The Small Business Administration reports that there are nearly 30 million privately held businesses in the United States, of which nearly 6 million have multiple employees. The owners of many of these privately held businesses are baby boomers (individuals born between 1946 and 1964), who are now in the early stages of a massive transition from working to retirement. As that transition occurs, many small- and medium-sized business enterprises (SME) will be sold or otherwise passed on to the next generation of owners. It is important for a business with multiple owners to have a buy-sell agreement, but the time to create such an agreement is not during an ownership transition, but rather right at the outset, when all of the owners are involved and an orderly transition can be planned for.
This article discusses the advantages and potential pitfalls of buy-sell agreements for SME business owners and provides questions and comments for CPAs, in their roles as financial advisors and business appraisers, to consider when engaged to provide their professional input.
Purpose of Buy-Sell Agreements
In practice, a buy-sell agreement accomplishes several objectives. It provides a mechanism for an orderly business succession should an owner decide to transfer his interest due to a voluntarily event, such as retirement, or an involuntary event, such as death, disability, insanity, or bankruptcy. Any such event is referred to in the context of a buy-sell agreement as a triggering event. It also affords the co-owners or the business entity the ability to maintain the option or mandatory obligation to purchase the interest from an existing owner in order to restrict outsiders or undesirable business partners from becoming owners. This is often a useful provision for family businesses.
In order to avoid internal conflict and a smooth transition in situations where one or all owners desire to leave the business, a good buy-sell agreement may have any of the following additional provisions:
- Call rights (the SME at any time can elect to purchase an owner’s interest for a premium, i.e., 125% of the fair market value)
- Put rights (an owner can demand the SME purchase her interest at a loss, i.e., 75% of the fair market value)
- Deadlock provisions (i.e., a mechanism for owners to part ways or dissolve the SME)
- Right of first refusal (i.e., an owner is permitted to sell his interest to a third party provided the other existing owners or the SME refuse or waive their first right to purchase the interest).
Generally speaking, all of these provisions attempt to streamline situations in which the SME no longer desires a particular owner be part of the business, when an owner wants to sell, or when one owner wants to acquire the interest of another. Whether because of deadlock or simply a voluntary departure, each of these provisions provides a smooth transition in such event. Again, as noted above, it also prevents any unwanted owners from being a part of the SME.
While all of these provisions can assist, if a triggering event occurs, they are only as good as the degree to which the owners cooperate in carrying out the procedures described in the buy-sell agreement. In other words, there may be instances where one owner must turn to the courts to enforce the buy-sell agreement. This is still preferable, however, to having no agreement in place for the court to enforce.
In addition, a buy-sell agreement may provide a predetermined valuation clause should a triggering event occur. Some buy-sell agreements contain a set value or formulaic valuation clauses, while others defer to the use of an independent third party, such as an accountant or business appraiser, to determine value on a periodic basis (e.g., annually). Financing and payout terms of the purchase can also be included as part of the buy-sell agreement. In theory, this type of clause should reduce conflicts regarding value between buying and selling owners, but this is not always the case in practice.
Definition of Value
As noted above, buy-sell agreements will generally contain a valuation clause with the terms of the buyout and, often, a definition of value. “Fair value” and “fair market value” are two commonly used definitions of value, but they are separate and distinct terms of art. They have very different implications on the dollar value that a business appraiser or accountant would reach when determining the value of a business interest. Therefore, it is important to define the standard of value that will apply to the buy-sell agreement.
Fair market value is the premise of value for estate and gift tax valuations. The term is defined in Revenue Ruling 59-60 as follows:
Fair market value as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
“Fair value” does not have a common definition, but rather is used differently by accountants, attorneys, and the courts. The AICPA uses “fair value” for fair value measurements in Accounting Codification Standard (ASC) 820, Fair Value Measurements and Disclosures. Attorneys and courts, however, use the term in the context of owner disputes. When drafting a buy-sell agreement, owners must bear in mind the language they wish to use and the consequences of using such language in different contexts.
To a business appraiser, fair market value may imply that certain valuation discounts should be applied to the value of a noncontrolling, or “minority,” interest. These discounts will reflect the noncontrolling character of the interest and may also reflect the lack of marketability of an interest for a privately held business. When these discounts are applied, the value of a noncontrolling interest is significantly lower than the value of a controlling interest. To avoid pitfalls in the drafting of buy-sell agreements, business owners should consult with both attorneys and accountants as well as business appraisers in order to ensure that the language of the buy-sell agreement meets the intention of the owners and that all owners understand the implications of these definitions.
Avoid Ambiguous or Unclear Language
The importance of clear language can be illustrated with an example from one of the authors’ professional experience: a buy-sell agreement between owners of a holding company had a clause which, in summary, stated: “the appraiser will determine the fair value and the parties will transact thereon based on such value. However, if one such party disagrees with the fair value and the transaction has not consummated within 90 days after the date of the appraiser’s report, the transaction price will be fair market value” (emphasis added). In this case, “fair value” had one specific meaning, and “fair market value” had a completely different meaning. The difference between the value calculated on a “fair value” basis and a “fair market value” basis was in the millions of dollars.
Ambiguity in a buy-sell agreement generally leads to conflict about the required procedures upon the occurrence of a triggering event and the value at the time of a triggering event. Both the buyer and seller in the transaction may feel like they are being cheated by the other side; such conflict can lead to years of costly litigation and animosity between the buyer and seller.
Most buy-sell agreements are written and reviewed by experienced lawyers, and such ambiguities are fixed during this process. Sometimes, however, owners create buy-sell agreements themselves to avoid the cost of a lawyer (which happened in the case of the above example). While this can save money in the short term, it can be extremely costly in the long term. Litigation can cost up to hundreds of times what it would have cost to draft a proper agreement. The few thousand dollars that business owners spend today could save millions in the future.
In a situation where owners wisely seek the advice of an attorney, accountant, or business valuation professional, each individual should be aware of who each professional represents—whether it is the SME or one of its owners. It is a professional’s responsibility to make this clear. Knowing who the attorney or accountant represents will be important with respect to how the buy-sell agreement is drafted and reviewed.
Not only should an attorney draft and review the buy-sell agreement—accountants and business valuation professionals should also examine the agreement’s valuation provisions to identify any contradictory or ambiguous language before it is finalized. In valuation, certain words and phrases have specific meaning to the appraiser (as “fair value” versus “fair market value”), and casual use of these words may create unintended conflicts in the future. An appraiser can read the valuation provisions and provide suggestions that will help identify ambiguity. Such suggestions might also relate to “noncontrolling” versus “controlling” values, discounts for lack of marketability, and discounts for lack of voting rights. Accountants and appraisers can help identify issues with valuation language and help business owners and their legal counsel choose more precise valuation language.
In many cases, drafters of buy-sell agreements gravitate toward the use of “fair market value” as the underlying premise of value. This allows the value derived for a buy-sell agreement to potentially be used for gift and estate tax planning. Under that scenario, the deceased co-owner’s business interest would be bought out at a price by the surviving owners and would be the value that would govern for estate tax reporting purposes. The case of True v. Comm’r (T.C. Memo 2001-167), however, demonstrates that formulaic methods may reach conclusions that are below fair market value. If a court deems the taxpayer intended to avoid estate taxes in such a case, it may invalidate such valuation for estate tax purposes.
Accountants consulting on valuation provisions within a buy-sell agreement must be sufficiently qualified to opine on valuation matters. The Tax Court’s opinion in True found that while the business owner consulted with his family’s accountant and longtime financial advisor on the valuation provisions within the buy-sell agreements, the accountant “did not have a detailed understanding of valuation methodologies, as he had no academic or practical experience in the valuation area” and rejected “any notion that [the family accountant] was qualified to opine on the reasonableness of using the tax book value formula in the … family buy-sell agreements.” The opinion goes on to state that the accountant’s “objectivity was questionable [and] more importantly, he had no technical training or practical experience in valuing closely held businesses.” Finally, the court concluded that the owner’s “discussions with [the family accountant] were insufficient to assess objectively and accurately the reasonableness of using a tax book value formula price for the … companies’ buy-sell agreement.”
What Is the Stock Worth?
Ensuring that the terms of the buy-sell agreement are in writing and having the owners agree to those terms before the occurrence of a triggering event helps to eliminate potential conflict in the future. At the time the buy-sell agreement is executed, no owner knows who will be bought out, when, or why. Moreover, relations between owners are likely good at this point, so they should be able to come to a consensus on the terms. When a triggering event occurs, relationships may well be strained; failure to have a solid buy-sell agreement in place may result in conflict, arbitration, or litigation, all of which can become extremely costly, both emotionally and financially.
