Oftentimes, businesses encounter problems and unforeseen operating and administrative issues at the entrance and exit of an equity owner. Many of these problems and issues can be avoided, however, if close attention is paid to the construction of a sound buy/sell agreement.
It is critically important that businesses with more than one owner have a well-written and well-thought-out buy/sell agreement specifying, as much as possible, what happens when an owner enters or withdraws from the business. A buy/sell agreement is most often fashioned as a contract between the owners (or the owners and the business entity itself) that establishes rules and restrictions applicable to changes in ownership.
The typical buy/sell agreement provides that an owner’s interest in the business will be sold (or at least offered for sale) at a specified price to the other owners and/or to the business entity itself upon the occurrence of specified events. This prevents unwanted persons from becoming members of the ownership group and ensures a ready market for closely-held ownership interests. It also provides liquidity to a deceased owner’s family and assures the remaining owners that they will be able to continue the business without interference from the family of the deceased owner. Buy/sell agreements also offer estate planning benefits by establishing a value for the business prior to an owner’s death. Finally, an effective buy/sell agreement can be a useful tool in succession planning.
A critical provision in any buy/sell agreement is one setting out the methods selected to establish value. Common methods for determining the purchase price under a buy/sell agreement include 1) establishing a fixed price in the contract, 2) requiring an independent appraisal, or 3) specifying a formula such as a percentage of book value. One recent survey of attorneys shows the most prevalent means recommended for determining the value upon a triggering event is to have a business valuation professional perform the valuation (according to 43% of the responders). Second and third choices cited were a formulaic method set out in the agreement (39%) and using a predetermined fixed price (17%). Clearly, no methodology can provide more accurate outcomes than using an independent business valuator to determine value at the appropriate date.
Events that trigger a buy/sell agreement are specified by the owners in the contract. Generally, buy/sell agreements are triggered by circumstances that might cause an owner to dispose of an ownership interest, such as death, disability, bankruptcy, or retirement.
At inception, and while the business is running smoothly, few equity owners exhibit concern for inbound and exiting equity owners. However, waiting for the smooth ride to become bumpy before addressing this important issue can be a big mistake. The best time to establish a buy/sell agreement is before a problem develops.
If you currently do not have a buy/sell agreement for your business, GYF’s Business Valuation Group would be happy to discuss the merits and help you and your attorney in formulating the terms of the agreement. If you already have a buy/sell agreement in place, we can review it with you to ensure that it is current and includes appropriate provisions to protect you in the event of an ownership change.
Please email Bob Grossman or Melissa Bizyak or call 412-338-9300 discuss this matter further.
