The Potential Pitfalls of Gambling with Your Buy-Sell Agreement

For most business owners, one of the single biggest assets they have is the ownership of their closely-held business.  So, why would anyone risk gambling with such a large piece of their financial puzzle if something catastrophic could happen?  As an owner of a company with shareholders and partners, you may already be taking such a gamble if your company either lacks a buy-sell agreement or has other problems with an existing buy-sell agreement.

A Buy-Sell Agreement
A buy-sell agreement is a document signed by all owners in a business which establishes a mechanism for how transfers of ownership in the company can be facilitated between or among shareholders.  It provides the road map for how someone’s interest it to be bought out in the event of certain defined “triggering events,” which may include death, disability, bankruptcy, termination, divorce or other such events as determined as necessary by the owners.

Importance of a Buy-Sell Agreement
A buy-sell agreement should be one of the first documents put into place when a business involving multiple owners is started. However, at the time an agreement is put into place, the owners are typically in the “honeymoon phase” when everyone gets along, and the shareholders’ interests are all aligned.  However, with businesses as in life, circumstances and interests change and that’s when problems arise from agreements that pose more questions than answers.

Under a buy-sell agreement, different approaches may be utilized in determining the value of an owner’s interest once a triggering event happens.  An agreement may call for a fixed price to be assigned to the company or interests, or may utilize a formula approach, or may call for the guidance of an outside appraiser or valuation expert, just to name a few.  However, under each of these different approaches, the possibility exists for questions or vagaries of how to interpret the agreement, leading to potential problems at a time when such uncertainty would be most difficult or unwelcome, such as the death of one of the owners.

Buy-Sell Agreement Examples
For example, with a fixed price provision, the agreement will call for management to agree upon a price for the Company, or per share value, and formalize such agreement in corporate documents.  This agreement may happen in the first few years, but often in later years, management fails to come to an agreement for the called upon value on a consistent basis.  What price should be used if a value hasn’t been agreed to in five years?  What value should be used if, since the last documented value, the company has started offering a new, highly profitable product line or landed a new contract?

Another common approach allows for the employment of a formula, such as the value of equity of the company near the event date or multiplying the company’s earnings times a factor, such as 5.  Again, the potential for interpretation of vague or open-ended terms can lead to problems.  How is the value of the company’s equity determined – by certain accounting principles, or based upon the internally generated financial statements?  What if the company maintains its books on a cash basis – should the value of equity include the businesses receivables and payables, even though they are not formally recorded on the financial statements?

Earnings formulas can also present potential pitfalls – are earnings determined on a pre-tax basis or post-tax basis?  Should only the latest year’s earnings be utilized or should an average of some years be used?  What if the company incurred some unusual expenses, such as the cost of litigation, that is not part of normal operations – should that expense be eliminated?  Should the owner’s compensation be normalized to prevailing market rates, or left alone?

For these and other questions or potential problems, there is not one right or wrong answer for everyone, but rather are dependent upon the needs and wishes of the owners.  Where business owners can protect themselves is to utilize the help of outside advisors to address any potential pitfalls before problems occur which might result in a financial shortfall for them or their heirs and resentment towards those that remain in the business.

Without a clear and realistic mechanism in place in a buy-sell agreement and a full understanding and documentation of potential pitfalls, the shareholders in business are gambling that they won’t be on the losing end once something happens. In the end, it’s best if you have an advisor involved in the process of your buy-sell agreements.