Creating a buy-out agreement with multiple business owners
Starting a business with someone else is like a marriage. At the beginning, everyone is positive, excited for the future, and sure of its success. However, if one or more owners leave the business, motivations have a way of changing, as they often do in the case of divorce.
Defining "fair" and "reasonable" ways to undo the relationship becomes difficult, and too often ends up in the courtroom. As business owners are coached, "Don’t get into business together without first defining how you’ll get out of business with each other."
Creating a buy-sell agreement
The way to define and document how to handle the buy-out of one (or more) of the owners is by creating a buy-sell agreement. The buy-sell agreement outlines what happens to the shares of an owner who leaves the business, for any number of reasons. It is a legally-binding agreement that is typically drafted by an attorney. When an owner leaves the business, the most critical paragraphs (referred to as the valuation provisions) of the buy-sell agreement define how the departing owner’s shares are to be valued. Unfortunately, the valuation provisions are too often ill-defined or non-existent.
The key to well-defined valuation provisions is to consider all the possible triggering events to one of the business owners leaving, and then define the owner’s intent under each event-not just in case of death or disability. What if an owner quits? Is fired? Retires? Gets divorced? It is typically stressful, emotional, and unfortunate when a business owner leaves the business. This is not the time to come to an agreement on what is a reasonable approach to valuing the departing owner’s shares. Too often, business owners in this situation reach for their buy-sell agreement only to realize it is silent under the triggering event that has occurred, or is ambiguous as to how the shares should be valued. Terminology such as "book value," fair market value" and other such language does not give sufficient or clear instruction to a business appraiser who will be hired to do a valuation of the business. More information and direction regarding the owners’ intent is needed.
Some important clauses that should be discussed and included in the valuation provisions of a buy-sell agreement include:
- Who is able to buy out an owner’s shares in the business? It can be open, or limited to specified people.
- What events will trigger a buy-out?
- How will the value be determined? Does this differ under various triggering events?
- Do discounts and/or premiums apply relating to control or minority? If yes, when do they apply and what should the premium or discount be that is applied to the valuation conclusion?
- Do discounts and/or premiums apply relating to marketability issues of closely held companies? If yes, when do they apply and what should the premium or discount be?
- Should there be an additional discount if someone decides to quit (leaving the remaining owners responsible for the business)?
- Once the value has been determined, what are the terms of payment? Sometimes this depends on how large the value is.
- What is the funding mechanism? Is there insurance available (in cases of death or disability)?
- What date should be used for the valuation? It is possible that an owner’s leaving can hurt the business financially? If this could be the case, make sure the valuation date is not as of, or before, the date of separation.
While an attorney can help create or update a buy-sell agreement, it is wise to work with a business valuation expert on the sections pertaining to these valuation issues. Unfortunately, templates or boilerplate language do not work because it is critical that the owners define their intent-what do they consider fair or reasonable under each circumstance, before they know who will be the one to trigger the event. If a death occurs, it is outside of their control and the buy-out can be funded with life insurance. If a business owner quits, it may leave other owners in a lurch. If a business owner is fired because of a particular reason or because of an internal disagreement, owners typically would agree to have that situation treated differently.
To guarantee an agreement that will truly help the owners separate, they need to go through numerous "what if" scenarios and answer questions so there are no surprises. At a minimum, have an independent business appraiser review the valuation provisions and give feedback to the existing language. The goal is to have an unambiguous agreement that defines how the owners will act under any possible triggering event. An appraiser can provide questions that need to be answered to define the valuation provisions of such an agreement. Business owners will spend far less time and money with these best practices than in litigation later when one of the triggering events occurs and the owners begin to fight for their own best interest.
Catherine J. Durham is accredited senior analyst, principal, and president, Capital Valuation Group; edited by Emily Guenther, associate content manager, Control Engineering, CFE Media, email@example.com.
- Defining a buy-sell agreement for multiple business owners.
- What to include in the valuation provisions of a buy-sell agreement.
- How to simplify a buy-out scenario between multiple business owners.
How often should a buy-sell agreement be revised or reviewed?
Coming soon: A link to part 8 in the Business Valuation Article Series will be offered below.