Fixed price buy-sell agreements are agreements in which the parties agree to a set (fixed) price at which future transactions will occur when trigger events happen. Typically, the parties agree (in their agreements) to reset the fixed price every year so that it will remain current.
Since the idea of a fixed price that the parties agree to is appealing, many companies employ this form of agreement. The pricing is relatively simple and inexpensive, at least conceptually. The problem is that the parties seldom reset the prices in their fixed price agreements.
The Tax Cut and Jobs Act of 2017
The Tax Cut and Jobs Act of 2017 was signed into law by President Trump on December 22, 2017. Probably the last thing anyone was thinking about with the new law was its potential impact on fixed price buy-sell agreements. There were more important issues at hand. But now, the new law is in place and we must think about implications for fixed price agreements and a host of other things, as well.
In a prior post, I addressed the issue of the marginal impact of the new tax law on corporate value and valuation multiples.
The recent change in tax law providing for a reduction in the federal corporate tax rate for C corporations from 35% to 21% is having an impact on the value of businesses. There were corollary changes in the tax rates applicable to tax pass-through entities such as S corporations and limited liability companies.
These changes will have and are having a significant impact on the value of businesses across America, including those with fixed price buy-sell agreements.
The public stock markets are still internalizing the impact of the changes on publicly traded companies, but the early evidence is clear that the value of business equity has risen significantly. The focus of this post is not directly on business valuation. However, we can look briefly at the potential impact of the recent tax change on business values in light of the many fixed price buy-sell agreements that exist in private corporate America.
Tax Cut Valuation Impact at the Margin
In the figure below, we look only at the change in the C corporation corporate tax rate (ignoring state taxes), and assume that the tax act will have little direct impact on multiples of after-tax earnings (true, but unproven here).
Consider a company that earns $2.0 million in Earnings Before Interest and Taxes (EBIT) and has no debt. The old federal tax rate (prior to 2018) was 35%, so taxes (ignoring state taxes) are $700 thousand and debt-free net income is $1.3 million. Under the new tax law, the tax rate is lowered to 21%, so taxes fall some 40% to $420 thousand, and net income rises to $1.58 million. That’s a 21.5% increase in expected net income on a going-forward basis.
If we assume that the appropriate price/earnings multiple is 10.0x before and after the tax change, debt-free equity value rises from $13.0 million to $15.8 million, or 21.5%.
This analysis is marginal and assumes only that the federal tax rate changes for C corporations. Like a good economist, I have assumed that “all other factors are held equal.” Lots of things will change in 2018 and beyond (relative to 2017), but the upward pressure on private equity value is clear.
Implications for Fixed-Price Buy-Sell Agreements
Consider these implications of the tax cut on fixed price buy-sell agreements:
- No dated fixed price agreement will take factors like the above into consideration.
- Every fixed price agreement signed prior to the present is already dated, and cannot reasonably reflect value after the tax law change.
- Every fixed price buy-sell agreement needs to have its price reset, preferably with the benefit of competent business appraisal expertise.
Clients often think they know about the value of their business because they are aware of a similar business that sold in the past and know (or think they do) the multiples that were paid in those transactions. This information “informs” them about their fixed price. But things have changed. Can your business owner clients look at recent transactions with similar companies to assess the reasonableness of their dated fixed prices? No. Why?
Every transaction that closed prior to the end of 2017 occurred under the old tax law. The multiples of EBIT and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) that they reflect were under the old tax law. However, as we will see in a future post, EBITDA multiples will rise prospectively, and dated transactions, i.e., the ones we are accustomed to citing, are irrelevant to current value.
Should your clients with dated fixed price agreements be comfortable? Obviously not. Business appraisers take new tax laws into account, as well as the host of “other things” that are not equal, when they provide current appraisals of private companies.
That’s why an appropriate valuation process agreement is preferable to a fixed price agreement virtually every time. You can work with your clients to amend the pricing mechanisms of their fixed price buy-sell agreements to minimize risks associated with them.
If you want to talk to me about ideas of how to amend your clients’ fixed price buy-sell agreements to minimize the risks associated with this problematic pricing mechanism, give me a call (901-685-2120) or email (email@example.com)
Valuation is important for business owners for many reasons. One of these reasons is for the operation of buy-sell agreements. If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.
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