Formulaic Valuation Clauses: Pros and Cons
Some buy-sell agreements use formulaic valuation clauses that are simplistic blends of accounting information and valuation multiples. Examples can include book value, 50% of the prior 12 months’ revenues, seven times earnings, or four times earnings before interest, taxes, depreciation and amortization (EBITDA). Such formulaic agreements may create a discrepancy between the transaction price for the departing owner and the fair market value of such interest. Formulaic valuation clauses are the most simplistic on the surface, but the benefits of their simplicity may be outweighed by their inaccuracy. The pros and cons of a few common valuation metrics are discussed below.
Book value is an accounting concept rather than a measure of economic or financial value; it is the accounting value of a company’s owners’ equity (i.e., its total assets minus its total liabilities). The benefit of using book value is that it is a simple method in which value is determined by looking at a company’s balance sheet. Usually this balance sheet will be prepared by an accountant, but many SMEs have only tax returns for their financial statements and do not have a formal audit or even review. Thus, buy-sell agreements using tax returns and tax book value may conclude a value using accounting information that has not been prepared in accordance with GAAP. Either way, book values often have no relation to the economic market value for an entity.
Formulaic valuation clauses are the most simplistic on the surface, but the benefits of their simplicity may be outweighed by their inaccuracy.
Another positive of using book value is that it takes into account the company’s working capital and the collection of accounting values for its assets and liabilities. This same point can be a negative, however, as figures like fixed asset values will be reported at their depreciated value as opposed to their fair market value (i.e., true economic value). Another negative of book value is that it may fail to consider assets or liabilities that are not on the company’s books, such as identifiable intangibles or goodwill. These assets and liabilities would have to be valued separately and then included in the book value calculation. Also, the obligations associated with liabilities not recorded on the books—and the resultant negative effect on value—may not be considered, thereby overvaluing the company’s equity.
Finally, if the buy-sell agreement value is to be used in either a gift tax or estate tax context, the values therein may not be accepted by the IRS or the courts. In True, tax book value was used to determine values in buy-sell agreements and in subsequent gift and estate tax transactions. The court concluded that the formula clauses of the buy-sell agreements were not using “fair market value” and that the taxpayer was establishing the formula to create lower values for testamentary purposes.
Multiples of revenue.
Multiples of revenue can be used for companies in which there is little book value and little net income. Service companies (e.g., advertising agencies) often fall into this category, as they tend to have more “human capital” as opposed to the land, building, and machinery of manufacturing industries. In addition, advertising agencies and other types of service companies may pay out most or all of their income in the form of employee and owner bonuses, leaving little to no net income. As such, income multiples would not provide a high value; book value may create a similar problem, as retained earnings would tend to be small for a company that reports little to no net income year after year. Therefore, multiples of revenue can be an indicator of value for service companies.
An advantage of the revenue metric is that revenue is generally easy for an SME to measure, and therefore this method is easy to apply. Similar to the book value method, however, the ease of use may be outweighed by the departure from determining an accurate economic value. Another negative is that it values similarly sized companies at the same value, irrespective of their profitability.
Multiples of earnings.
A third potential formulaic valuation clause is using a multiple of a profit measure, such as price-to-earnings (i.e., the market value of the interest’s common equity relative to a multiple of earnings). Using earnings multiples does consider a company’s profitability; however, sometimes this profitability may be influenced by one-time items that make the company’s unadjusted earnings either higher or lower than if such earnings were adjusted for the one-time item. One example of this could be proceeds or expenses from a lawsuit, for which such adjustment could also include adjustment of legal expenses for the year in question.
In determining value, a professional appraiser will make normalizing adjustments for unique or nonrecur-ring events, which a formula may not consider.
Multiples of EBITDA.
There are more sophisticated earnings formula clauses as well, such as multiples of EBITDA. These formula clauses may potentially result in a purchase price that is vastly different from the fair market value of the interest being sold because they fix a valuation multiple and fail to take into account changes in market conditions, growth prospects, profitability, and capital structures.
In determining value, a professional appraiser will make normalizing adjustments for unique or nonrecurring events, which a formula may not consider. In addition, appraisers may study multiple years of a company’s earnings history in order to assess earnings trends, growth, and any cyclicality in the business’s earnings. Finally, a professional appraiser may apply other earnings-based approaches, such as total invested capital to earnings before interest, taxes, depreciation, and amortization (TIC-to-EBITDA) multiples. This type of analysis will consider a company’s earnings before interest expense and income taxes, and is best completed by an experienced appraiser, as a formula will not take into account changes in multiples over time or normalizing adjustments, as discussed above.
