Buy/Sell Considerations

January 11, 2020 | Article

Your investment in your business is one of your most significant financial assets. As you consider your exit strategy, retaining the value of your business is critical. One way to protect what you’ve built is through a buy/sell agreement.

What is a buy/sell agreement?
A buy/sell agreement is a contract that outlines how an owner or partner’s share of the business can be reassigned upon death or exit from the organization.

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?

The accuracy and clarity of your buy/sell agreement is critical. 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.

How can a buy/sell agreement impact my business exit strategy?
The four most common ways that business owners exit privately held businesses include:

Buy/sell agreements can provide guidance in all 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. 

Learn more about the different options you have when it comes to the sale of your business.

How can I tell if my buy/sell agreement is up-to-date?
A typical review of a buy/sell agreement will focus on three specific areas:

  • Triggering Events
  • Pricing
  • Funding

Triggering Events
The agreement should define the process for triggering events, such as shareholder retirement, termination, death, disability, sales, divorce and bankruptcy. 

Pricing
Pricing is usually defined by a fixed price, formula price or an appraisal.

Fixed Price
- 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- Agreements are often out-of-date when inked.

Formula Price
- 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.

Appraisal
- 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.

Funding
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? Is it 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. 

The importance of a buy/sell agreement
Buy-sell agreements are commonly used to allow a company or its shareholders to purchase the interest of a shareholder who decides to withdraw from the company for a specific price or by using a set formula to determine a price. However, instead of preparing for a smooth exit, many buy-sell agreements tend to cause more issues as the use of a set price or a formula may not consider the current economic and financial condition of the company, which could lead to legal (and expensive) issues. Used properly, the buy/sell agreement is a great tool to provide direction for all kinds of triggering events that affect shareholders.

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