Valuation Corner: Best Practices for Buy-Sell Agreements

7/7/2015

What’s the best valuation method for a buy-sell agreement? This question is the subject of much debate among business owners, valuation analysts and financial advisors.

Everyone agrees that fairness is the goal. But how can fairness be achieved with so many variables affecting the value of the company from day to day and year to year? Moreover, what’s really “fair”?

Critical Choices
A buy-sell agreement dictates what will happen when a partner or shareholder retires, dies, becomes disabled or leaves the company for some other reason. The agreement describes the arrangements of an owner buyout, including purchase pricing, funding and payment terms.

Having a buy-sell agreement in place takes the emotion out of the discussion when a partner leaves. The agreement minimizes the possibility that shares can be sold or left to individuals or businesses that might create an undesirable or untenable partnership for the remaining shareholders.

But what the buy-sell agreement hinges on is value. This is why the valuation provision is one of the most critical aspects of a buy-sell agreement. How much is the departing shareholder’s piece of the company worth?

Types of Provisions
Buy-sell agreements typically include one of three types of pricing mechanisms: fixed price, formula and valuation. Most financial advisors agree that a fixed price is unworkable because the price is out of date as soon as it’s fixed.

Formulas are more flexible and are designed to reflect a current price based on current inputs at the time of the triggering event. The challenge with this methodology is agreeing on the various inputs and the nuances thereof. For example, if net income is the basis for calculation, then how, by what and over what duration is net income adjusted? Unless the buy-sell agreement precisely clarifies the inputs, the document doesn’t serve its purpose well.

A valuation appears to be the “fairest” way. But like a formula approach, it begs the question of inputs as well as the standard of value to be used, discounts, valuation date and appraiser.

Proactive Valuation
Z. Christopher Mercer, author of BuySell Agreements for Baby Boomer Business Owners, suggests a valuation-based approach he calls “Single Appraiser, Select Now and Value Now.” While it has valuation at its core, the approach addresses a number of the questions that typical approaches leave unanswered. Mercer suggests that the buy-sell agreement name one independent appraiser (or firm) to do the valuation. This is not an unusual provision.

However, Mercer suggests that the chosen analyst conduct the valuation now, and not wait until a triggering event. This initial valuation “tests” the valuation provision in the buy-sell agreement and gives owners a baseline value, which is reappraised every year or every other year to keep the value current.

Mercer identifies several advantages to this approach. The owners know the current value of the company at all times and know precisely how that number is calculated. Any issues regarding interpretation of the valuation provision in the buysell agreement are ironed out prior to any triggering events. When the buysell agreement is actually triggered, there are no surprises. All parties are confident in its mechanics and resulting outcome.

Each company is different, and every set of partners has unique issues. No matter how peaceful and friendly the current relationship between partners, discussing the buysell agreement valuation provision tends to cause anxiety.

For this reason, it’s wise to make decisions about the buy-sell agreement while everything is copacetic, everyone’s in good health and the business is thriving. Revisiting the valuation provision now can save a lot of heartache — and money — in times of stress.