Regular Updates Are Essential 

Key Takeaways:
  • A buy-sell agreement only works as intended when valuations are clear, transparent and agree upon — including who performs them, which methods are used and how discounts apply.
  • Relying on outdated formulas or valuation terms can create major dispute, especially around minority-share discounts, making regular review and updates essential.
  • All multi-owner businesses — especially family-owned companies — need a current, well-written buy-sell agreement to prevent conflict and ensure smooth ownership transitions.

 

A buy-sell agreement is like a living will for a business, as it guides how business owners handle major decisions at times of change in their companies. Among other elements, it spells out the parameters for when to obtain a valuation, how the valuation will be performed, who does the valuation and other important factors. In other words, valuation is deemed a critical element in a company’s ability to weather major changes by one of the most important documents in the company’s legal arsenal. 

Triggering events for a valuation, as delineated in a buy-sell agreement, often include: 

  • Death of a shareholder 
  • Divorce of a shareholder 
  • Departure of a shareholder 
  • Shareholder disputes 
  • Major business disruptions such as a key executive’s departure or the loss of a major customer 

One Valuation or Two? 

A buy-sell agreement may spell out in detail how a valuation is to be performed and who should obtain the valuation. While detail is good in many instances, sometimes too much detail can have a negative effect. 

For example, a physician-owner wants to leave a medical practice owned by multiple physicians and start a separate practice. The practice’s buy-sell agreement requires that both the departing physician and the other partners (as a group) obtain separate valuations. This may seem like a good idea that protects everyone’s interests, but it doesn’t always work out that way.  

It’s difficult to ensure that the same methodology is used in competing valuations, or the same discounts applied to minority owners’ shares. Without aligning these factors, two valuations on the same business can come to significantly different valuation conclusions, with one very high valuation and one low. 

The buy-sell agreement language may anticipate this and call for splitting the difference, but again, this may not satisfy all parties. 

There needs to be transparency whenever a valuation is done related to an owner’s departure. The two sides should work together to agree on the methodology, as well as who the valuation professional should be.  

Formula-based Approach 

Some companies, particularly those with many shareholders, write their buy-sell agreements to require a formula-based approach to valuation. Such an approach will specify how valuations should be reached, such as using a multiple of EBITDA (earnings before interest expense, income taxes, depreciation and amortization). Often, the formula-based approach is written into the buy-sell agreement to be specifically consistent year over year. 

However, the problem is that market factors change, industries become disrupted and companies go through internal change. A formula that worked when the buy-sell agreement was written may be misaligned with the realities of the marketplace today. If the shareholders disagree, they will usually consider obtaining a full independent valuation. 

Discounts for Minority Shares 

Buy-sell agreements often specify whether there will be valuation discounts applied to minority shareholder interests, and sometimes they specify no discounts. Generally, in a smaller company with three or four owners, each owner will hold a minority interest of 25% to 33%. But if one shareholder buys out another, they become a controlling shareholder. 

When determining valuation, discounts for minority shares are straightforward and usually pegged to fair market value. 

Buy-sell agreements can be written to be more advantageous to majority owners than minority shareholders, which often leads to litigation when the time comes to abide by the agreement. Discounts to minority shares are often the crux of this type of litigation, particularly if a buy-sell agreement specifies a 25% to 30% share value discount, which severely disadvantages minority shareholders. 

Occasionally, valuation professionals will determine that market factors are significantly different than when a buy-sell agreement was written, so they state in their report that they disregarded the specified discount and give an explanation as to the reason.  

Who Needs a Buy-Sell Agreement? 

All businesses with more than one owner should have a buy-sell agreement, but many do not have them.  

Buy-sell agreements are common at companies like architectural and engineering firms, accounting firms, law firms and other companies that typically have many shareholders. These are companies that have an active internal market where people are retiring or buying out regularly, and new partners are buying in.  

But buy-sell agreements are less prevalent — and more complicated — in family-owned businesses. Many owners believe family members can work things out together when a disruption occurs in the business, but that is not necessarily the case.  

It’s much easier to reach consensus about how to handle the impact of a family member’s departure or divorce if there is something in writing to guide the way. You don’t want to be in a situation down the road where there’s a contentious litigation that causes an irreparable family rift. So family shareholders need to understand why a buy-sell agreement is critical. 

Review and Update Regularly 

Valuation drives many of the major decisions that business owners make, and to the degree that buy-sell agreements control how valuations are performed, the buy-sell agreements need to be current at all times. 

A best practice in companies with a large group of shareholders who are buying and selling on a regular basis is to update the buy-sell agreement every year, as well as the independent valuation. 

In many companies, a buy-sell agreement is written and filed in a cabinet, never to be looked at again — until there’s a crisis. 

Buy-sell agreements must be reviewed and, if necessary, updated at least every five years. Your accountant or financial advisor can help with the review and make recommendations, if necessary, for changes, but your attorney will have to draft the new agreement. 

What To Do Now? 

  • If you have a buy-sell agreement that was written more than five years ago, pull it out and review it. Have your accountant or attorney review it and help you decide whether it needs to be updated. 
  • Be sure to consider changes within your company, your family (if it’s a family-owned business), your industry and your marketplace before updating. These will all impact valuation. 
  • If you don’t have a buy-sell agreement, it’s not too late. Talk to your attorney about drafting one now, and get some input from your accountant, as well, about any language that may impact valuation procedures down the line. 
  • When drafting a new buy-sell agreement, consider how discounts will be applied for minority shares in a way that will be fair and equitable in the event of a change in ownership. This will make a future valuation go more smoothly and avoid disputes that could lead to litigation. 
Questions? 

Buy-sell agreements heavily influence when and how valuations are performed in companies with multiple shareholders. If you would like to discuss your company’s buy-sell agreement to ensure it aligns with current the company’s current needs, contact an Adams Brown advisor.