Introduction
In the dynamic landscape of closely held businesses and partnerships, uncertainty is a constant. Owners may face unexpected events such as death, disability, retirement, or personal disputes that can significantly impact the business’s continuity and value. One essential tool to mitigate these risks is a properly crafted buy-sell agreement.
However, some buy-sell agreements could have negative financial consequences if the language regarding how to assess business value for transactions doesn’t factor in the appropriate language. This is especially true if there is a formula utilized to establish the value to be used for the shareholder transaction. While a formula is an easy way to assess the potential purchase price, formulas can either overstate or understate the Fair Market Value of the company and cause negative financial consequences to either the shareholder that is buying or the shareholder that is selling the company.
Why Formulas in Buy-Sell Agreements fall short
Formulas are not recommended in buy-sell agreements as they can be inflexible and ambiguous. Formulas may not account for unique circumstances, economic fluctuations, or changes in the industry. Formulas can also be subject to misinterpretation if terms are not clearly defined.
For example, formulas that I have seen utilized in buy-sell agreements may include a multiple of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization”) with noted adjustments such as subtraction of debt, addition of cash, etc. However, there is so many more potential adjustments that are often made in a Fair Market Value valuation by an accredited appraiser that it would be hard to write that all into a formula in a buy-sell agreement. For example, let’s say a buy-sell agreement uses a three-year average EBITDA and one of those years included the receipt of PPP (“Paycheck Protection Program”) funds. If the formula in the buy/sell agreement didn’t reference an adjustment for this nonrecurring income, the EBITDA would have been likely higher than the Fair Market Value valuation would have arrived at.
The Recommended Approach to establish a shareholder purchase: Independent Appraisal
The only way to factor in all the nuances to a business value, which would include not only the multiple and historical earnings but also the Normalized Future Earnings and Excess assets and liabilities, would be to have an Accredited appraiser establish the Fair Market Value. Fair Market Value (FMV) is defined as “the price at which property would change hands between a willing buyer and seller, neither under compulsion and both having reasonable knowledge of relevant facts.”
Utilizing independent appraisals ensures that valuations are:
- Accurate and Current: Reflecting the company’s true value at the time of the triggering event,
- Objective: Provided by qualified valuation professionals who adhere to industry standards, and
- Comprehensive: Taking into account all relevant financial and non-financial factors affecting the business’s value.
Discounts for Minority Interest
When valuing ownership interests, especially for minority shareholders, applying discounts for lack of control and marketability is often warranted.
The Lack of Control (Minority Discount) reflects the risk related to the inability to influence significant business decisions, affecting the attractiveness and value of their shares. The Lack of Marketability discount reflects the inability of a minority interest in a closely held company to be sold due to the absence of a public market. However, I have seen many buy-sell agreements that would reference the purchase price to be “Fair Market Value, without considering Lack of Control or Lack of Marketability Discounts”.
Minority interest discounts reflect the economic realities and risks associated with minority ownership as well as the tax consequences to the buyer and seller. When a shareholder sells an ownership interest back to the company, that would be in the form of a stock sale rather than asset sale. However, valuations of a 100% interest, without factoring in discounts, don’t take into account the negative tax consequences to the buyer under a stock sale. That is why factoring in relevant discounts in a buy/sell agreement consider all the financial aspects of the transaction.
By including language that restricts the use of discounts in a buy-sell agreement, it restricts the appraisers from providing an accurate “Fair Market Value” for the ownership interest being appraised.
Conclusion
Buy-sell agreements are essential tools for managing ownership transitions in closely held businesses. They must be carefully crafted to:
- Ensure Business Continuity: By providing clear procedures for ownership changes, businesses can avoid disruptions.
- Facilitate Fair Valuation: Utilizing independent appraisals and incorporating appropriate discounts for minority interests ensures fairness.
- Prevent Disputes: Using precise terminology reduces the risk of misunderstandings and litigation.
A thoughtfully prepared buy-sell agreement that avoids the pitfalls of fixed price and formula clauses can prevent financial losses, protect relationships among owners, and contribute to the long-term success of the business. Hawkins Ash CPAs has a team of qualified appraisers with over 50 years of combined experience in the valuation of closely-held businesses. Contact them to get an opinion on the value of your company.
Disclaimer
This article is for informational purposes only and does not constitute legal, tax, or financial advice. Readers should consult with professional advisors before making any decisions related to buy-sell agreements or business valuations.
I'm able to provide expert advice with a deep understanding of my clients' needs. Over the years, I have gained extensive experience in testifying in court on valuation and other financial matters. Additionally, I'm a frequent speaker on topics such as valuation, sale transactions, and transition planning.
