Entrepreneurs starting a business with a partner are bombarded with legal filings and agreements, and too often, they rush to sign them without considering the ramifications.
That, however, is a mistake. Take, for example, the wife of a deceased business owner. The husband and a friend had put 30 years into the business, growing it to having revenues in excess of tens of millions of dollars. Upon his death, however, the wife received just $1,000 for her husband’s interest.
How could this happen? Thirty years earlier, he had signed a poorly drafted buy-sell agreement in which he agreed to the $1,000 figure.
A buy-sell agreement spells out what you and your co-owners are entitled to receive should a triggering event, such as death, disability, retirement or bankruptcy, occur. When it does, the agreement dictates the dollar value that the owner, or his beneficiaries, is entitled to.
However, agreements are often signed early in the life of a business, using a standard template, and are never revisited to capture increases in value as a company grows and becomes profitable.
Buy-sell agreements may contain vague terms or incorrect references that can be open to interpretation. For example, many say an owner’s interest will be his pro-rata share of book value but don’t spell out what that refers to or under what accounting standard such book value is defined. Or they might specify a formula to derive the value of an ownership interest, such as five times net income. But how is that net income determined?  What line items does that net income include or exclude?  For example, should the net income include any extraordinary amounts, such as nonrecurring expenses such as relocating the operations?
Getting it right
A poorly worded buy-sell agreement can cost millions. So what is a better way?
If you don’t have a buy-sell agreement, call counsel immediately to have one drafted. If you do have one, consider having an appraisal expert perform an initial valuation of the company so all parties understand what is involved and can address potential sticking points. After the final valuation report is delivered, the owners agree the valuation will be in effect for a specified number of years, generally not to exceed two or three.
After that, you’ll need to do an update so that any appreciation in the company’s value will be captured and properly distributed if a triggering event occurs. Consistently valuing the company can seem daunting, but having the business routinely appraised also helps make sure you have adequate funding via life insurance if a buyout becomes necessary and helps the owners with estate planning.
While the cost for the first valuation may seem high, you should view it as an insurance policy to ensure your family is protected should something happen. Future updates should cost significantly less, as the appraiser will be familiar with the company and the appraisal should be less work.