Buy-sell agreements protect businesses with multiple owners in the event that an owner dies, becomes disabled or voluntarily decides to leave the company. They should dictate who can buy the departing owner’s interest, when, how and for how much. Ideally, these contracts are drawn up when a business is launched, but they can always be entered into — or modified — later on.
Sooner is better than later when it comes to buy-sells. Comprehensive agreements provide certainty when the unexpected strikes, and establish a reasonable buyout plan while the parties are still on amicable terms. Disputing owners seldom agree on buyout price and terms.
A comprehensive buy-sell agreement addresses more than legal and tax considerations. It also answers questions related to valuation issues, such as:
Hiring an Appraiser
How many appraisers should value the departing owner’s interest? Some owners prefer to use one joint appraiser or hire an appraiser under the company’s name. Other buy-sells permit each owner to hire his or her own appraiser. If the two appraisers arrive at divergent conclusions of value — of, say, 20 percent or more — the buy-sell may call for a third expert to resolve the difference.
Who fronts the retainer and pays the appraisal fees? Often the company funds the retainer to expedite the process, but shareholders may be expected to reimburse the company for appraisal fees.
Who is the preferred appraiser? Some buy-sells name a specific valuator (or firm) to appraise a departing owner’s interest. Pre-screening appraisal candidates helps facilitate the valuation process if an unexpected event suddenly triggers the buy-sell.
Definition of Value
What’s the appropriate standard of value? Fair market value — as defined by IRS Revenue Ruling 59-60 — is the most common standard of value. But, by using this term, the owner may be bound by tax court precedent when buying out a departing owner. Instead, some buy-sell agreements require buyouts to occur at fair value, which the agreement may define as the interest’s pro rata share of the business’s value on a controlling basis.
Do valuation discounts and adjustments apply? These are some of the most contentious issues when parties to a lawsuit disagree about the value of a business interest. Comprehensive buy-sells iron out these details before disputes occur by specifying which discounts — marketability, control, swing vote, key person, etc. — and which types of financial statement adjustments — unusual, non-operating, related party payments, above — or below-market owners’ compensation, etc. — apply. They also may prescribe a preset amount or methodology for quantifying discounts and adjustments.
[Note: The existence of a buy-sell agreement may, in turn, affect the magnitude of a company’s discount for lack of marketability. On one hand, a buy-sell provision effectively creates a “market” on which owners may sell their interests. This makes an interest more marketable. On the other hand, a buy-sell agreement may also restrict transfers of ownership interests to unrelated parties, which can make an interest less marketable.]
Do different standards of value apply to different triggering event or ownership blocks? Owners may, for example, decide that the death of an owner warrants a higher buyout price than the bankruptcy of an owner. Or they may decide that a 2 percent interest warrants a discount for lack of control, but a 30 percent does not.
What’s the appraisal timeline? When an owner dies, his or her estate may argue that the remaining owners are unnecessarily dragging out the appraisal process to delay a buyout. The buy-sell agreement may prescribe a timeframe for valuing the business interest.
What’s the “as of” date for the valuation? If an owner dies, the date of death or the alternate appraisal date (six months later) may be used. Different triggering events may warrant different “as of” (or effective) dates. In a volatile market, the value may differ significantly from one appraisal date to another.
What’s the appropriate reporting format? Estate tax filings may require a comprehensive written appraisal report to satisfy the IRS’s adequate disclosure requirements. Written reports are also important if the owners are fighting over the buyout in court. But a letter or verbal reporting format may suffice for amicable buyouts.
Are there any scope limitations? Usually, appraisers perform a full valuation for buy-sell purposes. But some shareholders opt to prescribe an industry rule of thumb or a specific appraisal method to expedite the appraisal process. Scope limitations result in a “indication of value” (as opposed to a “conclusion of value”) that probably won’t survive courtroom or IRS scrutiny, however.
How will the buyout occur? Sometimes the company buys the departing owner’s interest; other times the remaining owner(s) purchase the departing owner’s interest. For voluntary departures, some buy-sell agreements call for noncompete contracts, earnouts and/or ongoing consulting agreements. A valuator can help owners understand the typical deal terms in the company’s industry, which may vary over time depending on the prevailing market conditions.
Will installment sales require interest payment? Appraisers determine a cash-equivalent price, but sometimes owners prefer buyouts to occur over time for tax and cash flow purposes. If interest is charged, the buy-sell may prescribe a reasonable interest rate.
Will buyouts be funded by key person life insurance policies? Life insurance proceeds are free of federal income tax, as long as the surviving owner was the original purchaser of the policy on the deceased owner. Things get more complicated if there are more than two owners, because each owner must buy policies on all the other owners’ lives. A valuation professional can help ensure that each owner’s cumulative life insurance coverage is sufficient to buy out his or her interest.
These questions provide a sampling of the relevant valuation issues that come up during shareholder buyouts. Because market conditions change over time, it’s important to review these questions regularly to determine whether the company’s buy-sell agreement needs to be updated. Periodic appraisal updates also help owners gauge what their interests are worth, thereby avoiding surprises when a triggering event occurs.
Michael Harvey is our business valuation and litigation support expert and he’s here to answer your questions.