Is a Formula the Formula for Success in Buy-Sell Agreements?

Buy-sell agreements can be an afterthought for many business owners.  After all, buy-sell agreements are only triggered when certain events occur, including but not limited to, the death or disability of one of the owners.  Since people tend to avoid thinking about their own demise at all costs, do we really need to talk about it with our partners or fellow shareholders?  Despite the typical owner’s insistence on cheating death for the rest of eternity, buy-sell agreements are important to consider for estate planning purposes and also come into play when a business owner wants to sell her shares.  A lack of understanding on how a buy-sell agreement functions can be extremely detrimental to a business owner or her estate.  A grim start to the blog, but it can only go up from here!

An important piece of the buy-sell agreement is the determination of the value of the business at the time the agreement is triggered.  If a dispute arises, and an owner wants to sell her shares, it is imperative that all parties involved know how the business’ value is going to be calculated.  The easiest answer to this is a simple formula.  The buy-sell agreement can say that at the time the agreement is triggered, we take a multiple of prior years earnings before interest, tax, depreciation and amortization (“EBITDA”) and boom, we have our value.  Not so fast, my friend!  This is where we can get into some trouble.  Is a formula the best way to determine business value for your buy-sell agreement?

Buy-sell agreements and how business valuation can help

Let’s look at an example:

The buy-sell agreement for XYZ Corp. was signed by all three owners in 1999.  XYZ Corp. owns a fleet of taxicabs that operate in a few upstate New York cities.  The buy-sell agreement states that if an event occurs causing the agreement to trigger, the company’s value will be calculated based on a 4x multiple of the prior year’s earnings.  The company has operated for the last 20 years without a hitch, until one of the owners wants out in 2019.  How much has the economy and specifically, the taxi industry, changed in the last 20 years?  Does the 4x multiple that was thought up in 1999 include the threat of ride-sharing services such as Uber and Lyft?  Can we be sure that the 4x multiple is still appropriate?  This is just the start.

The remaining owners know that a 4x multiple is too high, given the additional risks that have come about since the buy-sell agreement was signed two decades ago.  The exiting owner wants the value that is defined in the agreement, knowing that it gives him an inflated value for his shares and more money is his pocket on the way out the door.  The remaining shareholders do not want to overpay to redeem the exiting owners share.  It is clear that the potential for litigation arises in this scenario.  Is it possible that there is a way to have avoided this mess in the first place?

What’s the ideal scenario? 

Although a formula is very easy to understand and administer, it is not the ideal solution for buy-sell agreements.  It is next to impossible for a simple formula to capture all the economic and industry risks, as well as the future earnings capacity of the business.  It is often, if not always, the best option for buy-sell agreements to require a business valuation by a qualified appraiser.  A business valuation can capture the benefits and risks associated with the business at the time the buy-sell agreement is triggered in a way that is not afforded by a simple formula.  This is the only way to ensure that all parties involved are treated fairly when it comes to the determination of value.

The ideal scenario would involve a business valuation on the date the agreement is signed.  Why does it make sense to engage an appraiser to value the business when the buy-sell agreement has not been triggered yet?  That seems like it might be a waste of money.  Although it does involve a modest expenditure upfront, it is likely to save significant money in the future for all parties as potential litigation, like that in the case of XYZ Corp., may be avoided.  The upfront valuation allows for a baseline value to be determined.  Additionally, all parties involved are privy to the valuation methodologies and procedures that the appraiser is using and the considerations of the appraiser for future valuations.  This will minimize, if not entirely avoid, valuation issues when the buy-sell agreement is triggered.  Periodic valuations will probably make sense so that all owners remain on the same page, at least annually, as to the value of the business.

Ask yourself:

When was the last time you reviewed your buy-sell agreement?  Does the agreement include the use of a formula to determine value?  Would you be willing to sell your shares for the amount stipulated by the agreement?  These are a few questions that business owners can ask themselves.  If these questions go unanswered, it may result in issues down the road.  Now may be the right time to look at your buy-sell agreement with a critical eye and Team DKB can help!