Formulaic valuation metrics do not take into consideration things such as changing market conditions (perhaps industry multiples are on the rise, and a once-typical 7 times earnings ratio is now too low), growth prospects (a company that has just been awarded a new significant contract will likely be worth more if such contract results in incremental future cash flows), profitability, and capital structures.
Nonformulaic Valuation Clauses: A Better Solution
Nonformulaic valuation clauses specify obtaining a periodic valuation for a company’s equity. An example of such a clause: “Every year, the company will obtain a valuation from an accountant (or appraiser) qualified to make such appraisals. Such appraisal will constitute a ‘certificate of value.’ If no such certificate of value has been obtained in the last three years, then an appraiser will be hired to perform such valuation.” In reality, owners of privately held companies may agree to have an appraisal every year, but after one or two years, they usually stop, as the cumulative costs of appraisals becomes expensive, and in the absence of triggering events, the owners’ mentality becomes, “why bother?”
Then, of course, a triggering event occurs. For example, if an owner dies unexpectedly and there is no current certificate of value, the surviving owners must (depending upon the buy-sell agreement) buy out the deceased owner’s interest, which necessitates a determination of value. Looking at the annual appraisal as a kind of insurance premium helps owners understand why the annual appraisal is a worthwhile endeavor. It provides for a value before the triggering event occurs and before any parties are identified as the buyer or seller. The appraiser delivers the valuation report, and the owners have an opportunity to read it, provide comments, and then have the value in hand. If, later in the year, a triggering event occurs, conflicts over value should be reduced, as the parties have already agreed on a value. It is important to keep the valuation provisions of buy-sell agreements up to date, as market conditions and other factors will change from year to year.
Sometimes buy-sell agreements will require appraisals only after the triggering event occurs; for example: “Upon the occurrence of a triggering event, both parties will hire an appraiser to value the equity interest of the owner who is selling his or her interest. If the appraisals are within 10% of each other, the values will be averaged, and that average will be the transaction price at which the interest will be purchased. If the two appraisals fall outside of 10% of each other’s value, then a third appraiser will be selected, and such appraisal will be used for determining the value for the transaction.” In such a case, the third appraiser may help determine the final conclusion of value, but sometimes these situations end up in court because one of the parties feels cheated.
Terms of Repurchase
Buy-sell agreements may also specify the terms of repurchase. For example, once the valuation has been determined, the buy-sell agreement may provide that 20% of the purchase price is to be paid on closing, with the remaining 80% paid over a finite number of years at a specified interest rate. Accounting for these terms in writing at the time of the creation of the buy-sell agreement helps define how the purchase price will be paid. If financing is used, owners should be cautious about stating a fixed rate; for example, the low interest rates of the current business environment may be too low for a future purchase in a higher-rate environment. Some owners may want to use “applicable federal rate (AFR),” which is set by the IRS as an imputed interest rate for, and generally used as a minimum interest rate on, debt. The IRS sets the AFR for short-term, mid-term, and long-term instruments on a monthly basis. Others may want to draft financing terms that reflect the market rates of the time, such as “the prime rate plus 2%” or “Libor plus 3%.” All of these terms should be discussed and understood by the owners at the time of the drafting and execution of the buy-sell agreement.
The Value of Foresight
Buy-sell agreements are useful tools to provide for the orderly transition of equity interests in privately held business entities. When constructed correctly and reviewed annually, they serve multiple beneficial purposes, such as providing for the purchase of an owner’s equity interest in the business due to a triggering event, whether voluntary or involuntary; limiting owners to those parties that the nonselling owners want to have as potential co-owners and business partners; providing an agreed-upon price at which a buyer and seller can transact before a conflict and buyer/seller valuation biases arise; providing agreed-upon terms for the payment of the transaction price related to the sale; and binding additional owners to the provisions of the buy-sell agreement.
Spending a few dollars on a clear and unambiguous buy-sell agreement prepared by an experienced attorney in consultation with a business valuation expert is a worthwhile cost that can help reduce future problems. SME business owners should obtain annual updates of value from a qualified appraiser before the occurrence of a triggering event, which will help reduce the chance of a contested value and the resultant financial and emotional costs of such a conflict. CPAs serving privately held SMEs with multiple owners should ensure that the entity and owners have a buy-sell agreement in place and that such agreement has been reviewed by competent and experienced professionals.