Buy-sell agreements are among the most important yet most often overlooked business agreements. If you are a business owner or partner and are suddenly unable to work, what would happen to your business? If the business has an effective buy-sell agreement, then you should not have to worry.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
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