So You Think You Have to Have a Fixed Price Buy-Sell Agreement?

In this post, I explain why I believe that fixed price buy-sell agreements are not workable for most closely held and family businesses. This is as true for large companies as well as much smaller companies. However, if you, or your client if you are an adviser, insist on using a fixed pricing mechanism in a buy-sell agreement, take the steps recommended in this post to maximize the probability of success and minimize the potential for future disputes. My text for this sermon lies in Chapters 9, 13, 14, 16 and 17 of Buy-Sell Agreements for Closely Held and Family Business Owners.

Buy-Sell Agreements

Buy-sell agreements for most closely held and family businesses are agreements between a company and its shareholders/members/partners. These agreements dictate what will happen at future points in time when certain (usually) bad things happen – like death, firing, disability…

Importantly, they determine the price(s) and the terms under which the transactions will occur. What most business owners and many attorneys don’t really think about is that buy-sell agreements are important ownership transition agreements where owners are agreeing, in advance, on how ownership will transfer when specified trigger events happen.

There are three primary types of pricing for buy-sell agreements, fixed price agreements, formula pricing agreements, and agreements that call for an appraisal process.

So You Have to Have a Fixed Price Agreement?

This post is for those readers who believe they must have a fixed price agreement. Perhaps they don’t want to pay for appraisals, or actually believe that they can consistently agree (at least annually) as to the value of their companies for purposes of their agreements. Perhaps an attorney suggested that fixed price agreements were the simplest agreements. Who knows?

Let me say, from personal experience and observation that the parties to fixed price agreements seldom, if ever, update the pricing as called for in the agreements.

Personal experience. I hate to admit it, but we had a fixed price agreement at Mercer Capital for about a dozen years and just never got around to updating the price. This was at a time when the value of the business was growing significantly, so the agreement was substantially undervalued for years. We were lucky that nothing happened. By the way, that issue was fixed immediately and the price for our agreement is now determined by independent appraisal.
Observation. I’ve had opportunities to review many fixed price agreements over the years. Most of them, like ours, are just never updated. A few of them were never priced at all.

The fact is, as time passes, the interests, ages, health, financial positions, working positions, family situations, and more change for the various parties to fixed price agreements. It gets harder and harder to update pricing as time goes on.

An Illustrative Example of Why Not

Assume that the parties to an agreement initially set the price at $10 per share. Over time, value may go up, and it may go down, or it may stay the same. Let’s look at two possibilities.

Over time, value rises to $16 per share and the agreement is not updated.
Over time, value falls to $4 per share and the agreement is not updated.

Graphically, it looks like this:

What are the implications of each of these situation, either of which is possible when an agreement is initially signed? Consider the following:

Value rises to $16 per share. If there is a trigger event, the party who is bought out will lose out on value of $6 per share ($16 – $10), and the shares will be undervalued by 37%. The party who buys, likely the company, will pay $10 per share for stock worth $16 per share, and will be beneficiaries of a significant windfall.
Value falls to $4 per share. If there is a trigger event, the party who buys will overpay by $6 per share ($10 – $4), and the shares will be overvalued by 250%. The party who sells will receive a substantial windfall as result of the operation of the buy-sell agreement – i.e., if the company can afford to pay that price!

My Conclusion re Fixed Price Agreements

Fixed price buy-sell agreements are ticking time bombs and will achieve reasonable resolutions only by chance – and chance is not good enough for such important transactions for the parties.

A Bad Solution to the Problem

Some fixed price buy-sell agreements have a backup provision in the event that the price has not been updated by the parties with, say, two years. That provision is typically very short and incomplete, but it typically calls for:

The company to select an appraiser
The selling owner to select another
Both appraisers provide valuation opinions
If their conclusions are within 10% of each other (virtually never!) the conclusion is the average of the two conclusions.
If not, the two appraisers select a third appraiser who provides yet another appraisal.
This third conclusion is averaged in some way with one or both of the other two to reach a conclusion for the process.

The problem is that the backup, multiple appraiser valuation process is almost certainly poorly specified. The standard of value may not be clear and the level of value may not be clear. The qualifications of appraisers are likely not specified. And the standard of value and level of value may be missing or unclear. Appraisers may interpret confusing language differently and reach widely disparate conclusions.

