A well-structured buy-sell agreement is a critical tool for privately held business owners. It provides clarity for ownership transitions, helps prevent disputes during emotionally charged times, and protects both departing owners and those that remain.
Too often, even where a buy-sell agreement is defined, it can outlive its original intent or design, resulting in a value that is unfair or impractical. Choosing the right valuation approach: fixed price, formula, or independent appraisal (and updating it when appropriate) is one of the most consequential decisions business owners can make. Each method carries its own benefits, drawbacks, and risks. Understanding these tradeoffs can help business owners choose an approach that remains fair and relevant.
Fixed Price Valuation: Simple, but Often Stale
Under a fixed price approach, the owners agree on a specific price for the business, which is documented in the buy-sell agreement. That price remains the same until the owners agree to change it.
Advantages
The appeal of a fixed price is its simplicity. Owners know exactly what the business is worth for buy-sell purposes, which can make funding straightforward (including using life insurance policies). There is no ambiguity and no need to hire outside professionals at the time of a triggering event.
Drawbacks
The selected price may be subjective and not reflect the actual value of the business, even when it’s initially set. And even prices that are fair when assigned can quickly become obsolete. Businesses evolve, revenues grow or decline, margins shift, capital structures change, and industry conditions fluctuate. Unless the value is updated regularly (and actually documented), the fixed price is generally the method that’s least reflective of true value.
In practice, updates are often overlooked, especially when relationships are good. The result is that the fixed price may only be revisited when a triggering event occurs, precisely when interests diverge and disputes are most likely.
Best Suited For
Fixed price works best for owners who are disciplined about updating the value, when true economic value is not important in a buy-sell price, and when used in conjunction with insurance for funding.
Formula Valuation: Predictable, but Potentially Rigid
A formula valuation establishes value using a predefined calculation, such as a multiple of EBITDA, gross revenue, or book value, sometimes with adjustments for debt or working capital.
Advantages
Formulas offer predictability and are relatively easy to administer. They can scale automatically with business performance and reduce the need for subjective judgment at the time of transfer. For companies with consistent operating metrics, a formula can feel objective and efficient.
Drawbacks
The challenge is that no formula captures the full economic picture in all circumstances. Multiples that made sense when the agreement was drafted may no longer reflect market conditions, risk profiles, or growth prospects years later.
Formulas tend to oversimplify complex businesses and they often ignore new or changing dynamics in the business’s operations. Formulas’ predictability can also allow them to be gamed. For instance, formulas driven by historical performance can allow owners to time transactions, such as selling just at the start of a downturn.
From a valuation perspective, formula approaches are often a significant improvement on fixed prices but still require careful design and periodic review to remain relevant.
Best Suited For
A formula valuation works for stable, mature businesses whose earnings and operations do not fluctuate significantly over time.
Independent Appraisal: Flexible and Defensible, but More Complex
An independent appraisal relies on a qualified valuation professional to determine the value of the business at a point in time, after conducting a detailed analysis and giving consideration to multiple valuation approaches.
Advantages
Independent appraisals are inherently adaptable. They reflect current and projected financial performance, market conditions, and current company-specific risks. This approach is often viewed as the most equitable, particularly when ownership interests are large or when the business is complex.
An independent appraisal is also the only method that can be relied on to align the transaction price with fair market value. This can be critical, as a transaction price (set by a fixed price or formula) that does not reflect actual value can raise separate risks and consequences with the IRS. For instance, in a transaction involving family members, the IRS may determine that a below market value transaction price is actually a disguised gift, triggering tax exposure. Similar risks exist with estate taxes.
Drawbacks
The tradeoff is cost, time, and less predictability. Appraisals require financial analysis and professional judgment, which take time, and the resulting estimate of value will not be known until that work is complete. A party’s willingness to buy or sell may then be impacted by the determination of value.
These concerns are best mitigated through careful planning. Many buy-sell agreements define who will perform the valuation, build in a reasonable timeframe for its completion, and provide dispute resolution mechanisms. In addition, periodic updates to an independent valuation can provide greater predictability and significant cost savings.
Best Suited For
An independent appraisal is usually the right choice for companies with significant value, a larger number of shareholders, shareholders that rely on receiving fair value upon exit, or family members.
The Importance of Periodic Review
Regardless of the method selected, buy-sell agreements should not be “set and forget” documents. Valuation provisions should be revisited from time to time to ensure they continue to align with the company’s economics, market conditions, and the owners’ objectives. Proactive review, often in coordination with your legal counsel, accountant, and valuation specialist, can prevent costly disputes and unintended consequences down the road.
Begin Strengthening Your Agreement Today
A buy-sell agreement is a critical planning tool, but its usefulness is dependent on the valuation mechanism behind it. Choosing thoughtfully today, and reviewing periodically, can save significant time, expense, and stress when the agreement is ultimately needed.
If you’re questioning whether your current buy-sell agreement still fits your business, our team is here to guide you. Contact your Kreischer Miller accountant or one of our business valuation experts to discuss how to keep your buy-sell agreement accurate, equitable, and aligned with your goals.