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It is critical that business owners agree on the Standard of Value to be applied at a triggering event. A common standard of value for buy-sell purposes is Fair Market Value. Fair market value is defined as: “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Under a fair market value standard, a partial interest in a company might be worth considerably less than its pro-rata value because of potentially applicable discounts such as those for lack of control and lack of ready marketability. 

Fair value is another standard of value. Fair value is typically defined by statute and case law in the state in which a company is organized and commonly is interpreted as that which is fair or equitable. In some states, this includes discounts for lack of control or marketability and in others, it does not. It is important that owners agree upon a definition of this standard if it is going to be used for buy-sell purposes. In states in which a business interest is not subject to discounts, fair value is typically defined as a pro-rata value of 100% of the equity in a company. Broadly, 10% of a company worth $100 would be $10 under those fair value statutes.

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Independent assessment of value. This determination of value typically utilizes one or more valuation analysts to opine on the value of a business interest. If it is agreed that an independent assessment is to be the method in which the value of a business interest is determined, the parties must decide how to select the professional(s), how many to use, and how to reconcile differences in valuation opinions if multiple appraisers are utilized. Overall, it is important to select (an) experienced, credentialed professional(s) to determine value. 

Formula pricing. This method does not equal fair market value but is, rather, a means to estimate a value in an ownership interest. Formulas appeal to many parties to buy-sell agreements because they are objective and inexpensive to determine. They may, however, miss subjective factors that influence value. Clients using a formula price should revisit the formula periodically to make sure the resulting value is still representative of their intentions. A formula can become outdated very quickly and its use for buy-sell purposes is generally not recommended.

Book value. Value is sometimes defined as net book value as recorded in the entity’s records, tax returns, or as determined under generally accepted accounting principles (GAAP). This value may be based on a company’s financial statements, an independent audit, or tax return information. Net book value is typically indicative of historical cost and not fair market value.

Value based on insurance proceeds. In a buy-sell agreement, it is not uncommon for the purchase price of an interest in a closely-held company to be the amount of an owner’s life or disability insurance policy proceeds. While this is a simple method, it may or may not approximate fair market value. This potential variance may cause problems for the redeemed owner. Its use for buy-sell purposes is generally not recommended.

Periodic review and consensus. A company with several owners may periodically hold meetings to review and update an agreed upon value. Buy-sell contracts with a static value provision will need to be modified at regular intervals. Owners must resolve how often the contract should be updated, how those changes will be documented, and what happens if the agreement is not updated. Owners should ensure that all changes to the agreement are documented and properly executed.

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To draft a buy-sell agreement that satisfies all owners and helps preclude future conflict, owners need to understand their goals, their options, and how specific facts may affect a future transaction. An experienced valuation practitioner can help clarify the effects of an owner’s choices and facilitate discussion. Discussion points that parties to a buy-sell agreement must resolve may include: 

• Selecting the standard and definition of value the agreement will use (see above).
• Deciding whether to employ an independent business valuator.
• Making sure the agreement clearly defines the procedures that are to be applied in determining purchase price.
• Making sure the agreement anticipates the funding requirements of a buyout and defines the payment terms.
• Including a provision in the agreement that requires the purchase price on the death of an owner to be no less than the value of the shares “as finally determined for federal estate tax purposes.”
• Making sure the valuation provisions don’t provide an incentive for new shareholders to cause a triggering event and be bought out.
• Including a penalty for leaving early/misconduct/involuntary misconduct – to dissuade shareholder-employees from leaving the company, some buy-sell contracts give less than they would otherwise receive to individuals who leave voluntarily or in cases of misconduct as defined by the agreement. If an owner’s employment is terminated for cause, a “penalty price” such as net book value, a percentage of fair market value, or another predetermined value may be applicable.
• Considering a shareholder’s divorce – many entities want to protect the business against an owner’s spouse obtaining an interest. If so, include language in the agreement to require the purchase/sale of a spouse’s ownership interest if he/she is awarded stock in a divorce settlement. In any event, it is common to require a business owner’s spouse to become a party to the agreement. Spouses should obtain independent legal counsel. Note: If a purchase provision is invoked, the divorcing owner’s interest in the business may be diluted.
• Requiring new stakeholders to be a party to existing buy-sell agreements before becoming shareholders – make sure the valuation provisions don’t provide an incentive for stakeholders to cause a triggering event and be bought out.

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Buy-sell agreements can be a valuable tool for closely-held business owners who want to protect their ownership interests. But if drafted improperly, buy-sell agreements can lead to problems for both buying and selling parties. To ensure a satisfactory outcome, owners should work closely with professionals such as their attorney, an insurance agent, or an Accredited Senior Appraiser (ASA) to include the proper provisions in a buy-sell agreement. 

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