The process is time-consuming and expensive and creates angst and anger among and between the parties. No one knows what the result will be until after this long process is completed, likely in the midst of litigation.

And what if the company is small, with a value of $1 million or so? This “backup” provision may well cost the parties $200-$300 thousand in appraisal and legal fees to settle. If the company is larger and more valuable, the cost could be even higher because there’s more to fight over.

My Solution to the Problem If You Have to Have a Fixed Price Agreement

If you must have a fixed price buy-sell agreement, set the price as you must, and agree to reset the price annually as you will.

Now put in a workable backup provision. I’ll make two suggestions for use depending on your tolerance for expense and risk.

1. Single Appraiser, Select Now and Value Now

The process I recommend goes something like this:

Before you sign or update your agreement, the parties will all agree on a single, qualified and independent business appraiser. This should be lots easier if there is no trigger event and the interests of the parties are reasonably aligned.
The appraiser will be retained by the company to provide an appraisal at the financial control level of value. This value is described in pages 137-144 of my book, Buy-Sell Agreements for Closely Held and Family Business Owners and shown conceptually in the levels of value chart (Figure 8 at page 139).
The parties will see this appraisal in draft form and, hopefully, agree that it is reasonable, whether it is the exact price agreed to for the buy-sell agreement. The appraisal will be finalized.
Then the parties will write into their fixed price agreement that if a trigger event occurs more than ____ months [you pick] following the last agreed upon (fixed) price for the agreement, the selected appraiser (or firm) will provide an appraisal at the financial control level to determine the price for the buy-sell agreement. The cost of the appraisal will be born by the company.

This procedure will salvage the day when you have not updated your buy-sell agreement. The parties will have all agreed upon the appraiser and will know what his/her valuation process is and what to expect in terms of an appraisal. The appraiser will be familiar with the company and should have credibility with all parties. And all parties will all know what to expect and will know that resolution is forthcoming at the end of the appraisal process.

The insertion of a backup provision like the Single Appraiser, Select Now and Value Now process will save the day in the event that your fixed price buy-sell agreement is out of date.

2. Single Appraiser, Select Now

If you simply refuse to obtain an appraisal in connection with your buy-sell agreement, then go through the process of agreeing on an appraiser now. This appraiser will be qualified and independent.

Write the appraiser’s name/firm into your buy-sell agreement and state that in the event that the fixed price in the agreement is more than ______ months [you pick] old, then the selected appraiser will be retained by the company and on behalf of all parties provide an appraisal of the fair market value of the company at the financial control level of value, citing the same information above. You would, of course, talk with the appraiser about his understanding of what financial control value means and why it is the appropriate level of value for the appraisal.

The appraiser will then provide his opinion to the parties and that conclusion will set the price.

This procedure is less certain than the first, because the parties will not have experienced the appraiser’s process. However, it provides far more certainty than having no backup provision or having a poorly specified multiple-appraiser process in place.

Wrapping Up

To be clear, I do not recommend fixed price buy-sell agreements to any clients. I believe they are ticking time bombs waiting to explode.

Some business owners, often at the suggestion of some advisers, however, will insist on having fixed prices for their agreements.

If you do this, do not do so without a workable backup valuation provision in the (likely) event that the parties will not update the agreement each year.

My recommendation is that the backup provision be that of Single Appraiser, Select Now and Value Now, where the selected appraiser provides at least one formal appraisal at the appropriate level of value for the parties.

My next best backup provision is that of Single Appraiser, Select Now. Get a qualified appraiser written into the document reflecting the parties’ collective agreement. Then, if the fixed price is dated, engage the named appraiser to perform the necessary valuation to set the price.

Your fixed price buy-sell agreement will work until it doesn’t. And when it doesn’t, it will be to late to fix. So fix it now, before it is too late.

Set your company and your shareholders up for the smoothest possible ownership transitions when trigger events occur by fixing your fixed price buy-sell agreement.

If you have a fixed price buy-sell agreement, obtain a copy of Buy-Sell Agreements for Closely Held and Family Business Owners and read Chapters 9, 13, 14, 16 and 17.

As always, do call if you want to discuss any valuation, buy-sell agreement, or ownership and management transition issues in confidence.

In the meantime, be well!

Chris