One of the most important considerations in a Buy-Sell Agreement is the valuation method to determine the price at which a business owner may, or is required, to purchase the departing owner’s interest. There are three basic options for valuing your business in a Buy-Sell Agreement: (1) fixed price, (2) formula, or (3) appraisal.
Fixed Price Buy-Sell Agreement
A Fixed Price Buy-Sell Agreement operates exactly how it sounds: the owners pick a number and you live with it! This makes for easy drafting and understanding but can cause detrimental problems. For example, what if you fixed a price ten years ago when your business was much smaller and less valuable? You are basically betting that you outlive your business partner. A Fixed Price Buy-Sell Agreement can be updated annually to account for a growing business, but this is rarely ever done and could lead to disputes in the future.
Formula Method Buy-Sell Agreement
A Formula Method Buy-Sell Agreement states a particular formula to be used when valuing the business. Typically this will be a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) or Book Value. If this method is used in your Buy-Sell Agreement, I suggest that you calculate the price based upon the formula every year. This will help manage expectations and understanding as to the results of the formula. If the price is not what you expected, you can sit down with your partners to form a resolution.
Appraisal Buy-Sell Agreement
The appraisal method leaves the valuation of your company in the hands of a third party. The appraisal method can be effective but requires clear instructions in your Buy-Sell Agreement regarding the type of appraiser, number of appraisers, method of appraisal, etc. There can be a lot of unknowns with an Appraisal Buy-Sell Agreement. What “type of value” will the appraiser provide? Will there be one appraiser or multiple appraisers? Do we choose an appraiser in advance? I recommend that your Appraisal Buy-Sell Agreement address these issues up front. Also, it is important to have your business appraised at the beginning so that each owner agrees to the appraisal method implemented.
All of the three options for valuing your business in a Buy-Sell Agreement come with certain pros and cons. It is important to discuss your business with an experienced business attorney who can provide a solution that is specifically tailored to your unique situation.
Please check out my previous two blogs about Buy-Sell Agreements: