By: Guest Blogger Donald R. Parker, CFA, AVA | Gryphon Valuation Consultants, Inc.
Buy/Sell Agreements provide a blueprint for the transfer of business interests, allowing business owners to control and protect their investment and the integrity of the ownership structure.
These agreements address certain “triggering events” such as the death, divorce or departure of business owners and should be a part of every business planning process. A well-constructed Buy/Sell Agreement serves five crucial functions:
- Creates a ready-made market for a company’s shares or membership interests upon the occurrence of well-defined triggering events or under very specific transfer scenarios;
- Defines a price (value) at which the shares or membership interests will be transferred and the construct of the transaction;
- Ensures that any transaction is funded in a predefined manner;
- Imposes transfer restrictions that protect the integrity of the ownership structure; and
- Allows for succession and estate planning needs while mitigating possible conflicts.
Buy/Sell Agreements are often incorporated into a company’s governing documents such as an operating or shareholder agreement. As a business valuation consultant, I have reviewed hundreds of such documents, not from a legal perspective (that I am not qualified to do), but from the standpoint of how ownership interests were to be priced for purposes of facilitating their transfer.
Generally, there are three ways that Buy/Sell Agreements address value. Price is either:
- FIXED at the outset and then adjusted periodically;
- Set by a FORMULA that “kicks in” when a triggering event occurs; or
- Initially determined through an APPRIASAL process and updated at predetermined intervals and, if necessary, upon a triggering event.
FIXED-price agreements are generally easy to negotiate and involve little expense. However, they are often based on values that rarely reflect the actual fair and equitable value of a company’s shares or membership interests. Further, contrary to intentions, they are often not periodically updated. This is problematic because after a triggering event, the respective party’s interests are no longer aligned and in fact, may very well be dynamically opposed, meaning that agreeing on a fixed price after the fact is almost (if not absolutely) impossible.
Agreements based on a predefined FORMULA are generally easy to understand and, as with the fixed-price approach, are easy to negotiate and involve minimal expense. Nevertheless, formulas necessarily rely on variables. Over time, the variables that drive the value of a company can differ depending on changes within the company, the industry and the economy. A formula appropriate at one point in time may not be meaningful in the future.
Unlike the fixed-price and formula approaches, the APPRAISAL process incorporates the relevant information and conditions each time price is determined. Further, an appraisal conducted by a qualified business appraiser ensures that an independent and objective opinion of value is rendered. Additionally, an initial appraisal allows for a “test drive” of the Buy/Sell Agreement before it is actually triggered. In this way, any “kinks” in the process can be addressed while the respective parties are still sitting on the same side of the table.
Factors Affecting the Appraisal Process
Any factor required by the appraisal process that is not specifically spelled out in the Buy/Sell Agreement will result in certain assumptions having to be made. Leaving material facts open to interpretation can result in a very different determination of value than that originally intended.
The following factors impact how price will be determined:
Without specifying any qualifying criteria, anyone could be called upon to determine the price of the Company’s shares or membership interests when a triggering event occurs. Therefore, it is important that the Buy/Sell Agreement require that the appraisal be performed only by a qualified independent appraiser. This person should hold a designation sponsored by a recognized appraisal organization and have the requisite appraisal training and experience. Examples of appraisal designations include ASA, AVA, CBA, CFA and CVA. Credentialing and membership in an appraisal organization ensures that the appraisal will be performed in accordance with the applicable professional standards.
This is the effective date of the determination of value. This date dictates what relevant facts can and cannot be considered in appraisal process. The choice is critical because it can determine whether or not the triggering event itself can be considered. In the case of an unanticipated loss of a key person, whether the valuation date is the month-end preceding or subsequent to the triggering event could have a dramatic impact on the price determination. Further, even though certain events can be reasonably anticipated, their timing and probability of occurrence may not be known with any certainty.
Standard of Value
“Value” has many meanings. While it seems trivial, the difference between “fair value” and “fair market value” can be considerable. Business appraisal is not a one-size-fits-all proposition – the desired standard of value is critical to a successful appraisal process. I have read many Buy/Sell Agreements that call for “book value.” The fact is that book value is not a standard of value, but rather an approach to value; and, is not appropriate for all situations and certainly not all types of businesses. I suggest that in most cases the Buy/Sell Agreement stipulate the standard of Fair Market Value and let the professional appraiser determine the most appropriate valuation approach.
Basis of Value
In the world of business appraisal, there is a quantifiable difference between a pro rata share of the value of a business and the value of an interest in a business – especially if the business interest is less than a controlling ownership interest (50% or less). While the mechanics of the appraisal process tend to get a bit technical, suffice it to say that it is important to indicate the basis of value to be used in determining the price of each respective party’s shares or membership interests.
While the funding of the Buy/Sell Agreement doesn’t necessarily affect the appraisal process, there is some interrelationship between the two. Typical funding mechanisms include life insurance and/or promissory notes. Other options are cash (accumulated over a period of time) and external financing. The appraisal process can help determine which options are most affordable and under what specific terms. In respect to life insurance, the Buy/Sell Agreement should indicate whether any proceeds are treated as company assets (i.e. included in the value of the company). This decision can have a substantial impact on the determination of price.
Conclusion – Avoid Conflict and Confusion
If your company does not have a Buy/Sell Agreement, put one in place now. If you have an existing agreement, have it reviewed today. In addition to a legal review, engage a professional business valuation consultant to review your Buy/Sell Agreement to identify any potential areas of concern. Better yet, “test drive” your Buy/Sell Agreement by having your company appraised now. It will be much easier to address any issues before an actual triggering event than afterwards under possible adverse circumstances.
Donald Parker is a guest columnist for the Legal Checkup Blog. See his website here.
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