May 06, 2019
Buy-Sell Agreements: Minimize the Stress - Plan Ahead
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Privately held small and/or family firms may benefit from creating a formal Buy-Sell Agreement. This is especially true of new firms. The future is uncertain, full of risks, and can involve a multitude of decisions each day. If those decisions bear the right fruit, the value of the firm will grow over time. Without a formal Buy-Sell Agreement in place, significant and costly problems can occur at the death of one of the owners or if one of the owners wishes to sell their partnership units or corporate stock.
The absence of an Agreement opens the door to not only negotiation but to argumentation. Buy-Sell Agreements can stipulate a specific purchase price or exactly how the firm is to be valued when the need arises, how the date of valuation is to be determined, the agreed-on method or methods of valuation, and how the valuation is to be accomplished – whether internally or via an outside valuation professional.
For a valuation arrangement, a variety of alternative valuation methods are available for the determination of a firm’s worth and not all may be acceptable to the parties involved at a given time in the future. Prior to a time for sale of ownership units, the success of the firm is an unknown. When the need for a sale of ownership units is a reality, the level of success is a known factor. If no Agreement is in place, the discussion regarding a purchase price and/or how a valuation is be accomplished, and by whom, can be lengthy and fraught with disagreement since different methods can provide for different winners and losers in the purchases and sales of ownership units.
One common method is to apply a multiple of sales, earnings, cash flow, or some combination formula including a multiple as well as the addition of other factors such as assets. For example, a small grocery might be valued as 15% of annual sales, while a restaurant might be valued as 5 times its gross sales plus the value of its inventory.
More complicated and exact approaches include valuing the firm based on the tangible book or market value of its assets, a discounted valuation of a series of cash flows or profits, or the capitalization of a weighted average of a set number of years of earnings. Determination of acceptable discount or capitalization rates of return, and/or how those rates are be identified can further complicate the process where discounting or capitalization are required. As an alternative to a valuation at a future date, an Agreement may stipulate a specific per unit or per share purchase price. The stipulated price may be revised over time if adjustment times are included in the Agreement.
A formal Buy and Sell Agreement can help to avoid problems if prepared in advance. Preparing the document prior to the actual need to implement a sale and purchase of ownership units can provide for time to discuss and agree on either a pre-determined price, or on the valuation alternatives to be used, and possibly even the valuator or valuators if a valuation is necessary. The Agreements may be reviewed, revised, and adjusted over time if set times for review can be included in the Agreement.
In addition to setting a pre-determined price or how a value of the partnership units or corporate stocks are to be valued, a variety of other factors should be included in a well-structured Buy-Sell Agreement. The document may also provide, for example, clarification regarding tax-related issues such as estate taxation, and possibly, whether or not the new owner of the units or shares must be approved by the continuing owners. There are, of course, numerous other issues to consider in the creation of a valid and useful Buy-Sell Agreement but the key is prior planning and the creation of a good working Buy-Sell Agreement with the approval of all current owners.
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