You’ve heard (and probably said yourself) that everyone should have a will. A will is needed to plan and to provide instructions about how to dispose of an individual’s assets when he or she goes to the Great Beyond.
What’s true of individuals in this case is also true of businesses. Businesses don’t need a will, of course, but they do need a buy-sell agreement. A buy-sell agreement is to a business what a will is to an individual: a way to plan for the allocation or disposition of assets or interests in the event of the unthinkable. Every privately-owned business with two or more partners (or shareholders, members, unit holders, etc.) should have a carefully-drawn buy-sell agreement.
How is a Buy-Sell Agreement Activated?
To activate a will, the covered individual must die; to activate a buy-sell agreement, you needn’t go to that extreme. Exactly what triggers a buy-sell agreement is a matter for discussion and agreement between the partners, but they generally involve major changes in the life circumstances of one of the partners. A buy-sell agreement could be activated by death, but it could also be activated by:
- divorce, to keep the related business interest out of the hands of a divorcing partner’s spouse or child who may know very little about the business, or who may be hostile to the remaining partners;
- termination of service, whether a partner quits, retires, or is fired, or becomes disabled, or loses a necessary certification and is no longer able to work; or
- bankruptcy of a partner, to keep the business out of the hands of the bankrupt partner’s creditors, and to free the business from the stress of the partner’s bankruptcy.
What Should a Buy-Sell Agreement Accomplish?
A buy-sell agreement should accomplish certain things. It should:
- provide for the orderly transfer of interests for any partner who leaves the company;
- provide liquidity for the interest;
- specify the price and terms for any such transaction; and
- ensure, if possible, that financing for the transfer of the interest is available.
Types of Buy-Sell Agreements
There are four basic types of buy-sell agreements, some with variations. They are:
- agreements with a fixed value for the business interest;
- agreements in which the value of the business is determined by some specified formula;
- agreements in which the value of the business interest is determined by a process that, at first, seems almost worthy of Solomon, but really isn’t; and
- agreements in which the value of the interest is determined by a valuation process.
There are pros and cons to each of these approaches, as we’ll see.
Fixed Value Approach
The fixed value approach is very cheap and easy to implement. When a business is started, there may be some agreement as to the value of the business, and this value is incorporated in an agreement. But the agreed value almost certainly goes out of date very quickly. In some agreements, the partners may plan to update the value regularly, but then fail to do so. And if they do update the value, how do they do it? Do they use one of the other approaches, or do they just pull a number out of the air? And how do they know if the value they choose is realistic?
The formula approach is also cheap and easy to implement. But there is no formula that can always give the value of any business. If there were, there would be no need for business appraisers. If the formula approach is taken, the formula should be specified very precisely in three different ways: in words, in algebraic symbols, and by example. This may help to reduce disputes later. Even so, because the description of the formula may be ambiguous and subject to different interpretations, the agreement should also specify who is to calculate the formula (e.g., the company’s attorney, the company’s CPA, etc.).
The fixed value approach and the formulaic approach have certain advantages. They’re relatively inexpensive to adopt and easy to calculate. In addition, they yield results which are fairly predictable; i.e., an approximate value can be estimated by the individual partners at any time. This makes estate planning by the partners fairly easy. But these approaches are not necessarily good indicators of the value of a business.
Under the Solomon-like approach, one party to a dispute over the value of the business would specify the value of the interest, and the other would elect either to buy or to sell at that price. At first, this sounds fair. The party who named the price can’t complain that the price was unfair because they named it. And if the counterparty buys, then the counterparty can’t complain that the price was too high because they could have sold at that elevated price; if the counterparty sells, they can’t protest that the price was too low because they could have bought at that depressed price. So the process seems very simple and very fair.
But on further consideration, one can see problems. For example, if the buy-sell agreement were triggered by the death of one partner, he would certainly be in no position to buy, and his family might not be either, so the remaining partner(s), realizing this, could rig the game. As another example, if one partner owns 80% of a business, and the other two partners each own 10%, the minority partners might not have the financial ability to buy the larger interest. The controlling shareholder would realize this, and, again, could rig the game. As a third example, if a partner were retiring, it would be clear who would be selling, so, once again, the game could be rigged.
Those buy-sell agreements which specify a valuation process are the most expensive to implement. There are several variations to this approach, one requiring a single appraiser and one which requires two or even three independent appraisers.
Multiple Appraiser Method
Under the multiple appraiser approach, both parties to the transaction hire an independent appraiser. If the value conclusions of the two appraisers are close to each other (say, within 10% or 20%), the value is determined to be the average of the two values.
If the two values are not close to each other, then the two appraisers together may select a third independent appraiser. This third appraiser may mediate between the first two appraisers, or may choose between the two appraisals the one he finds to be most credible, or may conduct his own appraisal. If the third appraiser conducts his own appraisal, the final value determination may be the conclusion of the third appraiser, or the middle of the three values, or the average of the two closest values, or the average of the three values, or sum such amount.
Besides the financial cost, the three-appraiser process can take months to complete, while the fixed value method, the formula method, and the Solomon-like method can all be completed rather quickly. Under the three-appraiser process, each side must choose an appraiser, the two appraisers must each complete their appraisal, and the appraisals must be compared. If necessary, a third appraiser must be selected and, perhaps, complete an appraisal. And finally, a value determination must be made. All of this takes time.
Also, the resulting value is not predictable because the individual partners cannot know in advance what the independent appraisers will conclude. This is important because if life insurance is needed to fund the transaction, it’s important to ensure that sufficient coverage is available.
Single Appraiser Method
The single appraiser method is more expensive and time consuming than the fixed price method, the formula method, and the Solomon-like method, but less expensive and time consuming than the multiple appraiser method.
Under this variation, a single appraiser is hired not by the parties to the transaction, but by the company. This reduces both the cost and the time to complete the process when compared to the multiple appraiser method. But if the appraiser is not selected until the agreement is activated, the process can still take a considerable amount of time, and the value determination will be no more predictable than under the multiple appraiser method.
There is a very simple way around the shortcomings of the single appraiser method. If the appraiser is selected in advance and named in the buy-sell agreement, the process can be streamlined. And if the appraiser is selected and provides a valuation based on the specific language of the agreement at the time that the buy-sell agreement is adopted, and every year or two thereafter, the value determination will be both more current and more predictable. In that event, the price of any transaction would be the value that was determined in the most recent appraisal.
Business owners might object that annual or biennial appraisals can be expensive. They’re right. But compared to the time and cost of litigation, they can be a real bargain.
A buy-sell agreement is the business equivalent of a will. It’s important that they be well drawn, and that business owners give them the time and attention they deserve. It’s also important that the value derived be current and be somewhat predictable, and that the process, once activated, be completed without undue delay.
The single appraiser method, with the appraiser selected in advance and with an appraisal provided immediately and every year or, at most, two years thereafter, is the best way to achieve these results.