“But wait,” you say. “I don’t even have a buy-sell agreement.” While there is plenty of online material that explains the cost-benefits of these agreements, let’s quickly review what a buy-sell agreement is and why it’s a good idea to have one.
In a nutshell, a buy-sell agreement (BSA) is a written agreement between the owners of a business that spells out what happens to each owner’s share of the business in the event of another owner’s death, incapacitation or some other unanticipated exit from the business. The BSA is an appropriate layer of protection for anyone who owns a business with other partners (family-related or not).
The best time to draw up a BSA is when all owners are healthy, on good terms and have no active contemplation of leaving the business. In this way, everyone is in the same boat and will benefit equally from having a BSA in place. As the saying goes, what is good for the goose is good for the gander.
There are no hard and fast rules to drawing up a BSA, no “one size fits all” formula. And there is no need to be overly predictive about the “triggering events” that might cause the BSA to kick in. You can’t possibly foresee every scenario or account for every variable. Otherwise, you may never get to the desired outcome of a reasonably complete BSA that is signed by all parties. So don’t let the lack of total specificity on triggering events hold you back from putting a BSA in place.
Now back to your business to-do list. Like most other personal or business protection mechanisms (think estate plan, insurance coverage or disaster recovery plan), it is important to keep your BSA up to date, especially about your company’s value. Although the overall thoroughness of BSAs has improved in recent years, many continue to be silent on what is known in the business appraisal field as a “standard of value.”
Most current BSAs fail to adequately stipulate the standard of value to guide the person (typically a valuation expert) who will be responsible for setting the value of the business at the point of an actual triggering event.
There are several standards of value, each with distinct purposes. And different standards applied to the same set of data will yield different results. The most common standards used when developing an opinion of the value of a closely-held business are “fair market value” and “fair value.”
Fair market value is commonly defined as the price at which property (business or equity stock) would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.
The definition of fair value relies on state statutes, and so it varies from state to state. In his book, “Valuing a Business,” Dr. Shannon Pratt defines fair value as “an amount to fairly compensate a minority owner who was involuntarily deprived of adequate consideration for his or her stock.” In a fair value transaction, there is not a willing seller. This method is commonly used in dissenting or minority shareholder disputes, although it also has strong merit for use in BSAs.
Here’s why being clear about the standard of value is important. Let’s say you and your partners decide to sell the whole business, and its value is $10 million. Regardless of your relative ownership percentage, each owner will receive a proportional share of the proceeds based on the percentage he or she owned. The logical and practical concept here is fair value. Pretty straightforward.
But if a minority owner were to embark to sell his or her stand-alone, non-controlling interest, the value of that interest would likely be discounted because the buyer is purchasing a less-than-controlling position in the company. In this case, the standard of value is fair market value. The discount recognizes the lack of prerogatives of control, creating a gap between the seller’s expectations and what the market will actually bear.
This is especially nettlesome in cases where there are two owners each with 50% ownership interest (keep in mind that owning half the company does not give either person control) or three or more owners, none of whom have prerogatives of control. If a triggering event causes one partner to sell, it can result in a significantly discounted value. Using the fair market value standard creates a windfall for the buyer (who buys at a discount), while the seller (or his heirs) receives less than the expected payout.
On the other hand, using the fair value standard instead could leave the surviving owner(s) effectively paying a premium for the departing owner’s stand-alone interest. As you can see, without stipulating a standard of value in your BSA, things can get complicated.