Buy-Sell Agreement Categories

/in /by Jim Leonhard

The three types of Buy-Sell Agreements (BSA) are defined by the relationship between the parties to the agreement, i.e., the individual owners and their business entity.

Cross-Purchase Agreements are agreements between and among the owners of a business entity that requires the other owner(s) to purchase the interests of owner who has triggered the BSA. Cross-purchase agreements have common elements, including:

  • Funded by life insurance owned by business owners on the lives of other owners.
  • As the number of owners and the market value of the business rises, they can become unworkable.
  • Typically individual owners are required to finance ownership shares not related to a death and they may not have that ability.

Entity-Purchase Agreements require the business entity (corporation, partnership or LLC) to purchase the owners’ interest when a trigger event occurs. The entity must then define or provide the funding to complete the transaction. The actual funding may come from the purchase of life insurance, financing from a third party or the selling owner(s), cash in the business, or some combination thereof.

Hybrid Agreements give the entity the “right of first refusal” to purchase the interests in when a trigger event happens. Should the entity decline to buy the interests, it may offer the shares to the other owners according to their current ownership percentage or to selected owners. If the entity has refused to purchase the interests initially and the other owners elect not to purchase the interests, the entity is required to purchase the interests. Funding for the purchase is often via a combination of self-financing by the business, notes payable from selling owners, and life insurance.

Proper business valuation is essential for Buy-Sell Agreements to operate the way they were intended. For more information about business valuation as an element of Buy-Sell Agreements, please contact Jim Leonhard at 916-800-2716 or jhleonhard@exitstrategiesgroup.com.

The Dismal D’s of Buy-Sell Agreements

/in , , /by Al Statz

Well-written Buy-Sell Agreements (BSA’s) enable orderly share transfers upon the occurrence of certain events during the life of a business. Buy-Sell Agreements also prevent litigation that can quickly create a lose-lose situation for business owners. This article presents a list of 27 trigger events and common issues to be addressed in Buy-Sell Agreements. And, just for fun, each item on the list begins with “D”.

Buy-sell issues are unpleasant to think about; which is why owners often put off addressing them and why we call them Dismal D’s. However, it’s only good business to put a plan in place that protects company and shareholder interests when these events occur.  And they will occur.

Buy-Sell Agreement Dismal D List

  1. Departure (quits or leaves)
  2. Disinterest (mentally but not physically leaves)
  3. Discharge (fired)
  4. Divorce
  5. Death
  6. Disagreement
  7. Deadlock (major disagreement)
  8. Disability
  9. Distress (within the business)
  10. Default (personal bankruptcy)
  11. Disqualification (licensing, regulatory, etc.)
  12. Disclose (confidentiality)
  13. Donation (donate or gift stock)
  14. Do not compete
  15. Dual entities (e.g. holding and operating)
  16. Dilution
  17. Drag-along rights
  18. Distribution policy
  19. Dividends and Distributions after a trigger
  20. Dispute resolution
  21. Death benefits (life insurance)
  22. Down payment and debt (buyout financing)
  23. Determination of value (fixed price, formula, or independent valuation)
  24. Defining elements of any valuation engagement
  25. Discounts (for minority interests)
  26. Different discounts (depending on trigger type)
  27. Dueling appraisers

Items #1-14 are common trigger events. Items #15-27 are common issues to be negotiated and addressed in the BSA. Items #22-27 are nearest and dearest to our hearts as business valuation experts. Arguably, valuation is the most important (and argued over) aspect of buy-sell transactions.

The above list is essentially a checklist for consideration by shareholders when creating or reevaluating a Buy-Sell Agreement. Owners should work with their partners, corporate attorney, CPA and business appraiser to understand and address all of these issues.  “Daunting D List” may be a better description!

Not only is it critical to have a BSA (yes, many businesses don’t have one), but it’s also vital that the BSA be kept up to date. Owners come and go. Shareholders’ personal, family and financial circumstances change over time. Likewise, businesses are not static and economic and industry conditions, services offered, customers, management depth competition are in a constant state of flux – all key factors in business valuation.

