Many business owners realize the importance of having buy-sell agreements in place for their closely held businesses, but few realize the problems that can arise if these agreements have not been properly thought out. Failing to clearly define how the value is to be determined, and how often, can lead to disputes that may undo the benefit of having the agreement in place.
A buy-sell agreement is a powerful tool to help control the future of a business.
By contractually determining what happens to the company stock after a triggering event, it can help avoid shareholder disputes and can also solve the owners’ estate planning problems.
Consider All Possible Triggers
Most people are familiar with having a shareholder’s death trigger a buy-sell agreement, but they often fail to consider other events that can have an effect on the future of the business, such as when:
An owner or shareholder becomes disabled;
Married owners or shareholders divorce;
A minority owner is fired;
An owner faces personal bankruptcy; or
An owner is convicted of a crime or involved in a scandal.
But a poorly thought-out buy-sell agreement may cause more problems than it solves. Let’s take a look at some common issues often overlooked when drafting buy-sell agreements.
How Do You Find the Value?
There is no single, surefire method of determining the price, nor is the price necessarily the same in all situations. But having a well thought out and regularly updated valuation of the business is essential. Owners can set a price in a number of ways:
Objective Formula – Many people like having a formula they can generally apply with some degree of certainty. While a formula has the advantage of being objective, it can pose difficulties because it may not capture the many subjective factors involved in arriving at a value.
For example, how can upward or downward trends be considered in a formula based on a percentage of just one year’s revenue? Is net income considered before or after taxes? Failing to look at these questions when you draft your agreement adds to the complexity and expense of applying the formula when the agreement is triggered.
Independent Appraisal – Because so many issues cannot be captured by objective measures, many owners agree to use fair market value for the purchase price. Usually, they select one or more outside appraisers to find the company’s fair market value.
If you choose this route, address how you will select the business appraiser(s) and how many you will engage. If you are using more than one appraiser and they disagree, which result will you use? Your forensic accountant can be your representative in this process and be appointed a one of these appraisers.
Agreement by Parties – If feasible given the situation and personalities involved, you may want to have all of the owners meet periodically and agree to a value. The ownership group may decide on a formula or outside advisors to help determine the price in order for there to be an agreement on the value to be used for the buy-sell agreement.
But what if the last time everyone agreed to the value was six years ago? Since then, the business may have changed dramatically. You may want to include a stopgap measure that says, for instance, if the parties have not agreed to a value for 18 months or more, the prior value should be automatically re-calculated and adjustments that account for the changes in the business.
Act Now To Secure the Future
It would be wonderful if the future just took care of itself. But in the case of buy-sell agreements, the future depends on how you act today. Carefully crafting a buy-sell agreement for your business now will ensure that the future won’t pose problems you aren’t prepared to face.
David Fox has been a CPA for more than 25 years. He has ample experience as an expert witness for divorce cases, and he also holds a law degree. Located in West Los Angeles, he travels all over southern California for cases.