In this article...
In this article we explain how to determine value for buy-sell agreements.
In this article we explain how to determine value for buy-sell agreements. For some foundational information about buy-sell agreements, checkout our article: Buy-Sell Agreements for Closely-Held Corporations, LLCs and Partnerships Explained.
A buy-sell agreement allows business owners to plan in advance for how an owner and the business will part ways upon the occurrence of certain triggering events such as the death or disability of an owner, the voluntary decision to terminate ownership either through a routine sale of stock or through retirement, or the company’s decision to part ways with the owner with or without cause. For more information on how to use a buy-sell agreement if an owner is retiring, check out How to Use Buy-Sell Agreements to Plan for an Owner’s Retirement.
A well drafted buy-sell agreement should contain all of the following components:
- What events will trigger an optional or mandatory sale of an owner’s ownership interests to the company or to the other owners?
- When a triggering event occurs, how will the ownership interest be valued?
- What will the terms of the purchase be and where will the money for the purchase come from?
Methods for Assessing a Business’ Value
A buy-sell agreement will typically provide for an assessment of the business’ value in one of three ways:
- An agreed-upon value;
- Fair market value at the time of sale;
- Use of a formula to determine value.
Using an Agreed-Upon Value in a Buy-Sell Agreement
The simplest method for determining the value of a business in a buy-sell agreement is simply agreeing upon a dollar amount at which to value the business and stating that value in the buy-sell agreement. The problem with this method is that it does not account for a potential increase or decrease in value as time passes between the execution of the buy-sell agreement and the occurrence of an event that triggers a sale.
An agreed-upon value is not generally advisable, and only makes sense for very small and predictable businesses.
How to Determine Fair Market Value for Buy-Sell Agreements
Using the fair market value at the time of sale is certainly the most accurate way to assess a business’ value. However, it tends to also be the most expensive. Generally, fair market value is determined by having a professional appraiser appraise the business. Because of this expense, an appraisal makes sense if the value of a potentially departing owner’s ownership interest is large enough to make accuracy more important than saving on the cost of the appraisal.
Alternatively, in a scenario where the company or other shareholders is given first right of refusal in the event that an owner wants to sell his shares of stock, fair market value can be determined based on the offers that are actually received.
Using a Formula to Determine a Business’ Value for a Buy-Sell Agreement
Using a formula to determine a business’ value in a buy-sell agreement tends to be preferable when the value of the sale is not expected to be so large as to warrant the expense of an appraisal, but large enough that setting an arbitrary value does not make sense.
This is usually done by multiplying Earnings Before Tax, Depreciation and Amortization (EBITDA) by a certain number (usually 2 or 3). Depending on the type of business, the book value of the company may factor into the equation. Book value is essentially the assets of the company less its liabilities.
Businesses in different industries use different formulas to determine a valuation. It is important to research the specific formulas that are commonly used in your industry.
While using a formula is a great way to approximate a business’ value without the cost of an appraisal, formulas may not account for certain factors, such as year-over-year growth or intellectual property. Therefore, depending on the business, valuation by formula may run the risk of being unfair to one of the parties involved.
Business Value versus Purchase Price in a Buy-Sell Agreement
The value of a disassociating owner’s shares may not be the actual price that the company or the other owners must pay according to a buy-sell agreement.
There are many situations in which the owners will want to arrange for a “sweetheart” deal whereby the company or the other owners have the option or the right to purchase the shares at a reduced price. These may include termination of an owner for cause, an owner’s voluntary sale of his or her stock when the owners want to disincentive this, or the owner filing for bankruptcy or divorce.
In these cases, the buy-out agreement that the other owners or the company have the option to purchase the owner’s stock at a percentage of its actual value. For more information on this topic check out our article is How to Fund a Buy-Sell Agreement.
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