Successful Wealthpreneurs keep risk mitigation in mind while managing all aspects of their financial lives. They know that potential risks like the 5 D’s can become reality for even the most well-managed businesses. For multi-owner businesses, these risks are often addressed through a buy-sell agreement.
An undercover ownership transition plan
A buy-sell agreement is a contract among the owners of a business. It provides for the sale (or offer to sell) of an owner’s interest in the business to another owner or to the business when a specified event occurs. Death, disability, retirement, divorce, and withdrawal of an owner are common triggers of a buy-sell agreement. To savvy Wealthpreneurs, a buy-sell agreement is recognized as an ownership transition plan in disguise!
It’s all ice cream, but which flavor?
One of 3 popular approaches is often used to determine a buy-sell price. These options might seem simple, but a deeper examination reveals that each one may be a ticking time bomb!
- Fixed price: Fixed price buy-sell agreements are set at a point in time and are never reset. Due to this unchanging nature, the fixed price in a buy-sell agreement you drafted years ago could vary greatly from the fair market value of your business today.
- Formula price: Using a formula price for a business over time creates challenges due to changes in the economy, financing conditions, industry conditions, and the company itself. Such formulas may not address price adjustments if certain non-recurring or unusual events occur.
- Multiple appraiser: This approach involves two or more appraisers who each determine a buy-sell price. Typically, a conclusion is not reached until the end of a long, expensive, and potentially divisive process. Litigation is frequently required to reach price resolution.
Wealthpreneur Lesson
Dr. Mixon gets fired!
In 1998, Dr. Tynes Mixon and a group of other physicians formed Iberia Surgical, LLC. This Louisiana company operated an ambulatory out-patient surgical center. The LLC operating agreement provided that a member could only be expelled with a unanimous vote. In the event of expulsion or withdrawal, the departing member’s interest would be repurchased at “fair market value” as defined under the terms of the agreement. In 2002, this agreement was put to the test when the members unanimously voted to expel Dr. Mixon.
In the LLC agreement, “fair market value” was defined as equal to the “book value” of the net equity of the company. The company’s accountant calculated the book value of Mixon’s interest to be $71,357, but Mixon hired a valuation expert who determined the fair market value of his interest to be $483,100.
Mixon rejected the price as calculated by the company and sued. Unfortunately for Mixon, both the trial court and the appellate court held he was required to accept a price calculated in accordance with the LLC operating agreement he had signed. Mixon likely failed to seek advice on the accounting, tax, and legal implications of the document before he signed it. Dr. Mixon made a $412,000 mistake!
The Buy-Sell Crystal Ball
Before executing a legally binding buy-sell agreement, review sample illustrations of expected outcomes. These scenarios should include potential implications of a triggering event for a departing/deceased owner, continuing owners, and the company.
In the story above, Mixon’s legal fees probably far exceeded the $71,357 he received from Iberia Surgical. This negative outcome could have been avoided if Mixon had reviewed a sample illustration before the agreement was executed.
The gold standard
Instead of the 3 popular methods mentioned earlier, valuation experts often recommend the following approach to determine the price in a buy-sell agreement.
- The parties agree on a single appraiser. The appraiser may be named in the buy-sell agreement to memorialize this selection. After the execution of the buy-sell agreement, the company will retain the appraiser on behalf of all parties to the buy-sell agreement.
- The selected appraiser provides a draft of a business valuation for all parties to review. After reviewing the draft, the parties can discuss the valuation, consider revisions, and negotiate further. The appraiser will treat life insurance proceeds, if any, as agreed to by the parties. When all parties have submitted input, the appraisal is finalized. This valuation is the initial price for the buy-sell agreement.
- The buy-sell agreement provides for a frequency (such as annually or biannually) at which the appraiser will update the appraisal. This revaluation will reset the price for the buy-sell agreement until the next appraisal.
- If a trigger event occurs, the selected appraiser will provide a revaluation. If desired, the parties may negotiate and memorialize how the price will be finalized in the buy-sell agreement. This process may be based on how much time has passed since the most recent appraisal.
If you can’t afford gold, buy silver
The above approach works well for businesses that can afford a frequently prepared, full-scope valuation appraisal. Alternatively, the periodic valuation can be replaced by a more cost-effective range-of-value estimate prepared by a Certified Exit Planning Advisor (CEPA) who is familiar with the company and its owners. This estimate is not legally binding, but it can serve as a tool to inform the parties to the buy-sell agreement. If a trigger event occurs, a formal valuation report should be prepared by a qualified appraiser.
Flying With Buy-Sell Airlines
A buy-sell agreement is like ownership transition on autopilot. But will you, the other owners, and the company land safely when a trigger event occurs? Depending on the terms of your buy-sell agreement, some of you may crash and burn! To prevent this outcome, begin by asking some key questions.
- What will happen if your buy-sell agreement is triggered?
- Specifically, what will happen to the ownership percentage of each business owner if your buy-sell agreement is triggered?
- According to your buy-sell agreement and related documents, how will life insurance proceeds received upon the death of an owner be treated?
Prevent the explosion
Like Dr. Mixon, many parties to buy-sell agreements are not familiar with the accounting, tax, and legal jargon in these documents. Decoding this jargon is crucial to understanding what will happen upon a trigger event. A Certified Exit Planning Advisor (CEPA) can advise you regarding the potential impact of a future trigger event before you execute a buy-sell agreement.
The insights above were inspired by the teachings of Chris Mercer. For those interested in additional information, I recommend his book, Unlocking Private Company Wealth.
