A buy-sell agreement is among business owners’ most important documents. Often incorporated into an operating agreement, a buy-sell agreement dictates the terms of transfer for a departing owner’s interest in the company.
Among the legally binding provisions in a buy-sell agreement is a description of triggering events such as resignation, termination, retirement, death, disability, divorce, and personal bankruptcy. The agreement may also restrict who can buy a departing owner’s interest.
Frequently, the agreement also identifies the funding mechanism for the transfer. Typical funding mechanisms include life insurance, company cash, or a loan from the selling owner.
While there are many interesting issues to contemplate when drafting a buy-sell agreement, the valuation clause is among the most consequential. The goal of the valuation clause should be to satisfy both parties—the selling owner and the remaining shareholders. This clause defines how the departing owner’s interest will be valued. It may also identify payment terms.
Fixed price: This approach is straightforward, but as the business matures the fixed price will become almost immediately outdated and will otherwise need to be updated regularly.
Formula: Like a fixed price, using a formula is problematic because as the business matures and capital markets change, the formula must be updated regularly. If not, once again, one side wins and the other loses.
Shotgun: Using this approach, one party offers to buy or sell, and the other party has to sell or buy under those terms. Though it sounds efficient, this approach doesn’t account for differences in negotiating positions. For example, a 10 percent owner may not have the resources of a 90 percent owner. As a result, this approach is likely to result in an unsatisfactory number for one side.
Process: This approach is the most likely to result in an equitable outcome because it accommodates the dynamic nature of businesses and capital markets. It defines the standard, premise, and level of the valuation, which leads to an outcome based on current business conditions.
Best practices under this approach suggest that a valuation be done at the time the agreement is signed, with regular valuation updates scheduled, typically every year or every other year. Updates are less time consuming and less expensive because the parties are already familiar with the process and people involved.
To ensure consistency, the professional or firm performing the valuation should be named in the buy-sell document.
Following the “process” approach establishes a current baseline value and allows the owners to negotiate inputs to the process rather than argue about outputs from the process.
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Buy-sell agreements are legal documents drafted by attorneys. Valuation professionals can help attorneys draft thorough buy-sell agreements by providing complementary expertise that yields the most equitable results and satisfies both parties.