Valuation Methods in Buy-Sell Agreements

Regardless of what circumstances trigger a company’s responsibility to purchase an exiting shareholder’s interest, if no valuation method is provided, then the Buy-Sell is meaningless.

Buy-Sell Agreements are effective tools for governing the process surrounding a business partner's exit from the business. A good Buy-Sell will remove uncertainty by expressly listing what circumstances will lead to the purchase of the exiting shareholder's share by either the company or its other shareholders; or the Buy-Sell may provide a specific process the exiting shareholder must undertake in order to sell the shares to a third party. These circumstances--called "triggering events"--usually include death, disability, divorce, disagreement, and retirement, among others. For a better understanding of what options are available to address different triggering events, check out this blog.

But regardless of the triggering events in a Buy-Sell or the methods for handling them, one of the most important parts of a Buy-Sell is addressing how the departing shareholder's interest will be valued. Because of the conflicting interests held by Buyer and Seller, waiting until a triggering event happens to determine how to value the Seller's interest will lead to unnecessary conflict.  Furthermore, because the purpose of a Buy-Sell is to remove uncertainty, emotion, and contention from the exit process, failing to provide for how the Seller's interest will be valued essentially makes the Buy-Sell worthless. Requiring the business to purchase one’s interest is no victory if the parties must then fight over the price.

There are three primary valuation methods used in Buy-Sell Agreements. The first and least complicated method is a fixed price agreement. Under this arrangement, all owners agree on a price at the time the Buy-Sell is executed. The advantages of such a plan are its simplicity and ease of negotiating the purchase price.  Also, because of the simplicity, this approach is inexpensive.  However, owners who take this approach must beware its simplicity lest they forget to update the purchase price over time. As the value of the business changes, so should the agreed-upon purchase price of the shares. Owners taking this approach should renegotiate the price regularly (annually; every X years; whenever there’s a substantial rise or fall in the business, etc.). What typically happens under this approach is the business owners fail to update the purchase price, and when a triggering event happens, the predetermined purchase price is no longer a good representation of what the departing owner’s interest is actually worth. The company either pays too much or too little.

The next approach is a formula agreement, which involves the owners agreeing on a formula that will be used to calculate the price of the business once a triggering event occurs. Such formulas often use a multiple of earnings or book value of the business. This method, too, has advantages and disadvantages. While a formula appears to be objective, fair, and easily applied, it too should change alongside the business. If the business or industry undergoes changes, the formula may no longer be realistic. For instance, if the business model changes from being a product-based company to a service-based company, then a valuation formula that relies on book value (i.e. inventory, equipment, etc.) may no longer make sense.

Finally, the most precise valuation method lies in process agreements, by which each owner agrees to the use of appraisers to set the price for the business upon the occurrence of a triggering event.  The hard part for this is determining which appraisers will perform the appraisals, and when those appraisers are selected (i.e. at the time the Buy-Sell is drafted vs. at the time of the triggering event).  While this method is reliable and likely provides the most accurate valuation, appraisals can be costly and can take a long time to complete. Furthermore, if the process agreement provision of the Buy-Sell provides for second and third opinions, then those fees add up. This method does not make sense for smaller businesses—the appraisal fees may severely undercut the value of the departing shareholder’s interest to be purchased. Also, the use of a third-party appraisal removes predictability of the business’s value.

Which valuation method to employ in your business’s Buy-Sell Agreement will depend on several factors, including the business’s cash flow, the desired level of predictability of the business’s value, and the desired level of simplicity of the Buy-Sell..

For assistance in deciding which method to use in your business’s Buy-Sell or any other business agreements contact one of our Sioux City, Sioux Falls, or Omaha attorneys today.