When a co-owner departs a business, a responsibly drafted buy-sell agreement is crucial for ensuring that all parties are pleased with the value of the company and the financial terms of the co-owner’s departure. Otherwise, unwanted shareholder disputes and costly litigation are likely to arise. Buy-sell agreements are frequently worded in such a way that professional valuators as well as business owners can interpret the document differently, thus creating an unsatisfactory valuation and a need for litigation. Avoid these pitfalls by choosing the appropriate type of agreement and using clear, precise language that is not open to interpretation.
While the concepts and language used in an agreement will determine its effectiveness, there are three basic types of buy-sell agreements: fixed price, formula and process – and it pays to know which is best for you. If written well, the process agreement is the most effective type, though this article will only discuss fixed price and formula agreements. (Be on the lookout for “Co-Owner Leaving the Biz?” Part II for tips that could help you dodge costly litigation and shareholder disputes.)
The Fixed Price Agreement
Fixed price buy-sell agreements are made between the co-owners based upon what they think is the value of the business. They are generally easy to understand, write and negotiate. A business valuation professional is not needed to value the business in this type of agreement because the owners themselves determine the current value. Unfortunately, the assessed value is outdated almost as soon as the agreement is signed. Additionally, fixed price agreements usually call for an update every year or two. In reality, the price is seldom updated, even after many years have passed, and frequently the price is not even looked at until a triggering event occurs. At that point, negotiations may no longer be possible, making fixed price agreements dangerous to use and likely to result in a value that is unfair to at least one of the parties.
The Formula Agreement
Formula buy-sell agreements are usually agreed upon given the state of the economy and the company’s industry at the time they are drafted. However, changes can impact the appropriate value relative to any set formula. In addition, formula buy-sell agreements are fraught with definitional issues. They are based on historical numbers, do not allow for unusual one-time events, and can be subject to multiple interpretations.
To illustrate, let’s take a look at two possible formula buy-sell agreement examples (there are other possibilities as well):
1. Multiple of earnings before interest, taxes, depreciation and amortization (EBITDA)
If the agreement language states that the value will be, for example, five times EBITDA, does the agreement state whether debt should be subtracted or not? In valuation theory, debt is deducted because the EBITDA earnings stream flows to both interest-bearing debt holders as well as equity holders. If the agreement is silent regarding how debt is handled, the result is usually a higher value than can be economically justified, which could create a major dispute. If you decide to use some multiple of earnings, be specific, with as little room for interpretation as possible.
2. Two times Book Value
What if the company keeps its books on a cash basis and there are significant accounts receivable, inventory and accounts payable? Or, what if there is real estate that has appreciated (or depreciated) significantly from book value? The result of a two times book value agreement could be unfair to some of the owners, which may tempt them to move toward litigation.
Sometimes an agreement will say “in accordance with generally accepted accounting principles” (GAAP). This is a bit more specific, but GAAP does not measure changes in economic value. Furthermore, GAAP has gone through significant changes over the past several years and may no longer reflect the original intent of the owners, which means it is no guarantee that the valuation produced will be satisfactory.
The ultimate pitfall of formula agreements is that once prepared, they are usually not updated to reflect the current environment. Situations and conditions change, and if the agreement does not allow for that, unexpected results can occur. The best way to ensure your formula agreement will produce a valuation that pleases all parties is to update the agreement at least annually and make sure the formula’s language is as clear and specific as possible.
If you are unsure which type of buy-sell agreement is best for your business or if it’s time to update your current agreement, contact Royce at (626) 857-7300 or RStutzman@vicenticpas.com. Royce can work with your attorney to determine the best next steps for your buy-sell agreement.
Royce Stutzman, CPA/ABV, CVA is Chairman and leader of the Valuation Group at Vicenti, Lloyd & Stutzman LLP, a 59-year CPA and business consulting firm in Glendora. You can hear a recent webinar on effective buy-sell agreements presented by Royce.
Originally published by Manufacturing Executive Institute at http://www.mfgexecutive.com/Resources/WhitePapers/CorporateGovernance/tabid/117/Default.aspx