Updating Valuations for Buy-Sell Agreements

Philadelphia PA Business Planning Attorneys

The purpose of a Buy-Sell Agreement is to provide for the triggering events upon which one shareholder, member or partner in a business has the right or option to buy another shareholder, member or partner’s interest in the business. The triggering events usually include the death, disability, bankruptcy, incompetency, sale to third party, termination of employment, retirement, or estrangement of an owner. Other details of a Buy-Sell Agreement include the terms, conditions and manner of payment, who the departing owner has a right or option to transfer his interest to, how the acquisition will be funded and most importantly how the ownership interest will be valued. However, if the terms of the Buy-Sell Agreement do not provide for regular update of the valuation of the business or the procedure for updating the valuation, the benefits of having a Buy-Sell Agreement can be severely limited. If a triggering event occurs and the only valuation agreed upon by the owners is stale and the value of the business has changed significantly, at least one of the owners will be seriously disadvantaged and prejudiced.

Buy-Sell Agreements often reference a fixed sum or a certain formula for determining the purchase price whenever a buyout is triggered. The problem is that Buy-Sell Agreements are often agreed upon at the inception of the business and may then be put aside for many years, until a triggering event occurs. At that point, the value of the business is often drastically different and the valuation or valuation method is therefore completely inaccurate and incorrect.

Periodic Revaluations

One option is for the business to be re-valued on an annual basis. This can be done by an agreement of the owners of the business and become part of the Buy-Sell Agreement as an exhibit. If the valuation is more complex, because of the size and variables of the business and a professional valuation is too costly to obtain annually or bi-annually, it can be agreed by the owners that a professional valuation be performed if a triggering event occurs by a pre-determined professional, independent valuation firm. It should be further agreed in advance that in determining the fair market value of a shareholder/member/partner’s interest whether the appraiser should or should not apply a premium for control or discount for lack of control, lack of marketability, minority interest status, or the absence of a market for the selling owner’s interest in the business. For instance, does an anticipated majority interest in a business after the buyout represent a 25% premium for the selling owner’s interest or should the lack of marketability for a 25% minority interest present a 30% discount in the fair market value for a selling owner’s interest. Such issues cause honest disagreements even between business appraisers in certain situations and will normally cause discord between or among owners. Failure to clearly define, describe or stipulate the valuation assumptions may result in dissimilar, diverse and inconsistent valuations leading to discord and disputes resulting in costly and time consuming litigation.

Revaluation Upon Triggering Event

Although it may seem like an unnecessary expense to have a business professionally valued upon a triggering event, it is normally in the best interest of the owners. A professional valuation normally results in the most reasonable estimate of fair market value for which the purchase price may be determined provided the parties to the agreement stipulate the necessary assumptions for premiums, discounts and the financials reporting considerations such as the previous 36, 24, 12, 6 or 3 months.

Another option to protect the selling or buying shareholder/member/partner from being held to an inaccurate valuation is for the agreement to require the parties themselves to negotiate an agreed upon price upon the occurrence of a triggering event. However, in all instances this may not be in the best interest of the parties. While this method has the potential benefit of providing the most up to date valuation of the business and the cheapest costs, it also has drawbacks. Part of the problem with revaluing the business immediately prior to sale is that the dynamics among the owners may no longer be as amicable as they once were. Alternatively, surviving owners may find themselves negotiating with the heirs of an estate or the divorce lawyer of the selling owner’s spouse. Because of the stress attendant to these circumstances, it is possible that the valuation of the business interest could be a subject of considerable discord and devolve into litigation. In this instance, this office normally recommends that if the parties cannot agree on the fair market value of the selling parties’ interest within 15 to 30 days, the business is valued by a predetermined, independent, valuation firm.

Sometimes a Buy-Sell Agreement will provide that the re-valuation of the business will be done according to a formula. However, the formula valuation method that might be appropriate for a start-up business, such as basing the valuation on the “book value” of the business or a fixed multiple of EBITDA, may not be appropriate for an established business that has history of substantial profits or which is expected to continue to grow substantially in the foreseeable future. Even when a more sophisticated valuation formula is required by the Buy-Sell Agreement, it would not take into account the different purposes for which a valuation might be done. If an owner’s interest is being transferred to his family as part of his estate plan, a lower valuation is generally more desirable so that less Federal Estate and Gift Tax is due upon the transaction. In contrast, if one of the owners is retiring or being forced to retire and the valuation is being done to provide him with funds for his retirement, he will want the highest valuation possible. Moreover, the multiple may not take into account 10 years of immediate past sweat and labor with a major new product or account coming to market or fruition within the next 12 months.

Conclusion

If you decide to use a fixed-price valuation, it is imperative that the valuation be kept up to date. While it may not be necessary to re-value the business every single year, you could include language that says a fixed price valuation is void after 18 to 24 months unless the owners agree that the valuation still reflects the fair market value of the business or agree upon a new value. Otherwise, your estate or surviving family members may only receive a value for your interest in the business that is absolute outdated. If the owners do not take action to update or confirm the fair market value of the company, a strongly recommended alternate valuation method can be used, whether it is a formula or a professional, independent business appraiser with expertise within your field of business, industry or local/region with specific valuation experience and/or credentials. At a minimum, an annual “checkup” of your buy-sell agreement is mandatory to ensure it meets your business and estate planning needs and to avoid costly and time-consuming litigation.

If you have questions about drafting or updating valuations for Buy-Sell Agreements, our experienced Philadelphia PA Business Planning Attorneys can help.