Plan for Transition: Buy-Sell Agreements

Written by: Matt Gross, CPA

A buy and sell (buy-sell) agreement is a legally binding contract that stipulates how an owner’s share of a business may be reassigned at the time of a triggering event such as retirement, death, or sale of their business. Buy-sell agreements are typically used in sole proprietorships, partnerships, or private corporations to help smooth the process of an ownership transfer.

These agreements are often drafted by attorneys without any consultation of a valuation expert. The absence of a valuation expert during the drafting process can lead to expensive and lengthy disputes. Common issues and areas of dispute are discussed in the following sections:

Standard of Value

The Standard of Value is the lens in which a business is appraised. Common Standards of Value are fair market value, fair value, and investment value. Without a clearly defined Standard of Value in your buy-sell agreement, controversy can arise when the Standard of Value selected by the parties results in a vastly different value conclusion than anticipated or if the parties cannot come to an agreement as to how to best value the business or ownership interest. Explicitly defining the Standard of Value in a buy-sell agreement is a critical component and should be carefully considered.

Date of Valuation

When is the value of my business or ownership interest determined? The value of a business continuously changes over the passage of time. Without a clearly determined date of valuation, you are aiming at a moving target. Disputes can occur if parties cannot agree on a specified date of valuation. Specifying the date of valuation in your buy-sell agreement helps avoid unnecessary costs and lengthy negotiations.

Who Performs the Valuation

To avoid disagreement, the owner(s) may feel that that a third party should perform an independent valuation. This may be an independent business valuation expert or the Company’s certified public accountant. Although a buy-sell can be written to have any individual perform a valuation, we recommend having someone who is Accredited in Business Valuation (ABV) and/or holds an accreditation through the American Society of Appraisers (ASA) as they are held to held to the highest standards set within the business valuation profession. Agreeing upon the valuator ensures all parties are aware of each step in the transition process and eliminates the hassle of researching and selecting an appraiser during an ownership transition.

Discounts for Lack of Control and Marketability

Under generally accepted business valuation standards, when valuing a business, it’s common for there to be discounts applied to an owner’s interest if it is 50 percent or less as there is an absence of some or all the powers of control. This is referred to as a Discount for Lack of Control. Additionally, as many businesses are privately held and do not have a readily available market to sell their ownership interest, a discount may be applied to reflect the absence of an available market. This is referred to as a Discount for Lack of Marketability.

Controversy can arise over whether these discounts should or should not be applied. Sellers often push for the absence of discounts to keep their value high whereas buyers want the incorporation of discounts to lower the purchase price. Buy-sell agreements can also be written to include or exclude discounts based on the type of triggering event. For example, termination for wrongful conduct may result in the inclusion of discounts, but death or disability may result in no discounts. Determining whether the application of discounts is allowed is a controversial topic within the legal system and has a major impact on value. The application of discounts, or lack thereof, should be carefully thought over and discussed with a valuation expert and attorney.

Dispute Resolution

Cooler heads are known to prevail, which is why outlining the steps for dispute resolution is critical. In the heat of an ownership transfer, a buy-sell agreement is meant to smooth the transition process, not make it more complicated. Clearly outlining steps to resolve a dispute helps streamline the transition process and reduce costs.

At Cogence Group, all too often we are called in after a buy-sell agreement has been executed and parties are in the midst of litigation. Take the time to consult an expert and work together with your attorney to thoughtfully draft or revise your buy-sell agreement and avoid a headache that we see far too often. Don’t let your ownership transition be a roll of the dice, let us help you make sure your buy-sell agreement makes any ownership transition a smooth and successful one.