A buy-sell agreement is a contract that determines how a shareholder in a closely held business may purchase the interest of another shareholder who withdraws from the business. Integrating a business valuation into a buy-sell agreement is critical to ensuring that all shareholders are treated equitably if the agreement is executed.
Hypothetical scenarios that require a business valuation:
Several investors decide to start a company and wish to protect their investments (and prevent conflicts) arising from death, disability or retirement. A regularly updated business valuation can help serve as the basis of a buy-sell agreement in the event that an investor exits the company.
Two business partners who have a loosely written buy-sell agreement now dispute the terms of the agreement. One partner thinks that the agreement's original formula, based on book value, is unfair considering the profitable growth in the company. The partners may engage an independent business appraiser to settle the dispute.
Special considerations for buy-sell agreement valuations:
Crafting a buy-sell agreement often requires team of professionals to ensure that the agreement is developed appropriately. This team may include: an attorney to draft the agreement, an insurance professional or banker to help fund the agreement and an appraiser to determine the value of the business.
A common mistake in buy-sell agreements is the use of a simple, fixed formula, such as ‘one times sales’, ‘three times cash flow’ or 'book value' to determine a company's value. While simple in nature, these formulas rarely provide an accurate determination of a company's value and thereby create an inequality between shareholders. A business appraisal takes a multitude of factors into consideration which, in turn, provides a more accurate conclusion of value.
A well drafted buy-sell agreement could be rendered useless if there are no funds available to complete the transaction. Life insurance and disability insurance are common tools used to fund such agreements.
Documents required to complete an appraisal for buy-sell agreements:
Profit and loss and balance sheet statements for the last three to five years
Interim profit and loss and balance sheet statements for the current year
Federal income tax returns for the last three to five years
Copies of any forecasts or projections
Operating agreement, buy-sell agreement or any other shareholder agreements
