Are Your Clients’ Buy-Sell Agreements Ticking Time Bombs?
Poorly crafted, ill-conceived, outdated buy-sell agreements—or worse, no agreement at all— offer endless examples of business owners who’ve set themselves up to destroy their own wealth!
Many families and family businesses endlessly twist in the wind of litigation, as if a tornado has taken its toll, after a “triggering” event activates a poorly crafted, ill-conceived, or outdated buy-sell agreement.
Crafting a good buy-sell agreement is as much about protecting owners, their families, and a business owner’s legacy as it is about protecting wealth and maximizing shareholder value. The irony is that the owners of the buy-sell agreement are often not present to see the fruits of their wise planning or the havoc and destruction of their poor planning. The greatest wealth-creating generation, the Baby Boom generation, is about to retire. How will they plan for their last “BIG” deal?
Buy-sell agreements govern how ownership will change hands if a significant or “triggering” event happens to one or more of the owners. Triggering events that cause buy-sell agreements to be put into action include when an owner/shareholder quits, is fired, retires, becomes disabled, dies, divorces, enters bankruptcy, etc. The intent is to ensure the remaining owners control the outcome and direction during critical transitions. Buy-sell agreements can be between the owners and the company (entity agreement), between the owners (cross purchase agreement), or a cross between the two (hybrid agreement).
Buy-sell agreements should be designed to accomplish several objectives. They should define the conditions that “trigger” the buy- sell agreement, provide a market for shares, and establish a fair price as well as the terms so transactions can occur in an orderly and reasonable fashion. Buy-sell agreements should also specify financing (cash, life insurance, sinking fund, external borrowings, other) to acquire those shares (ownership interest). Unfortunately, many buy-sell agreements don’t accomplish these objectives.
Pricing Mechanisms and Their Risks
Buy-sell agreements typically are constructed with one of three types of pricing mechanisms, each with its own set of challenges to be addressed.
- Fixed-price agreements. In this mechanism, owners agree on a price and set that price in the agreement. However, over time, that price becomes out of date and can be far higher or lower than the current realistic value today.
- Formula price agreements. In such agreements, the owners agree on a formula to calculate the price. Often, however, no one recalculates the formula to reflect current realities, and the original formula produces an unreasonable result. The formula price may be higher or lower than a realistic value today. In addition, the owners often haven’t agreed on how to make any necessary and appropriate adjustments.
- Valuation process agreements. With these agreements, the owners agree to bring in a business appraiser(s) to determine the price when the buy-sell agreement is triggered. In essence, no one knows what the “price” will be or on what premises the definition of “value” that an appraiser will provide. Will the premises be as a going concern, an assemblage of assets, an orderly disposition, a forced liquidation, or something else? Could the definition of value be book value, adjusted book value, cost, replacement value, fair value, investment value, synergistic value, or fair market value, just to name a few? Could it be the value of an illiquid interest, an enterprise interest, an equity interest? What methods or approaches will be used? Will discounts be taken or premiums be given? What, if any adjustments, should be made for owners’ compensation or discretionary expenses? Have the parties determined the qualifications for the appraiser(s)?
In the end, will the value be reasonable or unreasonable given the owners expectations? No one will know the outcome until the end of a lengthy, cumbersome, expensive, and uncertain process that is divisive and often fosters litigation.
It’s also important to understand the differences between the two types of valuation process agreements: single appraiser and multiple appraisers. Single-appraiser agreements call for the selection of one appraiser whose appraisal conclusion forms the basis for the final price. Owners may either select an appraiser now and value at the time of a triggering event or select an appraiser after the triggering event.
Multiple-appraiser agreements call for the selection of two or more appraisers to engage in a process that will develop one, two, or three appraisals, whose conclusions form the basis for the final prices. The third appraiser acts as the reconciler, determiner, judge, and/or mediator.
For the owner in a valuation process agreement, the resulting scenario looks something like this: All parties involved are betting that the price will be favorable for each one of them. If the price is unrealistically low, an owner is betting the other guy will die first and you can buy at the low price. If the value is unrealistically high, an owner is betting that you’ll be the one to leave first so your family can benefit. The company is betting the process will work and the price set will be affordable. Everyone is betting, which means someone will lose.
Why take a chance and be on the wrong side of the bet? In the end, everyone is usually in for a big surprise when the buy-sell agreement is triggered.
