A “buy-sell,” as it’s often called for short, is a contract set forth by the owner or owners of a business that describes how ownership changes will take place. Like a good insurance policy, one of these arrangements will help protect you and other owners in difficult times.
Laying the foundation
Ownership transitions can transpire under many different circumstances — some good, some not so good. In the context of a buy-sell, these circumstances are referred to as triggering events.
They can include a relatively happy occurrence, such as a long-time construction company owner retiring to enjoy rest and recreation. But triggering events also include the death or disability of an owner, or an owner’s contentious departure because of a conflict over strategic direction.
As mentioned, the buy-sell will — in very specific detail — see to the orderly transfer of ownership and control following a triggering event. The agreement also will create a market for otherwise unmarketable ownership interests and create the liquidity needed to pay estate taxes and other expenses.
Setting the price
It’s critical for a buy-sell agreement to include a well-crafted, carefully worded valuation provision. This language will set the purchase price for a departing owner’s shares and, ideally, prevent conflicts and even litigation over share value.
Various approaches can be used to set share prices. Generally, the parties involved will hold negotiations to set the ground rules for share prices. Then the company will engage at least one independent, professional appraiser to value the company and apply a valuation formula tied to book value, EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) or other factors. Often, additional valuations may take place at either prescribed regular intervals or after a triggering event.
Negotiating the deal
Negotiation can be a cost-effective way to arrive at a price that’s fair to all concerned — so long as the parties can reach an agreement. If they can’t, litigation may be inevitable. One potential solution is to provide for a negotiated price but, if the parties can’t come to an agreement, bring in an independent appraiser to issue a binding decision.
Independent appraisals near the date of a triggering event generally produce the most accurate results. A professional appraiser will scrutinize your company, taking into account the special characteristics that distinguish it from other businesses in the industry and drive its value. The disadvantage of this approach, however, is that it can be costly.
To avoid this expense, many companies develop valuation formulas and incorporate them into their buy-sell agreements. Formulas are inexpensive and easy to use, but they’re also risky. Why? Because they become obsolete soon after the buy-sell agreement is signed. Book value, for example, may approximate fair market value at the time a company is established, but it quickly becomes out of date as the company generates earnings and builds goodwill.
Case in point: Two business partners had a buy-sell agreement that set the price at net book value plus $50,000. When one partner died, the surviving partner was able to acquire the deceased partner’s interest from his estate for just under $200,000 — even though its fair market value had grown to more than $11 million.
Some companies use formulas based on earnings multiples, but they also can be unreliable. A multiple of earnings may approximate a company’s value at the time an agreement is signed, but it won’t necessarily reflect the company’s value over time.
Making it rock solid
Even if you already have a buy-sell in place, be sure to review it from time to time as the circumstances surrounding your construction business change. And don’t go it alone: Contact Frazer, LLP as well as your attorney and a qualified appraiser to ensure your agreement is rock solid.