Key Valuation Considerations: Structuring a Buy-Sell Agreement

A buy-sell agreement is a crucial safeguard for businesses with multiple owners, offering protection when an owner dies, becomes disabled, or decides to exit the company. These agreements define who can purchase the departing owner's share, when the transaction should occur, how it will be handled, and at what price. Although it's best to establish a buy-sell agreement at the business's inception, it can still be implemented or updated at any time.

A well-structured agreement not only provides clarity in unforeseen circumstances but also creates a fair buyout process while all parties remain on good terms. Without one, disagreements over price and terms often arise between disputing owners.

A comprehensive buy-sell agreement addresses more than legal and tax considerations. It also answers questions related to valuation issues, such as:

Some owners prefer to use one joint appraiser or hire an appraiser under the company's name. Other buy-sell agreements permit each owner to hire his or her own appraiser. If the two appraisers arrive at divergent conclusions of value — of, say, 20% or more — the buy-sell agreement may call for a third expert to resolve the difference.

Often the company funds the retainer to expedite the valuation process, but shareholders may be expected to reimburse the company for appraisal fees.

Some buy-sell agreements name a specific valuator (or firm) to appraise a departing owner's interest. Pre-screening appraisal candidates helps facilitate the valuation process if an unexpected event suddenly triggers the buy-sell agreement.

Fair market value — as defined by IRS Revenue Ruling 59-60 — is the most common standard of value. But, by using this term, the owner may be bound by tax court precedent when buying out a departing owner. Instead, some buy-sell agreements require buyouts to occur at fair value, which the agreement may define as the interest's pro rata share of the business's value on a controlling basis.

These are some of the most contentious issues when parties to a lawsuit disagree about the value of a business interest. Comprehensive buy-sell agreements iron out these details before disputes occur by specifying which discounts — marketability, control, swing vote, key person, etc. — and which types of financial statement adjustments — unusual, non-operating, related party payments, above- or below-market owners' compensation, etc. — apply. They also may prescribe a preset amount or methodology for quantifying discounts and adjustments.

Important: The existence of a buy-sell agreement may, in turn, affect the magnitude of a company's discount for lack of marketability. On one hand, a buy-sell provision effectively creates a "market" on which owners may sell their interests. This makes an interest more marketable. On the other hand, a buy-sell agreement may also restrict transfers of ownership interests to unrelated parties, which can make an interest less marketable.

Owners may, for example, decide that the death of an owner warrants a higher buyout price than the bankruptcy of an owner. Or they may decide that a 2% interest warrants a discount for lack of control, but a 30% interest doesn't.

When an owner dies, his or her estate may argue that the remaining owners are unnecessarily dragging out the appraisal process to delay a buyout. The buy-sell agreement may prescribe a timeframe for valuing the business interest.

If an owner dies, the date of death or the alternate appraisal date (six months later) may be used. Different triggering events may warrant different "as of" (or effective) dates. In a volatile market, the value may differ significantly from one appraisal date to another.

Estate tax filings may require a comprehensive written appraisal report to satisfy the IRS's adequate disclosure requirements. Written reports are also important if the owners are fighting over the buyout in court. But a limited report format may suffice for amicable buyouts.

Usually, appraisers perform a full valuation for buy-sell purposes. But some shareholders opt to prescribe an industry rule of thumb or a specific appraisal method to expedite the appraisal process. Scope limitations result in a "calculation of value" (as opposed to a "conclusion of value") that probably won't survive courtroom or IRS scrutiny, however.

Sometimes the company buys the departing owner's interest; other times the remaining owner(s) purchase the departing owner's interest. For voluntary departures, some buy-sell agreements call for noncompete contracts, earnouts and/or ongoing consulting agreements. A valuator can help owners understand the typical deal terms in the company's industry, which may vary over time depending on the prevailing market conditions.

Appraisers determine a cash-equivalent price, but sometimes owners prefer buyouts to occur over time for tax and cash flow purposes. If interest is charged, the buy-sell may prescribe a reasonable interest rate.

Life insurance proceeds are free of federal income tax, as long as the surviving owner was the original purchaser of the policy on the deceased owner. Things get more complicated if there are more than two owners, because each owner must buy policies on all the other owners' lives. A valuation professional can help ensure that each owner's cumulative life insurance coverage is sufficient to buy out his or her interest.

These questions highlight some of the key valuation issues that arise during shareholder buyouts. Given that market conditions fluctuate, it’s essential to regularly revisit these considerations to assess whether the company’s buy-sell agreement requires adjustments. Periodic appraisals also enable owners to stay informed about the value of their interests, ensuring sufficient life insurance and helping to prevent unexpected outcomes when a triggering event occurs.

Interested in more information around how CSH can support your organization through buy-sell agreements and business valuation services? Connect with us today.