Business owners should consider having ownership, or buy-sell, agreements to help protect the interests of the business and its owners. Business ownership agreements can set forth provisions pertaining to:
- Regulation of the owners’ relationships,
- Management of the business,
- Transfers of ownership interests, and
- Privileges and protections of owners.
Proper planning with ownership agreements can help mitigate a variety of risk areas related to unforeseen events and changes in the interests, objectives, and circumstances of business owners. Owner characteristics can take many forms, such as level of ownership, operational involvement, personal characteristics, and the amount of investment relative to personal wealth. However, the execution and ongoing maintenance of these agreements can sometimes be an afterthought for entrepreneurial business owners focused on the business’s growth and operation. Such afterthoughts can lead to ownership disputes, resulting in costly litigious matters that can cause financial and relationship peril.
In part one of this “Buy-Sell Agreements” series, we’ll examine triggering events, key provisions, types of agreements, and methods to determine the purchase price.
Triggering Events
Buy-sell agreements may incorporate various triggering events that result in the purchase/sale of ownership interests. These triggering events commonly fall within three categories, all of which could potentially lead to adverse circumstances that can be mitigated via the buy-sell agreement.
- Potential Third-Party Sale Triggers – The owners of a privately held company are typically wary of sharing the ownership of the company with a new owner due to the major impact a single owner can potentially have on a private company’s decision making and operations. Owners also may wish to mitigate the risk of involuntary transfers of ownership interests, such as transfers to an ex-spouse of a divorced owner or creditors of a bankrupted owner. In those cases, a buy-sell agreement may protect the ownership of the company from interference by outsiders.
- Viability of Owner Triggers – Buy-sell agreements may attempt to manage the adverse impact of an owner’s physical or mental disability to protect the company’s operations. An owner’s death also may present challenges to the company. In addition, the agreement can determine if disability or life insurance may be maintained by the company or the owners as a funding mechanism.
- Relationship Severance Triggers – If an employee owner resigns, retires, or is terminated from employment, the departure could potentially create difficulties for ongoing ownership of the company. Buy-sell agreements can help mitigate potential risk if the employee leaves to work for a competitor, or outline the terms of what to do with a retired employee owner’s share of the company.
Key Provisions
Buy-sell agreements may incorporate a variety of provisions to help achieve the desired goals of ownership, management, and board members to mitigate potential adverse impacts or disputes that may arise in an ownership transaction, such as:
- Purchase Price Determination – The provisions of a buy-sell agreement that set forth the determination of a purchase price may vary substantially. For instance, a buy-sell agreement may establish the purchase price based on the following:
- Fixed price, e.g., book value,
- Agreed-upon formula, e.g., multiple of earnings,
- Agreed-upon methodology, e.g., market derived, and
- Valuation performed by a qualified business appraiser.
- Restrictions on Transferability & Rights of First Refusal – There are times when a buy-sell agreement restricts the transferability of shares—or makes the transferability conditional—in the interest of protecting the existing owners’ interests. Buy-sell agreements also may implement right of first refusal provisions, whereby an owner selling their ownership interest must first offer that interest to existing owners and the company itself before offering it to an unrelated third party.
- Employment & Non-Compete – When an owner leaves a company, there is a possibility that the departing owner may start another competitor company. As such, certain buy-sell agreements may contain provisions to govern or influence the future employment of departing owners to mitigate this competition risk.
- Call & Put Options – A call option is a contract that offers the option holder the right—but not the obligation—to purchase an ownership interest at a certain price, while a put option offers the option holder the right—but not the obligation—to sell an ownership interest at a certain price. In these instances, the option holder has the legal right to force the purchase (call) or sale (put) of the ownership interest. Such options should be considered carefully as to their impacts on ownership, management, and the business’s financial condition.
- Funding & Terms of Purchase – Even when owners agree on whether an ownership interest should be bought or sold, they may disagree about the technical mechanism of funding the purchase or sale. Buy-sell agreements may specifically state how the purchase or sale of an ownership interest should be funded.
- Preferred Returns, Conversion Rights, & Participation Rights – Private equity and venture capital are increasingly utilized as a source of capital or an available exit strategy for the current owners to sell part—or all—of their ownership interest in a company. These investors frequently seek to protect their investment by implementing provisions in the subject entity’s organizational documents or agreements that afford preferred returns, conversion rights, and participation rights to the investors’ class(es) of ownership interests in complex capital structures. Sellers or management also may participate in transactions of this nature with rollover equity with unique investment attributes that require careful consideration.
Types of Buy-Sell Agreements
Buy-sell agreements typically address three types of purchase arrangements:
- Third-Party Purchase Arrangements – Define how transactions among owners and third parties are consummated or restricted (cross-purchase).
- Business Purchase Arrangements – Define a purchase obligation or option for the business upon the occurrence of certain triggering events (redemption).
- Combination of Third-Party & Business Purchase Arrangements – Address both cross-purchase and redemption arrangements and may provide right of first refusal provisions for the remaining owners and the business.
A combination of provisions is the most common type, which is prepared to protect the interests of the current owners and address various circumstances that may arise.
Owners are faced with establishing the method that will determine the purchase price in a buy-sell agreement. Cost-benefit, understandability, credibility, and fairness are among many considerations when owners evaluate the ideal method to determine a purchase price. Owners and their advisors should gain an understanding of the nature of the subject company and the goals and characteristics of its ownership with mindful consideration of valuation theory and impacts of external and internal factors influencing value.
With respect to the valuation of ownership interests in a privately held company where there is no active market to readily establish a price, a myriad of factors may influence value, such as:
- Financial position
- Past earnings and future earnings potential
- Dividend-paying capacity
- Nature of the industry
- Stability/volatility of earnings
- Reasonableness of owner compensation and other fringe benefits
- Effect of nonrecurring transactions
- Fair market value of the assets as opposed to book values
- Lack of control and lack of marketability of the ownership interest
These factors may cause the values of businesses to fluctuate significantly over time. The values of businesses within the same industry may vary significantly due to differences in profitability, stage of development, expected growth, risk, etc.
