When Buy-Sell Agreements Go Wrong (And Why You Need to Update Yours)
For thousands of years, people have entered into business arrangements. And for just as long, many of those arrangements have gone bad at some point.
That’s why buy-sell agreements exist.
When a business relationship sours and one or both parties decide that it is time to part ways, people look to the terms of their buy-sell agreement to determine who gets what and how much. In theory, it is a good idea. However, in reality, it isn’t always a clean separation…even with formal paperwork in place.
Why Buy-Sell Agreements Are Important
It is essential to have some sort of plan in place so that everyone knows ahead of time what will happen in the event of the “4 D’s” of business:
Any one of those things can become what is known as a “triggering event.” When they happen, the business relationship is going to change. The amount of change and the level of difficulty often depend on how well the parties involved have prepared.
Why Buy-Sell Agreements Don’t Work
Buy-sell agreements (also referred to as buyout agreements, business wills, or business prenups) are designed to protect the business from disruption as well as the lives of the individual members and their families. However, buy-sells often fail because of one important factor: they overlook what the business is actually worth.
If the valuation provision of the buy-sell agreement isn’t written properly, it leads to a lot of disagreement over the worth of the company. The party paying the exiting member (or their estate) would normally like the value to be as low as possible. The one being bought out naturally wants it to be much higher.
Buy-sell agreements are often structured in one of two ways:
- Fixed Value. The shareholder agreement establishes a set per-share price.
- Formula. A predetermined methodology is used to decide the value of the buyout.
When a triggering event occurs, that value or formula is used to calculate how much the departing member receives.
The downside of using a fixed value is that it won’t really reflect changes the company has experienced since it was put in place. And a formula may not be accurate when market or industry forces outside the company shift over time.
Fortunately, there is a better way. And it isn’t that difficult.
Flawed buy-sell agreements can be fixed by simply adding a provision that states that a valuation must be performed by a qualified appraisal firm when a triggering event occurs.
The Value of Buy-Sell Valuations
When you know what the business is actually worth, you are in a much better position to make good decisions.
By structuring buy-sell agreements so that a formal valuation is required upon any type of owner separation, all of the affected parties can have confidence that they are being treated fairly. And much of the stress and conflict surrounding the triggering event can be avoided.
For further reading, nolo.com has a helpful buy-sell agreement FAQ on their site.
Trust Experienced Valuation Professionals
When (not if) one of the 4 D’s occurs, you want to have the confidence and peace of mind that comes from knowing that you and the remaining owners have a solid plan in place.
If you have a fixed-price agreement in place and that’s what everyone prefers, adding language that calls for a formal valuation at the time of the event may be all you need.
If you intend to use a formula, including a provision that requires a valuation if there is a dispute could be your solution.
Regardless of how you decide to buy out a departing owner, be sure to rely on experienced valuation professionals to help you make sure you’re working with accurate and realistic numbers.
Southard Financial has been guiding clients through all kinds of valuation situations for over 30 years! Contact us to find out how we can help make your buy-sell agreements work even better.