Click here for more information on how Exit Strategies’ helps with buy-sell agreements.

Business valuation plays a central role in buy-sell transactions and buy-sell agreements. Contact one of Exit Strategies’ senior advisors with any questions or for a no obligation, no cost and confidential consultation.

Your Buy-Sell Agreement – Keep It Current Before It Costs You Money and Grief!

/in , , /by Exit Strategies

Buy-Sell agreements (BSA’s) are an essential, and often overlooked, element in allowing shareholders to realize the value of their investment in a privately held company. The BSA’s purpose is to a) provide a market for ownership interests, b) establish the price and terms for these interests, c) specify a buy-sell process that is orderly and reasonable, and d) specify financing should a “trigger” event occur. There are several reasons this contract among owners can fail. Let’s briefly examine a few reasons why this can occur and it will become obvious why this document needs to “live and breathe” outside the confines of the corporate archives.

A BSA that is written upon entity formation, even if well-articulated, becomes less relevant as time marches on.  This happens for myriad reasons ranging from changes in business conditions and value, or changes in an owners personal situation or objectives. Language in BSA’s is often not sufficiently precise and leaves too much room for interpretation that can result in shareholder disputes and costly litigation that dilutes value for all shareholders.

There are three types of BSA’s: fixed price; formula pricing; and valuation process. Business valuation is a function of economic conditions and business fundamentals. Of the three BSA types, only the valuation process is flexible enough to fully accommodate the range of changes that can occur in a business. Fixed price and formula driven valuations may be less expensive to execute, but they are simplistic and can omit key value determinants that ultimately can prove very costly.

There are a wide range of trigger events where an owner may quit, be fired, retire, die, be disabled, or get divorced to name only a few. Each trigger event can alter the personal objectives of one or more owners, impact the business, and may have both control and valuation implications for all concerned parties.

Template-driven BSA’s frequently either omit, or do not make a clear distinction on the standard of value to be used in calculating value. For example, the difference between using an investment value standard or a fair market value standard can be very large. If the standard is not clear in the BSA, a buyer would naturally assume the lower price implied in the fair market value standard, while a seller would assume the higher price found in the investment value. Hence, if the BSA does not clearly address this issue, conflict and costly litigation is a likely outcome. Similarly, the level of value also has valuation implications that create potential for conflict if not clearly addressed in the BSA, because the difference between a controlling interest and a minority interests can be substantial.

As is now readily apparent, a well-defined and current BSA is important to accurately allocate value and keep the peace! Key elements of the BSA should seem reasonable to all owners BEFORE a trigger event (before the parties know if they will be a buyer or a seller), when it is easier to reach consensus. AFTER a trigger event this becomes difficult since there is an inherent conflict between a buyer and a seller.

Business valuation plays a central role in Buy-Sell Agreements. For more information about Exit Strategies’ BSA-related services contact one of our senior business appraisers.