Stop the Ticking Time Bomb
The solution for averting disaster lies with the owners. Rational conversations between all the shareholders regarding key aspects of the buy-sell agreement, although at times difficult, will lead to the best workable agreements. Questions that are relevant to the discussion include: What are the owners’ objectives and concerns? What do you want the buy-sell agreement to accomplish for the company and the shareholders? Who are the parties involved? When will the agreement come into play? How will it operate?
Review your buy-sell agreement from business, valuation, and legal perspectives. Engage the appropriate professionals the help define the intersections between business and personal objectives. Having an agreed-upon value is recommended. If there has not been one in the last 12 months, establish a process for conducting an annual valuation. If there is no agreed-upon value, then a valuation must be performed. The time to act is now. Once a buy-sell agreement is triggered, it’s too late to “fix” any issues that surface. Everyone will be bound by the “words on the page.”
A key recommendation to consider is to have a valuation process agreement consisting of a single appraiser, selected now and valued now, as well as at a triggering event.
By naming the appraiser at the time of agreement, all parties have a voice in the decision and can sign off on the appraiser’s selection, no matter how difficult the process of reaching agreement might be. The selected appraiser then provides a baseline appraisal in draft form to all agreement parties so that everyone can provide comments for consideration before the report is finalized. Ideally, the selected appraiser will provide revaluations for buy-sell agreement purposes every year or two thereafter.
The advantages of selecting an appraiser now and valuing now are many:
- The selected appraiser is viewed as independent. An independent appraiser acts as an advocate for his or her conclusion, not as an advocate of any of the parties involved.
- The appraiser’s valuation process is witnessed by all parties at the outset. The appraiser must interpret the “words on the pages” in conducting the initial appraisal. Any issues regarding lack of clarity of valuation-defining terms will be resolved at the onset.
- The appraiser’s conclusion is known at outset and has established a baseline price for the agreement. Because the process is observed at the outset, all parties know what to expect should a triggering event occur.
- The selected appraiser remains independent with respect to process and renders future valuations consistent with terms of agreement and with prior reports. Subsequent appraisals, either annually or at trigger events, should be less time-consuming and expensive than other alternatives.
- The parties involved gain confidence in the process and will always know the current value for the buy-sell agreement (helpful for all-around planning).
- The appraiser’s knowledge of the company and its industry will grow over time, enhancing confidence for all parties involved in the process. This also creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares.
Annually, the shareholders or board can set the company’s value using the appraisal or an interim formula. However, if value has not been set within 12 to 18 months and a triggering event occurs, the agreement should all for another valuation.
Begin Now With Three Key Questions
- Do your clients have a buy-sell agreement? If not, get one started now! If so, what type of agreement is it? And, how long ago was it written?
- Do you know what the buy-sell agreement says, from the business, valuation, and legal perspectives? There are six defining elements that must be in every buy-sell agreement, if the valuation process and, therefore, the agreement, is to work! These elements include the standard of value, the level of value, the “as of” date, the qualifications of appraisers, the appraisal standards, and the funding mechanism.
- How is the buy-sell agreement funded? How life insurance proceeds are treated can make a substantial difference in the valuation of the company. Is it a funding vehicle or a corporate asset?
While defining these specific elements can be difficult, being specific requires the parties to talk about things they may not want to think about. If you think the process is difficult now, imagine how it will be when the buy-sell agreement is triggered. At that time, they may be the only things you can talk about. Without a clear agreement, this process can be costly and time-consuming and can create hard feelings and certainly distract all the parties involved from running the business.
Identify areas of concern in your or your client’s buy-sell agreement. Understand formula agreements and fixed-price agreements. Learn how to “fix” out-of-date formulas or fixed prices in those agreements. Know the differences between single-appraiser process agreements and multiple-appraiser process agreements. Understand the six defining elements that must be present regarding the valuation process. Identify the process by which most problems can be averted for you or your client’s buy-sell agreement.
Your client’s buy-sell agreement should be understandable, predictable, likely to achieve reasonable resolutions in accordance with the client’s business and personal objectives, and helpful in the wealth management process, saving them and their heirs time and money. Ensuring all of that from a properly crafted, well conceived buy-sell agreement will reflect favorably on you and your client relationships.