Whether your company is a family-run operation, a partnership among friends or a multi-owner enterprise, a buy-sell agreement helps protect it in potentially disruptive “what if” scenarios, including death, disability, divorce, disputes or simply a change of heart. These events may trigger ownership transitions that, without proper planning, lead to costly conflicts and financial strain.
How can you ensure a buy-sell works when it’s needed most? A solid business valuation framework helps an agreement withstand legal scrutiny and supports fair, efficient ownership transitions. An experienced business valuator can provide clarity in five critical areas.
1. Determining the value of the business
Knowing your business’s current value helps prevent unpleasant surprises. Whether an owner wants to exit the business or a tragedy occurs, a formal, unbiased valuation sets expectations and minimizes conflict. It also ensures that the remaining owners pay a fair price for the departing owner’s interest.
Business valuation pros use generally accepted valuation techniques: the cost (or asset-based), market and income approaches. What’s appropriate depends on the nature of the business, its financial performance and industry, the availability of market data, and various other factors.
2. Evaluating insurance coverage
Owner buyouts are often funded, at least in part, through life and disability insurance policies. However, this strategy’s effectiveness hinges on whether the coverage aligns with the business’s value.
A formal, up-to-date valuation is essential to determine whether the policy limits are sufficient to fund a buyout and any temporary operational disruptions, such as the loss of leadership, client relationships and revenue. As the company grows, insurance coverage may become outdated. Periodic updates help ensure coverage keeps pace with increases in business value.
3. Setting valuation parameters
A buy-sell agreement should clearly define the appropriate standard of value to avoid misinterpretations and future disputes. Appraisal terms like “fair market value” or “fair value” might seem interchangeable, but they may generate different conclusions. For example, fair market value often includes discounts for lack of control or marketability — especially in private companies — while other standards of value may reflect pro rata (undiscounted) values.
Another key consideration is the appropriate valuation date, especially in today’s volatile markets. The agreement should specify whether to use the date of the triggering event, the last day of the company’s most recent fiscal year or some other date. Using a cutoff other than the date of the triggering event discourages owners from timing their departures to maximize the buyout price.
4. Outlining the valuation process
Owners should plan how they’d prefer the valuation process to unfold if the buy-sell agreement is triggered. To streamline a buyout and reduce tension between the owners, consider the following questions:
- Who will pay for the valuation?
- How long should the valuation take?
- Should both parties hire valuation professionals, or would a joint valuation be more cost-effective?
Some buy-sell agreements sidestep the formal valuation process to save money and instead call for using valuation formulas or industry rules of thumb. Beware: These shortcuts often prove costly because they may fail to address key value drivers, such as risk, earnings growth, off-balance-sheet liabilities and excess cash reserves. Moreover, in legal disputes, courts may reject rigid formulas as overly simplistic or self-serving.
5. Structuring the buyout terms
Buyouts are about more than just price. It’s also important to prescribe the buyout terms. Many companies don’t have the cash on hand to buy a departing owner’s interest immediately. A valuation specialist can help legal and tax advisors structure installment payments, determine fair interest rates and separate the business purchase from other contractual components, such as noncompete or consulting agreements.
Additionally, some agreements contain right of first refusal or transfer restriction clauses to prevent transfers to undesirable third parties. A valuator can weigh in here as well.
Expect the unexpected
The absence of a thoughtful, well-structured buy-sell agreement can leave business owners and their legal counsel scrambling in moments of crisis. Likewise, treating these agreements as “set-it-and-forget-it” documents can be perilous. An agreement written in 2015 — when interest rates were near zero and supply chains were stable — is unlikely to serve you well in 2025. Obtaining an updated valuation annually or when significant changes occur is generally advisable.
Whether you’re creating or updating an agreement, we can help provide a solid valuation framework to preserve business continuity, reduce legal exposure and ensure fairness. Contact us for more information.
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