Are Your Buy-Sell Documents Keeping Up With Your Business?
Many years ago, when you first started your business, you followed the wise advice to consult an attorney and have a proper written agreement between you and your business partners to provide a plan for transitioning your business. That document most likely included a provision for determining the value of each person’s interest in the business in the event that a person exits the business. If you are like most people, you placed that document in a file or drawer and have given little thought since then about the valuation provisions that are now dictating the value of your interest. If you have not reviewed your operating, partnership, shareholder or other similar agreement recently, you should dust-off the documents and evaluate whether the valuation provisions are compatible with the current business and the partner’s goals and expectations. There are several common valuation methods and each has a different set of concerns regarding when it may go “stale.”
An “Agreed Price” or “Certificate of Value” is an often used valuation technique. This method sets forth a present value with a requirement for the value to be revisited at least annually to be reset or confirmed. Often times the value may be related to an insurance policy amount or the then-perceived value of the business. While this method is employed with the best of intentions, the fact is that most business owners do not follow through on resetting the value as required by the agreement and the agreed value is no longer accurate. Similarly, insurance policies may change and other events (e.g., an increase in business) may cause the initial value to no longer be reflective of the true value of the business.
Some agreements will contain a formula (e.g., three times the average of the last three years revenue) or other metric to determine the valuation. You may see this in a business where a partner’s income is directly related to the receivables generated by the partner. This method will capture changes from year to year, but the formula itself may become antiquated or not be applicable to all members as it once was as members take on different roles.
Another popular method is to combine the two previous methods by beginning with an agreed price and include an automatic adjustment (e.g., $1 Million with an annual adjustment equal to the increase or decrease in the book value of the company). As with the other methods, the evolution in the nature of the business may render both the initial agreed price and the adjustment formula obsolete.
Some lawyers will attempt to eliminate the possibility of a valuation going stale by having the value determined by “the mutual agreement of the parties”. On its face, this technique seems entirely reasonable and early on, most partners are in a generally agreeable frame of mind (usually because the company is not yet profitable). The problem is, when tensions arise after a few years of doing business, partners die or roles change, at best, there may be little agreement. At its worst, the process can be abused. This rarely should be used as the sole valuation method. The parties can always agree among themselves to a valuation notwithstanding any other method if they so choose.
Finally, the appraisal method is probably the most frequently used valuation. This method requires a third-party appraiser or accountant (or possibly more than one) to set a value based upon the parameters (e.g., discounts, date of valuation, method of appraisal, book value, etc.) set forth in the agreement that is binding on all parties. While this method solves some of the problems associated with the previous methods, it is not without its drawbacks. Namely, the process can be disputed and drawn out if the buy-out is adversarial and the parameters for the appraisal can be outdated or incomplete.
As businesses evolve so must their organizational documents. It is not uncommon for a combination of valuation methods to be used where a business has diversified its assets. For instance, for a business that both owns real estate and operates the business, you would want the real estate and business separately appraised and valued. Keep in mind that one size may not fit all.
It is important to review your governing documents to determine if valuation provisions accurately reflect the current state of affairs of your business. If the valuations are obsolete, it should be addressed as soon as a possible. It is critically important to do this before valuation becomes an issue when the business partners are the most rational and you are not dealing with a successor to the interest. Once a triggering event has occurred and the owner’s interests are no longer aligned, the potential for a reasonable resolution diminishes.
Pictured Christopher Wisniewski, Esq.
If you need assistance with buy-sell agreements or in any way in connection with the purchase or sale of a business, contact Christopher Wisniewski, Esq. at 856-369-3020 or firstname.lastname@example.org.