Essential Elements for Small Business Buy-Sell Agreements
In a previous article (Buy-Sell Agreements in Construction – Even More Critical) we explained what a buy-sell agreement is and discussed why they are critical for our clients. In this article, we will discuss Business Valuation, which is an essential element of the buy-sell agreement. A Company needs to know what the business is (and will be) worth in order to set up buy-sell agreements that capture the true value of the shares or Member Interests.
There are a number of ways to value a business, but three of the most common types of business valuation are:
Valuation Process; and
Formula Price Agreements
Formula Price Agreements include a formula that sets the price of the shares or Member Interests at the date that the buy-sell agreement is executed. A common formula is a multiple of earnings before interest, taxes, depreciation, and amortization (“EBITDA”), but many other formulas could be used.
Formula agreements can result in a problem because conditions can change in the economy and the Company over time. In some time periods market multiples can be very strong, but in other time periods market multiples can be weaker. Formulas do not change with the economy and the Company’s changes. A situation can arise where the owners end up with a valuation that isn’t consistent with the economic realities at the time the buy-sell agreement is invoked. On the other hand, it sets an objective and flexible method by which the Company or shares must be valued.
Fixed Price Agreements
Fixed Price Agreements are exactly as the title implies. The price is set in the agreement, and that price stands until the agreement is updated.
Fixed price agreements often result in a problem because the agreed-upon price is typically not updated regularly. Also, it is common that there is little analysis behind the agreed-upon price. It is not unusual with fixed price agreements that the owners would be contemplating a purchase price for shares or Member Interests that was set years ago when the business was very different. Additionally, it is common that there is little to no support for how the owners arrived at the original price. In that regard, it is typically recommended to include language that allows adjustment to the fixed price based on objective criteria, but even that can have its shortcomings.
Valuation Process Agreements
Valuation Process Agreements require that a valuation be performed as of the date the buy-sell agreement is invoked. While they do not require anything specific about the actual value of the shares or Member Interests, they can be very specific about the process through which the value will be determined.
Valuation process agreements will include definitions and key considerations that must be considered. They can even state who the valuation analyst will be, but they do not give the value of the shares or Member Interests or a formula to determine the value of the shares.
The strength of valuation process agreements is that they specifically require the valuation analyst to consider the Company and the economy as they are on the valuation date. Valuation analysts are also required to consider the definitions and key considerations that the shareholders or Members put in the agreement so that the valuation is consistent with it. A weakness is that it takes some time, effort, and expense to develop a valuation report, which can still be subject to dispute and further negotiation.
Buy-Sell Agreement Best Practices
The recommended best practice is often to create a valuation process agreement, through the identification of a valuation analyst and the process that will be utilized to create the agreement.
Experience shows that if a Company follows these best practices, the shareholders or Members are far less likely to end up in a valuation dispute – which are often costly, contentious and drawn-out. Note, however, any valuation requires an expense. Analysts may have valuations prepared only when the Buy-Sell agreement is invoked. Such an agreement is less expensive, but it provides the shareholders or Members with less information as the Company changes over time. When the time comes for a valuation, some shareholders or Members could be unpleasantly surprised with the resulting value.
In any case, every Company should consider having a Buy-Sell Agreement prepared and ensure it has the critical elements described in our articles. We are glad to discuss and start a framework for your Company’s future.
Our team at the Truax Law Group offers elite legal services, trusted advice, and strategic guidance to the construction industry and small business owners in Northern Ohio and throughout the state. Have questions or concerns around your contracts? Feel free to give us a call or send us an email here >> and a team member will be touch!
About the author:
Patrick J. Ertle
I’ve been an Ohio attorney for over 30 years, primarily working in business transactions, the nonprofit sector, and estate and succession planning. When it comes to succession planning, I especially enjoy helping businesses create a solid plan that allows for a smooth transition with a strategic outcome.
My wife Susan and I live in Lakewood. We enjoy spending time with our four children and four grandchildren, and we share a love of travel.