Buy-Sell Agreement: Purpose, Problems, and Process
Unfortunately, handshake deals often fail. A Buy-Sell agreement is the most important contract that business owners will sign. Think of it as pre-nuptial agreement amongst shareholders. Key provisions of this vital contract include: providing liquidity for ownership interests at fair terms and a reasonable price; a funding mechanism that is affordable to the company; placing restrictions on who can own shares. The terms should seek to accomodate all shareholders BEFORE a trigger event occurs. Trigger events are many: death, disability, divorce, bankrupcty, and firings to name of few. Triggers create a buyer and a seller and the potential for conflict.
If the buy-sell is such an important tool for contingency planning – with legal, tax, insurance, and valuation repercussions – why does it so frequently become outdated and confined to the back of the file cabinet? It’s a good question. In our appraisal work the majority of buy-sell agreements we see are outdated and don’t address changes in the company (like new ownership and changes in the size and value of the company). Furthermore, the document language is often very imprecise leaving a lot of room for legal interpretation that can result in costly litigation amongst shareholders.
Valuation is a focal point in litigation – the buyer wants a lower price, the seller a higher price. If the language isn’t clear as to level of value or standard of value the case will go to court where everyone’s value gets diluted. There are three types of buy-sells: formulas, fixed-price, and valuation process. Formulas and fixed-price agreements are easy to understand and inexpensive. However, there simplicity means they often become stale and fail to capture the economic value of the business. A full valuation process, done by an accredited appraiser, is a much more robust way to understand business value.
Buy-Sell Agreement Reviews
A buy-sell agreement is a legal document and needs to be written by an attorney. However, not all lawyers aren’t deeply immersed in the nuances of valuation theory and its language. We can advise from a business, economic, and valuation perspective recommending changes to areas which could become problematic. It’s also important to have valuations updated periodically as business, shareholder, and economic conditions change. If you are thinking about attracting investment or selling the business, it’s a good idea to have a valuation done early in the process so you can put measures in place to increase and protect business value.
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