For many clients, the investment in their business is the most significant financial asset they own. Our goal as trusted advisors is to help them increase the value of that asset and realize that value upon exit of the business. However, many clients either don't have a buy/sell agreement or have one that simply won't work as the shareholders expected. Some of these agreements can be "ticking time bombs!"
Ask Yourself These Three Questions:
- Do you have a buy/sell agreement?
- Do you know what your buy/sell agreement says?
- How is your buy/sell agreement funded?
We often find agreements are not current, have a price determination that isn't fair or workable for all parties and lack funding for triggering events. Those situations can result in protracted litigation and sometimes the demise of the business.
It may be time to pull that old agreement out of the drawer and read through it again. Buy/sell agreements may be critical to business owners considering exit planning. The four most common ways that business owners exit privately held businesses are to sell to a third-party, sell to employees, gift to family members or liquidate. Buy/sell agreements can provide guidance in all of these situations. Imagine each of these exit strategies and read through your buy/sell agreement to see if the language is clear and provides the results you want.
We've worked with many clients to identify trouble spots in their agreements. After working with clients through litigation and various disputes, we understand the importance of understanding how the buy/sell agreements work. Our review of buy/sell agreements focuses on three key areas: Triggering Events, Pricing and Funding.
The agreement should define the process for triggering events, such as shareholder retirement, termination, death, disability, sales, divorce and bankruptcy.
Pricing is usually defined by a fixed price, formula price or an appraisal.
- Fixed prices are easy to understand.
- Fixed prices are easy to set initially, but may be difficult to reset as time passes and interests diverge.
- Provisions are seldom updated and inequities are likely to result.
- Agreements are often out-of-date when inked.
- Formulas provide a mechanism to update the value based on various metrics in the business.
- Formulas selected at a point in time rarely provide reasonable and realistic valuations over time.
- Changes that occur in companies, industries, local, regional, national and world economies may impact the "true value" of an enterprise relative to any set formula.
- Formulas can be misinterpreted—or are subject to multiple interpretations.
- The valuation process can be known by all parties at the outset.
- All parties know what will happen when a trigger event occurs.
- Parties will always know the current value for the buy/sell agreement (helpful for planning all-around).
- Appraisers can incorporate key business drivers and risks into the value.
We ask our clients to consider appraisals of their businesses. Most of our business clients have some sort of profit sharing plan, such as a 401(k). You wouldn't have a 401(k) plan that doesn't provide current valuations to participants. You pay a percentage of the plan assets to manage and account for the plan funds. Why would a company not make a small investment to understand what their business is worth with an annual or periodic valuation?
The agreement should spell out how transactions will be funded in situations where the company buys shares back from shareholders or funding the buyout of other shareholders. Management should know and have a plan for:
- Who buys the shares?
- Other shareholders, the company or a combination thereof
- Should the agreement consider issues with passive owners versus employee owners?
- Should the company have life insurance policies?
- Has the company considered other financial resources available to buy the shares?
- What are the terms of the transaction?
- Down payment, interest rate, security
- Are there any restrictions on share payments under the company's loan agreements?
Other deficiencies in agreements may include the lack of signatures of all current shareholders, the agreement has not been updated for several years, the level of value is not defined or the valuation date is not defined.
As you can see, there are a number of potential issues that could result in your buy/sell agreement being a "ticking time bomb." Used properly, the buy/sell agreement is a great tool to provide direction for all kinds of triggering events that affect shareholders. We encourage you to discuss these matters with shareholders and your attorney.