Five Tips for Optimizing Buy-Sell Agreements
A Buy/Sell Agreement, also called a business pre-nuptial agreement, or a business will, is a legal document that is used as the mechanism governing business owners upon the exit of an owner. Buy-Sell Agreements create the necessary road map to make these exits less stressful by minimizing disruptions, and avoiding conflict.
The price to be paid for an exiting owner’s interest is the single most contended point during a transition of ownership. Owners can avoid future discrepancies in interpretation among owners by proactively addressing the following valuation-related issues in their Buy-Sell Agreement:
Update your business valuation regularly.
Your company’s value changes over time, so it is recommended that the business valuation be updated every two to three years. In the event that an unplanned triggered event happens, your family, remaining shareholders and any successors will have a clear understanding of the fair value of the business value.
Engage one appraiser.
Unplanned exits sometimes require multiple appraisers—one to represent each shareholder’s interest. If these two appraisers are not within a certain percentage, then a third appraiser may need to be hired. Obviously, this can become very costly. Business owners who plan in advance of a triggered event are able to hire one appraiser who serves as a trusted advisor, consulting with the shareholders on an ongoing basis.
Pass on using a formula method to value.
Using a formula method may certainly cut costs and seem easy, but again, the value of a business changes over time. The formula method values the business at a point in time, and may materially misprice the value of the interest to be transferred in the future. In addition, formulas and rules of thumb are not accepted valuation methods when subjected to IRS scrutiny. We recommend that your Buy-Sell Agreement calls for a formal, updated appraisal that reflects the true economic value of the interest to be transferred.
Properly fund your life insurance.
In the event of an untimely death, life insurance proceeds are often used for the buyout of the shareholder’s heirs and to pay any estate taxes due. A proper business valuation will help ensure there is enough life insurance proceeds to protect your family and fund these expenditures.
Specify the right standard of value.
There is not one standard of value recommended over another, because one-size does not fit all when it comes to ensuring that the agreement adequately addresses the owners’ objectives and the potential scenarios that could occur. The standard of value you choose should take into consideration the mutual intentions of all parties involved, estate tax implications, state laws, and funding of life insurance. The right standard of value is one where all interest holders are in agreement.
The reality is that every business owner is going to leave at some point. There are planned exits, such as pursuing other business opportunities, retirement, and sometimes just burnout. There are unplanned exits, such as death, disability, or shareholder disputes. Buy-Sell Agreements, coupled with a current, professional valuation are critical components which can alleviate some of the stress that comes with succession planning.