Last year I had the privilege of working with the owners of a successful closely held business. As part of the valuation process, I reviewed the company’s buy-sell agreement.
I noticed two things right away that caused me concern. First, the agreement had not been updated since it was originally signed more than 20 years ago. Second, I realized that the valuation mechanism related to accounting book value (shareholders’ equity on the balance sheet), and both companies were profitable and created significant intangible value. There were a number of other business-related issued that needed to be addressed with the owners and counsel.
I informed the owners of the issues and recommended that they take action immediately to update and revise their buy-sell agreements. Unfortunately, life intruded and the owners did not act immediately.
The company’s CFO has since contacted me asking to talk about the agreement. I was very pleased that the owners are taking this important step, and even happier that nothing happened to trigger the agreement during the past several months.
Dated Buy-Sell Agreements
Dated buy-sell agreements are worrisome for a number of reasons. Whatever the purposes for creating the agreements initially, it is virtually certain that things have changed since, including:
- At a minimum, the shareholders are older – in my experience 15, 20, 25 or more years older. This brings about changes in health, outlooks, personal situations, and so on.
- Conditions at the company have certainly changed.
- The original business needs that the dated buy-sell agreement was created to address have likely changed.
- The estate planning needs of the principal owners have changed.
- The ownership composition may also have changed.
- Business valuation theory continues to evolve.
The bottom line is that lots of things change over any extended period of years.
In the situation mentioned above, the buy-sell agreement was to be triggered by the death of a shareholder, and the agreement called for a price based on accounting book value (shareholders’ equity on an historical cost basis).
The company created significant intangible value – well above book value levels. The owners were making bets over the past 20-plus years, at lease implicitly. Both owners were betting, in effect, that the other would die (or not) first.
- The first to die. The first to die would receive value according to the buy-sell agreement’s pricing mechanism of only a fraction of the fair market value of the businesses. This result could be devastating to the estate planning of the first to die.
- The survivor. The surviving owner would receive the benefit of bargain purchases of the other owner’s interests in the company.
The only problem with these bets is that no one knows in advance who will be the first to die. Life is full of unintended and unexpected events. Business ownership should not be like buying lottery tickets. Both owners expect to achieve reasonable value for their interests if or when they need to sell them.
Rational planning for both owners requires that a reasonable valuation mechanism be established.
The call from the CFO indicates that the owners are addressing their buy-sell agreement issues now. The company has negligible net worth and is financed primarily by debt guaranteed by the owners. The disparity between book value and fair market value is glaring, and now, is recognized.
The CFO asked an excellent question. He asked if we were to value the company following the death of an owner, would we value it before or after consideration of the physical presence of the deceased owner? He further asked if there were any valuation standards or guidelines regarding this question.
I answered that in an ideal world, the revised buy-sell agreement would specify exactly what kind of value the owners had agreed upon. With this guidance, the selected appraiser would follow the guidance found in the buy-sell agreement.
I pointed out that if the agreement was silent on the point, the owners were, in effect, leaving this important decision up to the appraiser. Or, if the appraiser refused to make such an important decision, then the parties would simply try to agree and provide specific instructions to the appraiser.
Note the word “simply” in the previous sentence. At the death of a shareholder, the interests of the company and the remaining shareholders diverge from those of the estate. The estate wants to maximize value and the company and other owners desire to purchase at the lowest possible price. Litigation is the too frequent result.
That’s why I say it is so important to agree now, while the interests of the parties are aligned – or at least not so misaligned that they cannot talk! It is so much easier to reach agreement when both parties are in the here and now, and almost impossible when one of them is in the hereafter.
I am hopeful that we (I will likely be involved in the valuation portions of the revisions) can agree on and draft language that is crystal clear regarding the kind of valuation that the owners desire upon one of their deaths. I am sure that with their able counsel’s help, the other portions of the agreement can also be brought up to date.
Help and Recommendations
They will have a copy of our Buy-Sell Agreement Checklist as a helpful reminder of business and valuation issues that might be addressed.
As usual, I will also recommend that the companies obtain annual (or at least every other year) appraisals for purposes of updating their agreement. In my book, Buy-Sell Agreements for Closely Held and Family Business Owners, the primary recommendation for most successful businesses is for a “Single Appraisers, Select Now and Value Now” valuation process.
I will write a post shortly describing the “Single Appraiser, Select Now and Value Now” process in more detail and explain its benefits for businesses and business owners.