Every family business must have a workable buy-sell agreement, but in the absence of a triggering event, how can you know yours is workable?
Buy-sell agreements are some of the least understood, yet most important, corporate documents. These agreements establish the mechanism for the purchase (and corresponding sale) of equity interests upon the occurrence of certain trigger events, such as a shareholder quitting, being fired, retiring, becoming disabled, dying or divorcing.
Most business owners don’t know what will happen when their buy-sell agreements are triggered because too little attention is paid to valuation issues in the agreement. Unfortunately, once the agreement has been triggered and interests of the parties—even if they are family members—diverge, it’s too late to fix any problems. The good news is that there is a way to know in advance whether your buy-sell agreement will work as you expect.
Understanding buy-sell agreements
There are three types of buy-sell agreements:
1. Cross-purchase agreements call for individual shareholders to carry life insurance on the lives of other shareholders. This may not be economical (if a company has substantial economic value) or workable (if there are many shareholders).
2. Entity-purchase agreements call for a company to purchase shares when a shareholder leaves as a result of a trigger event.
3. Hybrid agreements provide for the company to pass purchase rights to shareholders under certain circumstances.
Most buy-sell agreements in significant closely held and family businesses are entity-purchase agreements.
There are four common pricing mechanisms in buy-sell agreements:
1. Fixed price. The shareholders agree on a fixed price. The only problem is that, if your business is like most others, you will probably not update the agreement and the value mechanism will soon (has already?) become woefully out-of-date. Out-of-date agreements can wreak havoc with estate planning for senior-generation owners, especially if a younger-generation member dies unexpectedly.
2. Formula price. The shareholders agree on a formula that will set the price. However, there is no formula that will provide reasonable results over time given the changing nature of the markets, the industry and the company.
3. Shotgun price. If you name the price, I get to decide whether I’ll buy or sell. Sounds fair, yet this seldom works with more than two shareholders. Also, a shotgun agreement can damage family relationships. Who wants to be involved in a “shootout” with a family member?
4. Appraisal process. Many buy-sell agreements provide for a business appraisal process to determine value when trigger events occur. There are multiple-appraiser processes and single-appraiser processes.
Some owners think they have a pricing mechanism with a right of first refusal. This is problematic because there is no requirement to either buy or to sell. Therefore, there is no assurance of a transaction when trigger events occur. Rights of first refusal are often used in conjunction with buy-sell agreements in order to ensure that family ownership is -preserved.
Other than appraisal processes, all the pricing mechanisms mentioned have a common characteristic: The parties to the agreements are betting that the other party (or parties) will be the first to die, retire or otherwise leave. One of them will be right; however, that will not likely be good for the other if the price is unreasonably set by an out-of-date fixed price, a faulty formula or otherwise.
Appraisal process agreements
Many agreements call for one side to retain one business appraiser and for the other side to retain another. Usually, both appraisers provide valuations. If they are within 10% or so of each other, the average is the concluded price and the process is over. If not, the first two business appraisers generally select a third business appraiser, whose job is to reconcile the disparities. The third appraiser’s conclusion either will be averaged with one or both of the first two conclusions or it may be determinative of value, depending upon what the agreement calls for.
Does this sound like a good process for maintaining harmony in your family? Keep in mind that all of this appraiser selection and valuation activity occurs after a trigger event when personal or family relationships may be frayed.
The reality of a multiple-appraiser process is that no one will know how the process will play out until a trigger event occurs. Further, no one in the family will have any idea what the value will be until the appraisal process is complete. That’s not good business.
In addition, based upon my experience working with hundreds of buy-sell valuation engagements, know this for sure: Family or not, when a trigger event occurs, the buyer(s) and the seller(s) generally have opposing ideas about value. This is natural, because their interests have diverged.
To avoid these problems with multiple-appraiser agreements, I have long recommended a single-appraiser process for companies, and especially for family businesses. The process is straightforward:
• All parties to a buy-sell agreement agree on a single appraiser at the time the agreement is signed.
• The appraisal is based on the level of value agreed upon (i.e., control, marketable minority or non-marketable minority). If there are problems with the definitions of value or other aspects of the process, they will be uncovered and can be fixed before a triggering event. This is easy at this stage because all family members and other owners are interested in creating a workable agreement that is fair and reasonable whether a particular party is a buyer or a seller.
• The first appraisal becomes the initial value for purposes of the buy-sell agreement.
• The selected business appraiser then provides a reappraisal every year (or two for smaller companies) to update the buy-sell price.
With a single-appraiser process, all parties have current valuation information for personal and corporate planning purposes every year. If too much time has passed between the last appraisal and a trigger event, the appraiser may have to provide an appraisal following the trigger event. However, there is comfort because everyone understands the process and is knowledgeable about value. That’s good business and good for family relationships and planning.
Defining elements for valuation
Your corporate and estate tax attorneys include items and information in your buy-sell agreement that are necessary for legal and estate planning purposes. These are critical to a workable agreement. However, if you want your company’s (and family’s) buy-sell agreement to provide reasonable valuation resolutions when trigger events occur, six elements must be included to define the valuation process.
1. Standard of value. This is a valuation term relating to the overall type of value. Fair market value is a common standard of value used in buy-sell agreements. This standard is well known by business appraisers and attorneys. Fair market value is the hypothetical price at which willing buyers and willing sellers—both reasonably informed, neither with compulsion and both with capacity—engage in a transaction. If the agreement says something else, be sure the parties know what it means and that business appraisers will interpret it similarly.
2. Level of value. This relates to the particular kind of value the agreement specifies. Do the parties desire that the price be that of a non-marketable minority interest, or a pro rata share of the value of the business? Or should the value be that which is obtainable in a sale to a strategic buyer? Lack of clarity on this point will create great confusion and busted valuation processes.
3. The “as of” date. This is the valuation date. One wouldn’t think there could be confusion on this point, but a number of agreements fail to specify the “as of” date clearly. Imagine the problem if two different business appraisers interpret the “as of” date to be different dates, significantly apart in time. The agreement must be crystal clear on this point.
4. Qualifications of appraisers. Many agreements call for each party to retain the services of “an appraiser,” “a qualified appraiser” or an appraiser by some other description. The qualifications of the business appraiser(s) must be specified in your agreement. For example, the agreement might read something like this: “Each party will retain the services of a business appraiser. To be considered, an appraiser must be an Accredited Senior Appraiser as designated by the American Society of Appraisers [or other designating body] and must have experience in valuing companies of similar size and scope as the Company.”
Designating specific industry experience might be attractive; however, be aware that some industries are so small or discrete that there are no real industry experts. Even if an industry has acknowledged industry experts, their valuation expertise may be lacking. Therefore, it is almost always a better idea to seek valuation expertise over industry expertise alone. Pre-selecting the appraiser by mutual agreement, as recommended above, avoids this future uncertainty.
5. Appraisal standards to be followed. Most of the major business appraisal organizations have recognized appraisal standards for their members to follow. Your buy-sell agreement should ensure that all business appraisers follow the same set(s) of appraisal standards; otherwise, confusion and misunderstanding can easily occur. What you definitely do not want is an unqualified business appraiser who follows no standards.
6. The funding mechanism. While the funding mechanism is not normally involved in defining the valuation (unless, for example, life insurance proceeds are involved), it is important to establish the funding mechanism for the buy-sell agreement. This may be as straightforward as defining the terms of payment, including specification of the terms of any note that would be required. However, this requires careful consideration, especially if there is other debt on the company’s balance sheet. If there is life insurance on family owners/members, it is critical that the application of proceeds be specified in the buy-sell agreement for purposes of valuation either as a funding mechanism (to purchase stock) or as a corporate asset (to be added to value).
There is more to the working of your family business’s buy-sell agreement than meets the eye. It is a good idea to review your agreement with family members and appropriate advisers, including a qualified business appraiser every year or so. There is a way to tell if your buy-sell agreement will work without triggering it. Now is the time to find out and to fix it if necessary.
Z. Christopher Mercer, ASA, CFA, ABAR, is founder and CEO of Mercer Capital, a national business valuation and investment banking firm (www.mercercapital.com; www.buysellagreementsonline.com), and author of Buy-Sell Agreements for Closely Held and Family Business Owners: How to Know Yours Will Work Without Triggering It.