In view of these factors that influence value, the following sections examine the common methods to determine purchase prices in buy-sell agreements and offer the advantages and disadvantages in their application to certain types of businesses.
Methods to Determine the Purchase Price
The following methods may be commonly found in buy-sell agreements:
Fixed Price
Fixed-price buy-sell agreements set the purchase price at a specific dollar amount, and any calculations or appraisal procedures are unnecessary. While fixed-price arrangements are simple, they run the risk of significantly understating or overstating the market value of the interest. Such a method may be ill-equipped to properly handle unexpected changes in business conditions that can impact the value of a business, and if not updated periodically, it may become outdated, not reflecting the current economic realities of a business. A fixed price, however, may allow for the business owners to effectively achieve a desired result as agreed by the parties. For example, a fixed price could be set low so that the owners have added a level of protection against the unexpected departure of an owner who is key to the operations and continuing viability of the business, or it could be set to protect the financial stability and viability of the business relating to the funding of a potential redemption.
Agreed-Upon Formula, e.g., Book Value or Multiple of Earnings
An agreed-upon formula specifies a distinct formula for determining the purchase price among owners. A common formula-based approach found in buy-sell agreements is known as book value. According to the “International Glossary of Business Valuation Terms,”1 book value is defined as the difference between total assets and total liabilities as they appear on the balance sheet (for business entities) and as the capitalized cost less accumulated amortization or depreciation (for individual assets). As such, book value is generally based on historical cost, as opposed to a current fair market value. Since book value is based on historical cost, there are numerous businesses and industries for which historical cost is not likely indicative of fair market value at a valuation date. Book value may be used to meet the objectives of owners seeking to establish a relatively low purchase price for new or departing owners.
A formula-based purchase price also can be calculated using a mathematical computation without applying professional judgment. The below depicts a formula-based purchase price:
This method may be advantageous due to its simplicity and low cost, as appraisal standards may not apply to such mechanical computations. The formula above may be referred to as a rule-of-thumb calculation. The American Institute of CPAs (AICPA) professional standards for valuations, Statement on Standards for Valuation Services (VS Section 100), states that rules of thumb are not technically valuation methods, and that they are not to be used as the only method to estimate the value of a business in accordance with such standards. However, rules of thumb may be used as industry benchmark indicators because rules of thumb are developed based on actual market transactions of similar types of businesses. Market-derived rules of thumb can provide an owner with an estimated value to be used as a purchase price in a buy-sell agreement. However, owners should be aware that the resulting value only represents an estimate and should be mindful of its limitations. The specific characteristics of a business can largely influence its value, and the value indicated by a rule of thumb may be unreasonable or inaccurate.
Agreed-Upon Methodology, e.g., Market Derived
Agreed-upon methodology specifies a certain valuation approach or method to be used in estimating a purchase price. In this sense, an agreed-upon methodology buy-sell agreement operates as a calculation engagement, as defined under the AICPA’s VS Section 100, in which the appraiser and the client agree upon the approaches and methodologies to be used in the estimate of value at the inception of the engagement. A calculation engagement generally does not include all of the procedures included in a valuation engagement, and the appraiser’s scope is limited, not considering all pertinent valuation approaches. However, certain types of businesses are frequently valued under only one approach. For example, interest asset-holding companies are often valued utilizing an asset approach/net asset value (or price/net asset value). In these instances, setting forth a single method may offer owners the increased comfort of transparency and decreased cost.
Valuation Performed by a Qualified Business Appraiser (Appraisal)
Buy-sell agreements involving qualified business appraisers may be separated into two categories:
Single Appraiser Agreements – These buy-sell agreements provide that a single appraiser conducts a business valuation to determine the purchase price. The following table highlights the advantages and disadvantages of single appraiser buy-sell agreements:
| Advantages | Disadvantages |
|---|---|
| Analytical | May be binding, even if one or both parties dislike the appraisal |
| In-Depth | No quality guarantee, merits of value opinion may depend on appraiser certifications, experience, and qualifications |
Multiple Appraiser Agreements – These buy-sell agreements engage multiple appraisers to perform business valuations that are used to establish the ultimate purchase price. Multiple appraisers may be incorporated into the valuation process in various ways and at different points in time. The table below captures the typical relationships in these agreements.
| Multiple Appraiser Agreements | Relationship Between Appraisers |
|---|---|
| 1 Initial Appraiser-Reviewer(s) | Reviewers critique/revise first appraisal, or independently determine value |
| 2 Initial Appraisers-1 Reviewer | Reviewer determines value |
| Reviewer critiques and revises first appraisals | |
| Reviewer chooses best valuation | |
| Reviewer mediates between two initial appraisals |
Which Method Is Ideal?
On the surface, retaining an appraiser to perform an appraisal may result in the most reliable estimate of value from which a purchase price may be determined. However, ambiguity in the buy-sell agreement, as it pertains to the essential elements in an appraisal, can lead to complications and disparate opinions of value.
How Forvis Mazars Can Help
Forvis Mazars has valuation and transaction professionals engaged to assist others with evaluating, administering, or disputing ownership agreements. It’s essential to periodically look at the provisions of ownership agreements in view of evolving characteristics of the business and the objectives of its owners. Eager to learn more? Consider how to avoid complications and disparate opinions of value in buy-sell agreements with our next article in this series. If you have any questions or need assistance, please contact a professional at Forvis Mazars.
- 1“International Glossary of Business Valuation Terms,” nacva.com, June 08, 2001.