Now is the time to review your buy-sell agreement and related provisions.

If you are a business owner and have not recently reviewed your buy-sell agreement, now is the time. In fact, it’s probably past time.

In this blog post, we’ll discuss the importance of keeping what should be a “living document” alive and well and how to do that.

Most buy-sell agreements are drafted at start up and then never revisited. Disregarding these important documents can have far-reaching negative consequences. We’ve seen a number of instances where the original agreement failed those it was intended to protect simply because the document was never updated.

Here are just a few examples:

Case 1. Individuals A and B form a business and include a buy-sell provision based on book value. The business grows and becomes very successful. The owners discuss updating the buy-sell formula, but they never actually follow through with those updates. However, the Company buys life insurance on A and B estimating market value at much greater than book value. Shareholder A dies. The Company collects substantial insurance proceeds. The Company buys out A’s estate based on the original buy-sell provision (book value), which is approximately 25% of the insurance proceeds and much less than market value of A’s interest.

Case 2. A buy-sell agreement for a professional services corporation calculates the purchase price of selling shareholder shares at accrual basis book value at the end of the month preceding termination of employment. The Company operates on the cash basis for tax purposes and reduces income to a low level at December year-end through bonuses and profit sharing. A substantial portion of the Company’s annual income is earned during the first four to five months of the year. Shareholder A resigns in June when share value is the highest.

Case 3. A professional services firm has three original owners who are still together 15 years after they established the company. The agreement has a formula valuation but no provisions for the remaining owners to finance a buyout. Then one owner passes away. The spouse of the deceased shareholder was told the value was much greater and was unaware of the agreement and formula. The two remaining shareholders are forced to negotiate with the estate and obtain outside financing at less than favorable terms.

Valuation

One of the most difficult tasks with buy-sell provisions is determining an equitable price. There is no ready market for closely held businesses, so the agreement must specify a formula or method for calculating the buyout. It’s common to see some version of book value or require the firm to engage one or more appraisers. Little thought is typically given to the valuation method after initial setup.

We prefer using an agreed-upon value whenever possible. The owners meet annually and agree (in writing) on a value for the next 12 months. What if they fail to meet and stipulate a value? The value reverts to a calculated alternative after some designated period of time—say two years. The $64,000 question is how is the stipulated value determined? Typically, the owners review a variety of data—book value, capitalization of earnings, comparable sales and industry ratios.  It’s important to note that in smaller firms, the go-forward value and economics might be much different with the loss of a key shareholder.

An annual agreement allows for discretionary market adjustments. If the previous year has been great but next year doesn’t look so good, the owners can adjust accordingly. Also, having a signed document stipulating the value makes a buyout easier, quicker and reduces professional fees.

If your agreement uses a formula to determine value, revisit that formula periodically and make certain the outcome approximates market value. Pay attention to the measurement period: Is it the most recent year-end or the last 12 months ending with termination of employment?

Many agreements also include a spousal acknowledgement where the spouse accepts that shares or ownership interests are governed by the agreement, and they agree to act in accordance with the terms of that agreement.

Terms

The agreement should offer the remaining shareholders (buyers) favorable financing terms to purchase shares from a departing shareholder. Terms typically vary from five years to as long as 10 years with the option to prepay the debt at any time without penalty. Interest rates vary from prime to the company’s borrowing rate. Before you decide on terms, we recommend running the numbers to make sure the agreed-upon terms will actually work—i.e. a sanity check. Terms can be different depending on the reason for termination—death versus termination for cause. Life insurance also should be considered. Many agreements direct most or all of the life insurance proceeds to fund the buyout with any shortfall subject to financing.

There’s a lot to think about, and now is the time to start.

Next time, we’ll talk about some common, real-world circumstances that could affect your buy-sell agreement.