Why businesses should prioritize buy-sell agreements
By: Audra M. Moncur, CPA, ABV, Partner, Business Valuation and Transaction Support Services
It’s easy for business owners to overlook buy-sell agreements. Some businesses may think they’re too small to need one. Others may have agreements, but they haven’t kept them current.
But for any business with multiple owners, having an updated buy-sell agreement should be a priority.
The purpose of a buy-sell agreement is to protect your interests and your business against the unpredictability of life. You can’t know if you or another owner will go bankrupt, want to sell, or be rendered incapable of operating the business.
In those instances, you need a plan. A well-crafted agreement helps ensure the transition is smoother for your business and that you get the value and the rights associated with your interests.
What triggers a buy-sell agreement?
Buy-sell agreements are usually triggered when an event leaves one partner unwilling or unable to participate in the business.
Some examples include:
- Death.
- Divorce.
- Mental or physical disability.
- Resignation.
- Termination.
But they can also be triggered by more routine circumstances, such as retirement or an interested third-party buyer.
How do you structure a buy-sell agreement?
How to structure your buy-sell agreement depends on the needs of your business. However, there are four key provisions that you can include to help ensure that your agreement is effective:
1. Method for determining the purchase price
There are three common ways you can determine the purchase price in a buy-sell agreement:
- Fixed price
- Agreed-upon formula
- Valuation performed by a qualified business appraiser
With a fixed price, the agreement includes a set price at which buying or selling will take place. This is often an attractive option because it’s inexpensive and easy to implement.
However, fixed prices are quick to fall out of date, resulting in a value that may not match the economic reality of your business when the deal is triggered. It can also be challenging for business owners to negotiate a set price.
Agreed-upon formula is another inexpensive option that’s easy to implement, but it carries more ambiguity. With this option, the agreement specifies a formula that will be used at the time the agreement is triggered.
This helps eliminate some of the potential struggles with negotiating a price. But how to apply the formula can be vague, with certain parts such as the book value or definition of earnings being open to interpretation. And the resulting price may not be representative of market value.
For a more accurate price in terms of market value, valuations are a better option. Valuations result in an unambiguous conclusion of value that will most closely reflect economic reality. But the terms of valuations can also be vague and lead to challenging negotiations if you’re not careful.
If you choose to use the valuation method, you will need to clearly define the following in your buy-sell agreement:
- Standard of value: Options include fair market value, investment value, intrinsic value, and fair value.
- Level of value considerations: Include factors that can increase or decrease the price set by the valuation, such as cash flow assumptions, nonoperating assets and liabilities, control premiums, minority discounts, and marketability discounts.
- Valuation date: Indicate whether the valuation date is tied to the date of a triggering event such as a death, retirement, or separation.
- Appraiser qualifications and appraisal standards: Specify the standards for the person who will be allowed to do the appraisal. This can be a general set of hiring requirements or you can specify a particular individual.
- Scope and methodology: Determine whether you will require a calculation or valuation. Valuations are more comprehensive, but calculations are cheaper and less burdensome.
2. Funding and terms of purchase
Apart from determining the price, it’s important to establish how the purchase will be funded. For example, you can use a life insurance policy as part of the funding in the event of an owner’s death.
You can also establish terms as for how the purchase will occur, such as opting to complete it over a set number of years.
3. Employment and noncompete clause
A good agreement should plan for the event in which an owner leaves for a competing post, whether through resignation or termination. In these cases, there are several provisions you can include.
For example, the redemption amount could be impacted by the departing owner’s willingness and ability to compete with their former company. You could also set up terms that indicate a former owner will not be able to compete for a certain number of years.
But be aware that a noncompete can present legal challenges and may not even be allowed depending on the state. If you choose to include it in your agreement, work with the appropriate parties to help ensure it is structured correctly.
4. Restrictions on transfer and right of first refusal clause
Another important provision to include is rights regarding potential third-party sales. With the right of first refusal clause, you can limit the ability of a third party to come and take ownership interest in a company. Alternatively, admission approval provisions can define the circumstances in which a third-party sale would be accepted.
How Wipfli can help
Wipfli is here to help you protect your ownership rights and prepare for uncertainty. Our knowledgeable team can help answer questions about setting up a buy-sell agreement that fits the unique needs of your business.
Contact us today to learn more.
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