Pro’s and Con’s of Price Formulas in Buy-Sell Agreements

/in , , /by Al Statz
Exit Strategies is regularly called upon to determine the value of closely-held company shares for buy-sell transactions. Common events that trigger a transfer of shares are when a shareholder retires or resigns from employment, is fired, dies, or becomes disabled, divorced or insolvent.
There are several facets to successful buy-sell transactions, but valuation is typically the most contested issue. The pricing method prescribed in your by-laws, shareholder, buy-sell or stock restriction agreement, as the case may be, is critical to the success of your next buy-sell transaction. Chances are your agreement (if you have one) stipulates one of these pricing approaches: a) a fixed price, b) book value, c) a formula, or d) an independent business valuation by one or more appraisers.
This article discusses the pro’s and con’s of formula pricing versus an independent valuation. Fixed price and book value are almost always bad ideas, so I won’t bother with them. Valuation formulas in the Buy-Sell agreements brought to us are usually pretty simple and look something like this:
Equity Value  =  Average EBITDA in the past two years  X  a fixed Multiple
Pro’s of a Pricing Formulapick_any_two
  1. Relatively quick and easy to calculate
  2. Inexpensive to apply
If your priority is to get to a price quickly with minimum effort and expense, congratulations, job done.
Con’s of a Pricing Formula
If however you and your partners’ want to see that all participants receive and pay a fair price, a set pricing formula misses the mark more often than not. One of the basic problems is that transactions occur sometime in the future, not when the formula is fixed, and formulas become stale as business and market conditions change over time.
Also, valuation itself is a forward-looking concept, and formulas generally use historical financial metrics. In other words, an investor ultimately cares only about what his or her return will be going forward, not what it was or would have been in the past. History is important in business valuation, but should never be entirely relied upon in determining the value of a company. As experienced business appraisers we see many companies whose future prospects are significantly better or worse than their recent past performance.
Let’s go into detail on some of the problems and solutions.
Businesses change.  A static formula can’t anticipate a change in business model.  One real-life example is a company that began life as a project-based, low margin contractor/installer of security systems, and evolved over time into a monitoring company with hundreds of annual customer contracts and high margins. Since monitoring companies trade for higher multiples than construction companies, the agreed-upon valuation formula undervalued the company when one of the owners died.  Solution: Rewrite the buy-sell agreement to require an independent valuation when a trigger event occurs.
Market conditions change.  Future market conditions are unknowable, and impossible to design into a formula. Consider the example of a real medium-size photographic processing company. With the advent of digital cameras and smart phone cameras, its film processing business was in steady decline when the founding partner wanted to retire. The pricing formula, which had been set 10 years earlier, overvalued the shares at the time of the trigger event. This led to a falling out and put a heavy burden on the remaining shareholders.  Solution: Require an independent valuation, or periodically update the formula at a minimum.
Stuff happens.  Major non-recurring events that substantially alter a company’s performance can happen at any time (think major lawsuit settlement, windfall sale, plant relocation or expansion, etc.). When such events occur during the formula’s measurement period, one side or the other gets penalized. Another issue we’ve seen many times, particularly as company owners age, is that they begin to rely on fewer and fewer major customers or suppliers for most of their business, which represents a major risk factor that won’t be accounted for in a pricing formula. For many reasons, pricing formulas can be rendered obsolete when things happen.  Solution: Have an expert evaluate the entire company at the time of the transaction.
Incomplete formula.  Most valuation formulas presented to us are too simplistic. What if, for example, the above formula was used to value an asset-intensive business — let’s say a heavy construction company. If the company had been deferring capital expenditures for several years, the formula would overvalue the company. Likewise, if it had recently replaced most of its equipment, possibly to take advantage of tax incentives, the formula would likely undervalue the company.  A formula can never be comprehensive and robust enough to capture all of the unique factors that can impact a company’s value.  I could list several dozen examples of this.  Solution: Have a seasoned appraiser thoroughly evaluate the company at the time of the transaction. If you must use a formula, have a qualified business appraiser design and update it periodically.
Formula is unclear or unfair.  Some of the pricing formulas presented to us are ambiguous in one or more significant ways; others are just plain unfair to one side or the other.  Usually the owners are completely unaware of this until a real trigger event occurs, at which point they are no longer objective. Sometimes the CPA or attorney who created the formula years ago is out of the picture or doesn’t remember what they intended.  Solution: Again, an independent valuation is the best option. Having a qualified business appraiser design and update the formula is second best. At a minimum, have your existing formula reviewed by a qualified business appraiser who can spot these types of problems and recommend improvements.
In summary, a pricing formula usually yields a share price that fails to reflect true economic value at the time of transfer; which leaves at least one party very unhappy. This is why most buy-sell agreements call for a business valuation. If you must use a formula, have it designed and reviewed periodically by a professional business appraiser for the reasons discussed here. If you have business partners and don’t have a buy-sell agreement in place, I urge you to create one now, before you are faced with a trigger event.
Business valuation plays a pivotal role in internal share transfers and all business succession plans. If I can provide additional information or advice on a current situation, please don’t hesitate to call me, Al Statz, 707-778-2040 or Email alstatz@exitstrategiesgroup.com.