Buy-Sell Agreements – Do You Really Need One?

In a business owned by more than one partner, the need for a buy-sell agreement may seem remote, especially while the business is still young and growing. Understandably, the owners are focused on the urgent and important matters of running and growing the business. Investing time into planning for the future exit of a partner seems like a distraction. Drafting legal documents requires an attorney, and that costs money.

As the business matures, the need for this document that defines the orderly transition of the business becomes more acute, but is often still neglected. The result is a nagging worry about what would happen if a partner became ill or decided to retire.

The sooner a buy-sell agreement is created, the more peace of mind the partners and their families will enjoy. Dealing with an unplanned exit situation will stress and cause conflict among even the friendliest of partners.

A well-planned buy-sell agreement can help avoid those pains. And, while the buy-sell agreement puts a legal framework around the transition process, the heart of the matter – and, the likely bone of contention — is the value of the business.

In some cases, the agreement stipulates a fixed dollar price. The partners adjust the price on a regular basis as the business expands or contracts. However, when the moment arrives, the heir of a deceased partner or the exiting partner hi/herself may claim this price does not accurately represent the true value of the business. The next step often involves lawyers.

A second approach to valuation involves the use of a formula or set of formulas that are based on revenue, EBITDA or some other definable metric. Valuation experts may be consulted to help produce these formulas. However, businesses change, markets change, the economy changes, which can alter the cost of producing those revenues. These changes can influence the selection of formulas, so that a formula which may seem appropriate in Year 1 may be wildly off base in Year 6.

A third common method for defining a fair valuation is to engage the services of a valuation firm. This approach is taken to arrive at an independent, neutral view. But there are ground rules that must be established to achieve a result everyone deems fair. Should the valuation value the entire company with no discounts and assign a pro-rata share to each owner? Should a minority owner’s interest reflect lack of control and lack of marketability discounts? Should these minority interests’ value also ignore above-market compensation paid to owners/officers, above market rent paid to related parties, and the like?
What about the proceeds from life insurance that was purchased to cover this buyout? Does the valuation analyst consider this a business asset and include it in the valuation, or is it to be treated solely as a funding mechanism for the buyout and ignored for the valuation?

Issues such as these must be addressed in the buy-sell agreement as they will significantly impact the valuation. The time to consider them and put the proper documents in place is now, when the business is running and partner exits are still a long way off, not at a time of crisis or disruption.