Avoiding the pitfalls and finding peace of mind
The title of this article doesn’t sound quite right, does it? The purpose of buy-sell agreements is to provide peace-of-mind for shareholders. In theory, these “agreements” should provide relatively easy business transitions from one shareholder to another.
Often, however, these well-intentioned documents fail business owners in highly emotional times (death, divorce, disability, retirement, etc.) and provide anything but peace. The agreements frequently contain incorrect and/or confusing language and/or outdated formulas. Given these problems, there is little wonder that some of these transactions end up in litigation where business transitions are never easy and peace-of-mind is rarely attained.
There are generally three types of buy-sell “agreements”:
- Fixed price agreements,
- Formula agreements, and
- Process agreements.
Fixed price is simple enough. Upon a triggering event (such as retirement), “Mr. Shareholder will be bought out at $500,000” is an example of a fixed price agreement. Its big advantage is its simplicity, and the fact that it eliminates uncertainty in highly emotional times. However, the fixed price probably becomes out-of-date the day after it was written. Therefore, when a triggering event occurs, either the buyer or the seller will be happy, but probably not both.
I have seen far too many buy-sell “agreements” morph into buy-litigate-sell disagreements. This is not what you or the company needs…
A formula agreement may be written as “Ms. Shareholder will be bought out at four times earnings times the appropriate ownership percentage.” Not as simple as the fixed price agreement, but simple enough. Or is it?
How do you define earnings? Is it net income, earnings before interest and taxes (EBIT), earnings before interest taxes depreciation and amortization (EBITDA), operating earnings or earnings before tax, etc.? Should the earnings be normalized? Is it the latest twelve months earnings, the last fiscal year’s earnings or the last calendar year’s earnings?
In times of stress isn’t it likely that two shareholders (the buyer and the seller) may view the earnings a little bit differently? You bet! I have seen far too many buy-sell “agreements” morph into buy-litigate-sell disagreements. This is not what you or the company needs, especially during transition periods such as death, divorce, disability or retirement.
Moreover, even if 4 times earnings represents market value today, will it represent market value a year from now when a triggering event occurs? Probably not. So again, either the buyer will be happy or the seller (or the seller’s estate, to the extent possible) will be happy, but probably not both.
It is crucial for corporate attorneys and business owners to consult with business appraisers in drafting these “formulas” to eliminate as much of the surrounding subjectivity as possible. Appraisers must carefully assess each word individually, and in aggregate, to ensure the agreement is well-crafted, explicit, detailed, and irrefutable – to the extent that it is possible in business valuation to avoid costly unintended consequences.
The last type of agreement is the process agreement. The following is an example of a process agreement, “Mr. Shareholder will be bought out at the fair market value of his shares as determined by a credentialed business valuation appraiser.” Fair market value (FMV) implies discounts for lack of control and lack of marketability, if appropriate. If shareholders would rather not take discounts, this can also be stated in the agreement.
What are the disadvantages of this type of agreement? There is no known take-out price or even a known formula. We have uncertainty. Uncertainty, as previously discussed, is not a good thing.
What are the benefits? The FMV should keep up with changing market conditions. Theoretically, both buyer and seller should be happy as the price is fair. Recognizing that valuation is part art and part science, sometimes these process agreements are written where the buyer has an appraiser and the seller has a different appraiser to perform the valuation. This is OK too, but more expensive for all involved. The agreement may then call for an average of the two conclusions, or possibly to bring in a third appraiser to settle the score if the first two appraisals are materially different. Does the third appraiser settle the score so to speak or does his/her conclusion then also get averaged in? As you can see if companies are not careful, this process can get incredibly unwieldy and exorbitantly expensive.
Can a firm eliminate some (but not all) of the uncertainty related to the scenario described above? You bet! A firm could obtain a valuation at the end of every year for example. If a triggering event occurs in the next year, then the valuation conclusion would be the take-out price. If valuations were obtained every year, it would create a nice historical record of progress that all shareholders could see. If perchance, anyone had an issue or did not agree with the valuation conclusion, then shareholders could discuss it before the emotion of a triggering event is facing them.
Moreover, one of the hidden gems of any business valuation is the opportunity to understand that if your business is worth $1 million today, you may be able to see how you could make it worth $2 million tomorrow by eliminating some risks uncovered in the valuation. So, shareholders could eliminate some uncertainty and gain a roadmap to build value with more frequent valuations.
There is one other important component of buy-sell agreements that I have not mentioned yet. That is life insurance. How you handle life insurance can have drastic repercussions on the buyer, the seller and the company. That will be discussed in future articles.