — is also a consideration. The premiums for whole life are substantially higher than for term, but it builds cash value that can be used even if a death doesn’t occur. The BSA should be specific in how life insurance proceeds are to be treated for business valuation purposes.
  2. Seller financing is often used in BSA’s. Price and terms of the note should be clearly spelled out: full payment upon a trigger event? Or a down payment, term, and rate? Some agreements adjust the rate annually to reflect market rates, where others leave the rate fixed or pegged to a benchmark rate as of the buy-sell date. What about protection in case of default? My point is that there is no prescribed way. Obviously financing is a negotiation that can be as creative or as simple as the participants deem practical.
  3. Corporate cash or a bank loan that provides funding is another funding. However, cash isn’t always an option for small, closely-held firms that lack large cash reserves. Securing a bank loan for buyouts is often challenging, especially when a firm has just lost a key executive.

As a fourth option, we occasionally see clients partner with a private equity group to buy out a departing shareholder. By doing this they can also gain access to new capital to support future growth. This type of funding is usually only available to companies with a few million dollars in annual free cash flow. We know a lot of private equity groups and can make introductions when appropriate.

It’s important to point out that these funding options are not mutually exclusive, and are often used in tandem to fund the buyout of a departing shareholder.  We recommend that not only should a buy-sell agreement and the valuation be updated every year or so, but also that funding options be reevaluated and updated based on the company’s financial position, ownership and current valuation.

Exit Strategies brings independence and over 100 years of cumulative business valuation and M&A transaction expertise to every engagement. Founder and president Al Statz is available for free confidential consultations. You can reach him via email or by phone at (707) 781-8580.

How a Covenant not to Compete Affects Value in Buy-Sell Agreements

When someone sells a privately-held company, the buyer usually insists that the seller sign a covenant not to compete. In fact, in over 20 years of business sales and acquisitions, I have yet to see a purchase agreement without a covenant-not-to-compete (CNTC) provision. Now let’s say that your Company or its shareholders purchase all of a departing 50% shareholder’s interest for fair market value; is it reasonable to expect that the selling shareholder would not compete with the Company? I think so.
Yet, many buy-sell agreements (BSA’s) are silent on the non-compete issue, allowing the departing shareholder to receive full value for their shares AND start, join or back a competing business. I briefly surveyed the last 10 buy-sell agreements that I’ve reviewed for valuation purposes, and found that fully half of them were missing a non-compete provision!
A covenant-not-to-compete provision in a BSA usually restricts the selling shareholder from soliciting customers and employees, and otherwise competing with the Company for a specified length of time within a specified geographic area. A CNTC is considered an intangible asset of the Company and may have significant value. Stated differently, the Company’s shares, post transaction, may have significantly less value without a covenant not to compete from the selling shareholder. CNTC’s have value because they protect the future revenue and profitability of the Company.
How does the absence of a covenant not to compete affect share value?
One common approach to valuing a CNTC is called the differential valuation approach; where the business is valued under two scenarios. The first valuation scenario assumes that a CNTC is in place, and the second scenario assumes that it is not. Another approach involves determining the present value of the potential future economic damages that would occur as a result of competition. In either case, the valuation expert’s job is to determine the net impact on revenue, margins and future cash flows arising from potential competition by the selling shareholder. The difference in company value for each scenario is the value of the CNTC.
To project cash flows, the business appraiser will have in-depth discussions with company management to understand and develop assumptions regarding:
  1. Seller’s business expertise in the industry and general ability to compete
  2. Seller’s intent to compete
  3. Seller’s economic resources
  4. Seller’s contacts and relationships with customers, suppliers, and other business contacts
  5. Seller’s age and health
  6. Seller’s intent to reside in the geographic area
  7. Barriers to entry that would limit the seller’s ability to compete
  8. Probability and timing of seller competing
  9. Probability that competition will harm the company
  10. Potential damage to the company due to the seller’s competition
  11. Ability of the company to prevent a customer from leaving
  12. Buyer’s interest in eliminating competition
  13. Duration and geographic scope of the (typical) CNTC
  14. Enforceability of the CNTC under State law
If valuing a CNTC sounds time consuming, subjective, speculative and expensive, it is.  You could be faced with a situation like this if your buy-sell agreement doesn’t prohibit competition. Or someone could be buying shares at a premium someday.
What does your buy-sell agreement say?
The main objective of a buy-sell agreement is to provide for the orderly and reasonable transfer of shares in the event an owner dies or leaves your Company. Yet many BSA’s don’t accomplish this because terms are ambiguous or incomplete, leading to contentious disputes and litigation when a trigger event occurs. Exit Strategies regularly appraises businesses for buy-sell events, and in doing this work we get to read lots of buy-sell agreements (and other corporate documents governing the transfer of shares), and witness firsthand how they don’t operate as originally intended by the parties.
As a business valuation expert, I recommend that you: a) have a buy-sell agreement, b) understand what it says, c) are convinced that it accurately reflects the intentions of your shareholders, and d) have great legal, tax, financial and valuation advisors to help you get it right. Otherwise you may have a time bomb ticking away in your file cabinet.
If you have any questions regarding non-compete or other buy-sell agreement provisions that affect valuation, Email Al Statz or call him at 707-778-2040.

Your Buy-Sell Agreement: Disaster Waiting to Happen? Needs a Tune Up? Or in Good Shape?

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:

  1. 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.
  2. 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.
  3. 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. 

Buy-Sell Agreement Categories

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 jhleonhard@exitstrategiesgroup.com.

The Dismal D’s of Buy-Sell Agreements

Al StatzWell-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

  1. Departure (quits or leaves)
  2. Disinterest (mentally but not physically leaves)
  3. Discharge (fired)
  4. Divorce
  5. Death
  6. Disagreement
  7. Deadlock (major disagreement)
  8. Disability
  9. Distress (within the business)
  10. Default (personal bankruptcy)
  11. Disqualification (licensing, regulatory, etc.)
  12. Disclose (confidentiality)
  13. Donation (donate or gift stock)
  14. Do not compete
  15. Dual entities (e.g. holding and operating)
  16. Dilution
  17. Drag-along rights
  18. Distribution policy
  19. Dividends and Distributions after a trigger
  20. Dispute resolution
  21. Death benefits (life insurance)
  22. Down payment and debt (buyout financing)
  23. Determination of value (fixed price, formula, or independent valuation)
  24. Defining elements of any valuation engagement
  25. Discounts (for minority interests)
  26. Different discounts (depending on trigger type)
  27. 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.

Click here for more information on how Exit Strategies’ helps with buy-sell agreements.

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.

Your Buy-Sell Agreement – Keep It Current Before It Costs You Money and Grief!

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.