Buy-Sell Agreements
A buy-sell agreement is a legally binding document that determines how a partner or shareholder in a closely held business may purchase the interest of another partner or shareholder who withdraws from the business. Integrating a business valuation into a buy-sell agreement is often critical to ensuring that all shareholders are treated fairly and equitably if one executes the agreement.
Special considerations for buy-sell agreement valuations:• Several friends are starting a new construction company, although excited about the prospect of a new enterprise they want to protect their relationships and prevent conflicts arising from death, retirement or disability. A regularly updated business valuation can help serve as the basis of the agreement and ensure that all parties are treated fairly.
• Two business partners have a long-standing buy-sell agreement, but they now dispute the terms of the agreement. One partner says that the 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.
A common mistake in buy-sell agreements is the integration of a fixed formula such as '1 times sales' or '3 times owner's cash flow'. One of the issues with this practice is that although the company may grow or decline, the formula is often neglected and not adjusted to reflect increased or decreased prospects. Adequate consideration should be given to developing such a formula by basing it on an independent appraisal and allowing for periodic review of the formula.
Another critical aspect of a buy-sell agreement is the funding mechanism used to execute the agreement. The funding mechanisms that are used can have a direct impact on the value of the business. They should be exhaustive and cover all potential outcomes regardless of whether the liquidating event occurs within the next few years or at retirement.
Crafting a buy-sell agreement often entails putting together a team of professionals to ensure that the agreement is developed appropriately. This may involve engaging a business appraiser to determine the value of the business, an attorney to draft the agreement and insurance agents or lenders to help fund the agreement. Each method of funding can have its own advantages and disadvantages; without careful consideration, a buy-sell agreement could be rendered useless if there are no funds available to conduct the transaction.
