For many business owners, embarking on a new partnership is sure to be an exciting time. However, it is imperative to plan for your future right from the start. Seeing things through rose-colored glasses during the early stages may end up costing you thousands, or worse, your business. Every business partnership should work with a business law attorney to have a buy-sell agreement drawn up to clearly outline the future of the business. Let’s take a closer look at how buy-sell agreements work.
What Is a Buy-Sell Agreement?
A buy-sell agreement, also called a buyout agreement, business will, or business prenup, is a contract that provides a mechanism for a business succession should an owner decide to transfer his interest due to a voluntary or involuntary event. A buy-sell agreement is made up of multiple provisions, designed to facilitate a smooth transfer of power between co-owners.
Elements of a Buy-Sell Agreement
Despite the name, a buy-sell agreement is usually much more than just the purchase and sale of a business. Many questions can come up during the process, and a good buy-sell agreement aims to clearly answer these questions. The agreement should outline:
- The type of agreement
- What triggers the buy-sell provision
- A clear definition of value
- The method used for assessing the value of the interest or shares
- How the purchase price is calculated
- Who has the right or obligation to purchase
- Any exceptions
Clearly outlining these terms at the beginning of a partnership can help minimize disputes between co-owners. In most cases, the buy-sell agreement facilitates a smooth transition between partners, should a triggering event occur.
Types of Agreements
There are two main types of buy-sell agreements: entity agreement, and cross purchase.
- In entity agreements, the business entity has the obligation to buy the shares.
- In cross purchase agreements, the remaining owners purchase the remaining shares of the business.
Some businesses will opt for a mixture of the two, with some shares being available for individual purchase, and others available for purchase by the business entity. The type of agreement you choose will depend on the type of business in question, and the owners involved.
The voluntary or involuntary events that cause a transfer of interest are also called “triggering events”, and include, but are not limited to: retirement (voluntary), death, disability, divorce, bankruptcy, or termination of employment (involuntary). The death of a partner can cause turmoil for a business, so it is important to plan for. Far more common, however, is retirement. Most partners live to retire and voluntarily sell their share of the business. Purchasing life insurance policies can usually cover both of these circumstances. Defining these triggering events and other provisions in a buy-sell agreement is crucial for the continuation of the business.
Establishing the Value
In order for shares of a business to be sold, there must be an agreed upon value established. It is important to have a clear formula in place to assess the value of a share. Some businesses will have a static formula to determine the value, while others will use an accountant to assess the value at any given time. When dealing with the value of the shares, avoid using ambiguous language. “Fair value” and “fair market value” are two very different terms, and should not be used interchangeably. To avoid confusion, a business lawyer, accountant, and business appraiser should all be utilized to ensure the language of the buy-sell agreement agrees with the intent of the owners.
Calculating the Purchase Price
There are a few different ways to calculate the purchase price of a business’ share. The method used depends on the type of business, as every business is different.
- Book Value: Assessing book value offers an accounting perspective of evaluating the business. By looking at the company’s balance sheets, you can get the accounting value of the owners’ equity. While this method is simple, it does not reflect the economic market value of the business.
- Multiple of Revenue: A multiple of revenue is a ratio used to measure a business’ value based on gross revenue. This method is generally easy to measure and easy to apply, however, it still does not offer an accurate economic value.
- Multiple of Earning: A multiple of earning is a ratio used to measure a business’ value based on earnings. This method does consider a business’ profitability, but could offer an inaccurate value because of one-time events that could cost or earn the business more money than usual.
- Multiple of EBITDA: A multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a ratio used to measure value by comparing Enterprise Value to annual EBITDA. This formula is more sophisticated, but can still yield inaccurate results because it does not take into consideration market conditions, growth, profitability, and capital structures.
- Non-Formulaic Valuation Clause: In the buy-sell agreement, this clause would require an annual valuation for the company’s equity. A business appraiser is able to appraise the real-time market value of the business, yielding the most accurate value.
Right or Obligation To Purchase
Defining who has the right or obligation to purchase is another helpful provision to include in the agreement. Some owners may wish to define who can purchase the shares, in an effort to avoid undesirable co-owners. This is especially useful in family business. More detailed provisions include:
- Deadlock provisions (ways for owners to dissolve the business or part ways)
- Right of first refusal (owner can sell share to a third party in the event the existing owners waive their right to purchase)
- Call rights (the business can purchase an owner’s share for a premium)
- Put rights (owner can demand the business purchase the share at a loss)
Using a Business Lawyer
While it is possible for business owners to draft their own buy-sell agreements, it is usually wiser to use a business lawyer. Business lawyers are able to draft, review and explain the document, while making sure it is free from ambiguous language, and in your best interests. Spending the money on a good lawyer in the beginning of your business venture could end up saving you thousands of dollars in litigation fees. It is also wise to consider having an accountant and a business appraiser review the agreement to make sure everything makes sense from a financial standpoint. Utilizing these professionals will help you get the best results from a buy-sell agreement.
A buy-sell agreement is a smart decision for any business partnership. The contract provides guidance when a triggering event occurs, and an owner wishes to sell their share. Drafting a buy-sell agreement at the outset of a partnership will ensure a smooth transition of power in the future. It is always in your best interest to seek professional legal guidance to draft and review buy-sell agreements. Contact the professionals at CJB Law today to get started.