A buy-sell agreement is a legal contract that outlines the relationships between the parties and the rights of the owners. These are drafted with the help of an attorney and are important to have at the start of the transaction in case of a conflict. In this post, we discuss the main types of buy-sell valuation provisions, key valuation considerations and best practices surrounding these agreements.
Main types of buy-sell valuation provisions
There are three common types of valuation provisions in buy-sell agreements: fixed, formula and process. The simplest type, fixed value provisions, are when the owners have agreed upon a value and state it as an exhibit to the agreement. Typically, these are designed to be updated annually but often end up being seldom updated, providing no basis for setting the value.
A formula agreement determines a method for deciding upon value. This can include a multiple of earnings (e.g. EBITDA), or book value, among other types. Several challenges can arise with this, such as if earnings or book value is negative, or EBITDA is artificially high due to working through pent-up demand. These scenarios can put owners at odds or result in gamesmanship.
Process agreements determine the value when a triggering event occurs. This typically involves one or more business appraisers estimating the value of the subject interest. This may seem to be the most costly option but often ends up being less expensive when factoring in all of the potential complications of fixed and formula provisions.
What are the key valuation considerations?
There are several key factors that should be established in the agreement to eliminate ambiguity and reduce the chances of a conflict. These include:
- What is the effective date of valuation?
- What is the standard of value?
- Are there any valuation discounts in play?
- What is the expected work product?
- Who is performing the appraisal?
- Will more than one appraisal be obtained?
- How frequently will the appraisal be updated?
- Who is paying for appraisal(s)?
- What methodology will the appraiser use, or will they exercise their own professional judgment?
- How will life insurance be treated?
All of these considerations help to account for the most common questions that come up during the creation of these agreements and help eliminate any potential grey areas.
What are the best practices?
Firstly, you want to be sure to establish a valuation process in case of a triggering event. Be sure to create your process in a way that leaves little room for interpretation among the parties or appraisers. The list above highlights a number of considerations to address in your agreement. It’s also recommended to only name a single appraiser, as this can help eliminate confusion and the risk of parties selecting the result that best fits their desired outcome. Having a single appraiser can also remove any confusion over how the appraiser will employ valuation methodology, exercise judgment and consider the nuances of the business. It’s also suggested to first establish an initial valuation and ensure regular updates are made to decrease the chance of there being any surprises during a triggering event.
It can be a costly process, but the cost of experiencing an unfavorable outcome is usually much higher for one party. RKL’s team of valuations experts can help your organization create a buy-sell agreement and navigate all the complexities involved. Reach out using the form below, or contact your RKL advisor to get started.