Buy-Sell Agreements: What You Need to Know
After reading hundreds of buy-sell agreements (or operating agreements for LLCs) over the years, I thought I would share some of the tips and reminders of making sure you have a good one.
First bit of advice: work with a really good attorney for drafting!
Second bit of advice: work with a qualified valuation professional to review the valuation components!
Let’s get the boring stuff out of the way. A buy-sell agreement is a contract among shareholders/members that determines what happens to the business equity in various instances using a previously determined understanding among the owners.
In layman’s terms, a buy-sell agreement is a prenuptial agreement for business owners. Business owners always get along with each other when the ideas are fun and the business is forming. But, when the going gets rough and ideas begin to bifurcate, shareholder dissention can rear its ugly head. Making decisions on how the “divorce” will work while you are getting along can make the business divorce somewhat less stressful. Having a really good, well-thought-out buy-sell agreement is the way to accomplish that. Below are some tips and pointers to successfully execute such agreement:
- Are life insurance proceeds to be included in the value?
- What does “book value” mean? Total book value or just tangible book value?
- When you say “income,” what income? Cash basis or accrual basis? Should the income include non-operating and/or non-recurring income and expenses?
An agreement that needs interpretation is not a good agreement. If two or more people read the agreement and have two or more understandings, go back to the drawing board.
what standard of value should be used
- Fair Market Value-The price at which a reasonable, knowledgeable, hypothetical buyer and seller, neither under the compulsion to buy or sell, would transact.
- Fair Value- The price- The price that would be received to buy or sell between market participants… excluding lack of control and marketability discounts.
- Investment Value- The value of an asset or business interest to a specific owner.
- Formula Value-The formula is dictated by the agreement and may not reflect any definition of value.
an “as of” date
- The value is as of a specific date in time.
- Value is based on the information known or reasonably knowable as of the valuation date.
- This is especially important when significant time passes between a triggering event and the culmination of the valuation process.
- Ensure to note that a qualified appraiser be used to calculate the value.
Qualified appraisers will be accredited through one or more of the following associations:
- NACVA- National Association of Certified
- AICPA- American Institute of Certified Public Accountants
- IBA- International Business Appraisers
- ASA- American Society of Appraisers
how the price will be determined
- Formula- Example: Tangible book value plus 2x
EBITDA excluding non-operating and non-recurring income and expenses.
- Different for each business and industry. No cookie cutter language!
- Written to prevent a significant swing in value from one year to the next.
- Revisit periodically.
- Calculated value- Engage your trusted qualified valuation professional when the time comes.
- Annually agreed on value- Be super careful here! Remember inflation and things change! Many owners forget to update this in a timely manner.
- Formula- Example: Tangible book value plus 2x EBITDA excluding non-operating and non-recurring income and expenses.
the type of purchase
- Cross purchase- Shareholders buy and sell amongst themselves.
- Equity redemption- The company buys the stock
- Combination- This can be tricky. Consult with a professional.
the funding mechanism
- Cash in the form of savings, external borrowings, or life insurance
- Installment notes and security
- Include a run on the bank provision
When a significant number of owners sell out of the Company at once, the Company may not be able to survive by paying out multiple shareholders at once. The provision will still allow for shareholders to be paid out but will lengthen the payment period and it protects the Company.
- Incent shareholders to stay versus leave the Company
- Read the agreement as if you are the buyer; read again as if you are the seller.
Will you be happy if you are in either set of shoes? Does the agreement make economic sense for both parties? If not, reconsider.
- Engage your trusted valuation professional to read through the valuation components of the agreement.
Remember that the agreement should be written to keep you and your business partners out of court. If the agreement is vague or ambiguous and you and your partners cannot agree during the business “divorce” the court gets to interpret the document. Do you really want to leave your fate up to the courts? If not, be precise! Use these tips to work with your attorney to draft a crystal clear super “tight” agreement to protect yourself, your business partners, and your business!
Have questions? Consider reading Buy-Sell Agreements for Closely Held and Family Business owners by Z. Christopher Mercer. Always contact your trusted attorney AND qualified valuation professional!
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