As the business owner’s average age continues to increase given the demographics of our population, there are a number of issues that may not have been perceived as important a few years ago that gain increasing attention as time marches on. The truth is that these issues (e.g. buy sell-agreements, business continuity plans, etc.) have always been important. There are a number of ways one can exit his/her business. Many of those exit plans are voluntary and planned while some are not. These agreements are often times overlooked as there is no sense of immediate need/urgency, etc. They also generally deal with less than pleasant scenarios that people prefer not to think about. The reality is that if you want to take care of your spouse and children, you really need to think about how your business is going to produce a liquidity event, in a timely, efficient and fair (think valuation) manner so your family can be well taken care of. It can also be helpful to you as a shareholder if for some reason you find yourself, or your partner, having to divest from the business for whatever reason.
In basic terms, buy-sell agreements deal with situations whereby a business owner leaves the business through death, incapacitation or some other unexpected set of circumstances. These agreements are also important in that if your partner is the one who is unexpectedly unable to continue in the business, the buy-sell agreement is the vehicle which will preclude his/her spouse from becoming your business partner. This last item alone can be very motivational for business owners to address this issue.
Some of the key terms addressed via a buy-sell agreement include who may buy the business interest, the events that trigger the agreement and the price to be paid for the business interest. All of these are very important elements and must be addressed thoroughly and with professionals who are expert in preparing such agreements. There are a few major, critical considerations which also must be addressed when structuring buy-sell agreements; 1) valuation criteria and 2) properly funding the buy-sell agreement.
The valuing of a business, or a share in a business, is an undertaking that can produce varied results. I’ve said many times over the years you can have one valuation expert arrive at different valuations for different purposes (there are a number of reasons a company may need to obtain a valuation) at the same point in time. You can also have different valuation firms arrive at very different results all valuing the business for the same purpose at the same time. The best way to mitigate the potential for an unexpected and/or unfair result is to hire valuation experts familiar with your industry and business. One size does not fit all when it comes to valuation and the selection of the right valuation firm is critical. Valuation is contingent on many factors including methodologies, styles and perspectives, who the valuation firm is hired by (buyer or seller), etc. Within the context of a buy-sell agreement, valuation is further challenging in that the principals are not necessarily looking for a value today, rather the goal is to ascribe a value to a business, or share of a business, at some unknown point in the future.
The best way to handle the valuation issue in a buy-sell agreement is to have a valuation performed in the first year and then get annual, less expensive updates to that valuation in subsequent years. Using this process, the many variables associated with properly valuing a business can be addressed given the set of conditions present at that time. It is impossible to build a formula that will successfully process all of the variables that can change in the future. That being said, in addition to building in a valuation requirement, it makes sense to insert a formulaic approach into your buy-sell agreement if for some reason a valuation wasn’t performed at the scheduled time(s) as a backup safety valve. A dynamic formula is better than none at all and can be critical in the absence of a valuation being performed. Arriving at a fair value for the business is essential to ensuring you and your family’s interests are protected.
Another important consideration in structuring buy-sell agreements is the funding of the liquidation event. Depending on the particular set of circumstances, there are a variety of ways to fund buy-sell agreements so that the business is not disrupted. Also, insurance can be an effective tool serving as value preservation in the event that the loss of a key individual adversely affects the valuation of the business. Generally speaking, there are a number of insurance products used to fund the buy-sell agreements so that the business has the liquidity it needs to pay out the proper value of the business to the appropriate parties.
A buy-sell agreement that isn’t properly funded is similar in many ways to establishing a living trust without funding it (i.e. converting title of assets into the trust, etc.) It ends up causing additional heartache and stress and the good intentions of putting such structures in place are nullified by the failure to complete the job and address all the issues up front. If you do not have a buy-sell agreement in place, or if you are unsure if it’s properly funded, you should reach out to your trusted advisor team and address it immediately. If your agreement hasn’t been reviewed in a number of years you should revisit it to ensure it will achieve your objectives so you and your family are protected in the event the agreement is triggered.