Buy-sell agreements are ownership transition plans in disguise.  Few business owners think about their buy-sell agreements in this light, but if your agreement is triggered, either through the death of a shareholder or otherwise, then ownership will change hands.  Your buy-sell agreement is really ownership transition on autopilot.  The real question is whether you, the other owners and the company will land safely when a trigger event occurs or if some or all of you will crash and burn.

This short post addresses a simple question:

Do you know what will happen if your buy-sell agreement is triggered?

We will address the three primary types of buy-sell agreements to quickly see if you know what will happen.

Fixed Price Buy-Sell Agreements

If your buy-sell agreement has a fixed price method for determining transaction prices following trigger events, it is a good idea to know what that price will be and how it is set and reset.  Most fixed price buy-sell agreements are set at a point in time and then are not reset on a regular basis.  As a result, the fixed prices in many buy-sell agreements may bear little relationship to the reasonable market values (or fair market values) of many companies today.

If the price is higher than current value and you are a remaining buyer, you will overpay, perhaps significantly, for the shares of a deceased owner.  The estate will get a very favorable price at the expense of you, any other shareholders, and the company.

If the price is lower than current value and you are triggered, you or your estate will suffer from a low price while the other owners and the company will benefit.

Neither possibility is what you would agree to if the owners all sat down today to set a price.

You fixed price buy-sell agreement may be a ticking time bomb.

Formula Buy-Sell Agreements

Many business owners want a (simple) formula for setting the price at which transactions will occur after their buy-sell agreements are triggered.  There is simply no formula that will provide reasonable conclusions for most companies over time given changes in the economy, interest rates, the industry, and with a company itself.

If your buy-sell agreement has a formula pricing mechanism, has anyone calculated the formula recently?  What is the result?  Is it reasonable?  If so, how do you know?

If your agreement has a formula and no one has calculated it, then you don’t know the answers to the previous questions.

If your buy-sell agreement has a formula, is there any basis for making adjustments to it if certain unusual things happen?

Your formula buy-sell agreement may be a ticking time bomb.

Multiple Appraiser Buy-Sell Agreements

Many buy-sell agreements have pricing mechanisms that call for the selling party to select an appraiser and for the buying party (usually the company) to select another appraiser.  These two appraisers then prepare appraisals.  If their conclusions are within (almost always) 10% of each other, the price will be the average.  But the conclusions are almost always more than 10% apart.

If there is a large difference, the two original appraisers will select a third appraiser who is supposed to save the day.  His conclusion may be averaged with the other two, or averaged with the closer of the other two, or it may be conclusive of value.

The point is, no one knows what the conclusion will be until the end of a long, expensive and divisive process.  Quite often there is litigation involved.  Quite often there is disagreement over qualifications of appraisers, or differences in the background and experience of the appraisers selected.

My point is that if you have a multiple appraiser buy-sell agreement, you don’t know (with virtual certainty) what will happen if a trigger event occurs.

Your multiple appraiser buy-sell agreement may be a ticking time bomb.

Life Insurance Associated with Buy-Sell Agreements

If there is life insurance associated with your buy-sell agreement, whatever type it is, it is critical to be sure that the language in the agreement and any related documents specifies its treatment precisely.  Life insurance can be used as a funding vehicle to acquire the stock of a deceased owner.  If so, the life insurance is not treated as part of the purchase price.  Alternatively, life insurance can be a corporate asset (corporate-owned life insurance, or COLI), and proceeds are part of value.

The two different treatments provide different, perhaps dramatically different results for selling owners and remaining owners.

If you don’t know how life insurance is to be treated with your buy-sell agreement, your buy-sell agreement may be a ticking time bomb.

Single Appraiser Process is the Key

I have long recommended that the preferred pricing mechanism for buy-sell agreements has the following elements:

• A single appraiser is agreed upon by the parties.  All agree on background, experience and credentials of the appraiser and the firm.  The appraiser is retained by the company on behalf of all parties to the buy-sell agreement.
• The selected appraiser provides a draft valuation to all parties.  The parties review the draft and all have the opportunity to see exactly what kind of value the appraiser develops.  There is then a chance for revision and additional negotiation.  The appraiser treats life insurance as agreed to by the parties.  When all have had input to the appraiser, the appraisal is finalized.  This appraisal conclusion becomes the price for the buy-sell agreement.
• Next year (or within two years at most) the appraiser provides a revaluation, which is the basis for resetting the buy-sell agreement price.
• If there is a trigger event, the selected appraiser provides a revaluation, which sets the price for the buy-sell agreement transaction.

This single appraiser process solves virtually all of the problems outlined above with the other appraisal mechanisms.

If you don’t know what will happen when your buy-sell agreement is triggered, get with your fellow owners and advisers to revise your agreement in line with the single appraiser recommendation just outlined.  Further resources discussing this concept can be found here: 

• Buy-Sell Agreements for Closely Held and Family Business Owners (Print book)
• Buy-Sell Agreements for Baby Boomer Business Owners (Kindle book)

Questions?

Look around this blog. I’m addressing many questions that business owners have asked and many more questions that I’ve heard about or observed. My answers will not be technical, but hopefully explanatory and illustrative of important business valuation concepts. If you have a question, comment on this post, email me (mercerc@mercercapital.com), or call me (901-685-2120).

If you know you need a business valuation and would like to receive a complimentary proposal, click here or call me at 901-685-2120.

If you would like to talk to me about your business and its value, about a transaction you are considering, or about any thorny management or ownership transition issues in a complimentary initial phone session, call 901-685-2120 and ask for Todd Lowe, my executive assistant. He’ll schedule a workable time for us, or, if serendipity strikes, we’ll talk when you call.

Until next time,

Chris