When a buy-sell agreement includes a provision for the company or one or more owners to buy out the stock or interest of an owner, one of the most fundamental questions is how much they will have to pay. There are several ways to handle this situation.
Agreed Value at Time of Purchase
First, it is always good to have a provision that allows the parties to work out a price on their own when they can agree. Hopefully, the document is designed as a back-stop to address what has to happen if the parties cannot agree. Accordingly, it should not force the parties into a situation that may not be as good as what they would do when they are able to agree on the valuation.
A second option is to have the parties agree on a valuation or price per share on a regular basis, for example, at a regular meeting of the shareholders or members. This is a stipulated value which the parties can discuss and adopt, and if an unforeseen event takes place requiring a purchase, the parties will be able to refer back to a valuation that was done at a time when the exigencies of the immediate crises are not influencing the discussion. Usually, a stipulated value will only be valid for a set period of time, at least a year until the next meeting, and a backup will be prudent.
Another simple, but potentially more expensive, option is to require a valuation at the time of the purchase. Several factors need to be considered in such a provision. First, as mentioned, a full valuation by a CPA can be an expensive process. Second, it is important to consider who the CPA will be. Depending on who selects the CPA, the CPA may have an incentive to push the valuation in a direction more or less favorable to one or more parties. The idea is to obtain a reliable and objective valuation on which all the parties are comfortable relying. There will be incentives and pressures in both directions as a higher valuation has tax implications for the seller, and a lower valuation is more palatable for the buyer. Sometimes the CPA for the company is used, sometimes the buyer selects the CPA and the seller has an opportunity to object.
The bottom line is that the parties will need a mechanism that allows the valuation to be determined without engaging in significant cost or a problematic dispute. Examples of ways to address this might be having a CPA selected and then allowing the other party, if they object, to obtain a valuation of their own. If different, the documents could provide that the two valuations are averaged. The documents could also provide that if the valuations are different, and the parties cannot agree, the party’s CPAs select a third CPA who’s valuation is binding.
A fourth option for valuation is for the parties to provide their own stipulated formula for a valuation. Certain industries have commonly accepted ways of valuing their businesses. Such a method could be put into the documents and then determined at the time a purchase is required.
Considerations for Stipulated Valuations
Regardless of the valuation methodology used, the parties need to understand what a valuation really addresses. It is often the case that the parties will select a valuation which represents not only the right of the owner to distributions or profits, but also includes an element of their salary and compensation for the work they have done. It is generally not good practice to include such items as they should be handled in other ways such as life or disability insurance, or retirement investments. Not only is this kind of valuation often inaccurate, it inflates the price that has to be paid and puts a potential burden on the buyer.
It is also important to remember that the valuation should be the value of the interest without the seller being involved any longer. If the seller is the rainmaker, and the profits of the company will decrease dramatically without their involvement, than the valuation should take that into account. Often, before such an event, when the parties attempt to identify a value for the company to be used in a buy-sell document, they will fail to discount the valuation number or assume it is higher than it should be.
Finally, parties can take steps to help alleviate the cash flow difficulties a purchase of an interest will require by including a required structure for the purchase such as a multi-year promissory note with a down payment. Part of the idea should be that the buyer will receive an interest which includes a right to distributions which will help pay for the promissory note. Of course, this expectation will still be dependent on the continued viability and performance of the company.