Multiple Owners? Don’t Sell Yourself (or Them) Short
No matter how successful and profitable, a privately held business with multiple co-owners can be significantly impacted when one of the owners dies, retires, becomes disabled, or leaves the company.
The best way to avoid disruption is by creating a detailed, comprehensive buy-sell agreement (BSA) now, before any such event occurs. The BSA governs how the remaining owners handle the buyout of a departing owner’s interest in the company.
The buy-sell agreement governs the buyout process.
A buy-sell agreement is legally binding on the signatory owners — so it’s important to understand the most essential elements.
First, a BSA may be structured in several different ways: In a cross-purchase agreement, the remaining owners purchase the departing owner’s interest in the business; in an entity-purchase or corporate redemption agreement, the company purchases the interest; in a hybrid agreement, the owners decide after an event triggers a buyout whether they or the company will purchase the interest.
Second, it is important to recognize that an owner’s interest in a company may be quite significant. A BSA may therefore mandate purchase of life insurance policies for each of the co-owners, with the proceeds intended to cover the cost of buying out the departed owner’s interest.
Third, a BSA should protect the signatory owners from others exerting undue influence or demanding unexpected compensation — situations that easily arise when family members are involved in a business or the company is based in a marital property state. The agreement, therefore, should address issues of management continuity and control, sharing of profits, compensation to surviving spouses or other family members, gift and estate taxes, and so on.
Accurate valuation ensures that the BSA is fair and equitable.
To succeed, a buy-sell agreement must reflect a valid appraisal of the business’s true value. A detailed, up-to-date valuation will take the company’s assets, depreciation, goodwill, accounting methodology, and all other elements into account. A company’s value changes over time, of course, and industry experts recommend periodic appraisal and adjustment of the BSA every two years at least.
Valuation methodology matters.
There are three fundamental approaches to valuation of a company — each of which will have a different impact on the creation of a buy-sell agreement.
Fixed price and formula pricing are two methods that determine the value of a business at a given point in time. This is helpful when first drafting a BSA but neither method ensures accurate pricing for the future.
Some companies prefer to specify that the owners will agree to a price when needed. While owner negotiation can lead to a deep and detailed valuation of the company, it works best when parties are not under pressure to act quickly, making it less efficient when a buyout is imminent.
In a process valuation approach, the BSA spells out exactly how the company will be appraised after a buyout-triggering event occurs, even identifying which company will perform the appraisal. More flexible than fixed/formula pricing, and more efficient and reliable than owner negotiation, process valuation is the preferred choice for many industry experts.
Make the best of your BSA with help from Southard Financial.
To initiate a conversation about valuation and buy-sell agreements, call Southard Financial at (901) 761-7500, use the form on our contact page, or reach out to us on social media.