By: Patrick Ungashick
Here’s the story of how one business owner’s buy-sell agreement understated his company’s value by a factor of 10, and what you need to know for your own business value and exit planning.
We recently spoke with the majority owner of a professional services firm who has several minority partners. All of them have signed a buy-sell agreement1, which is typically a good and advisable way to mitigate risk.
The majority owner contacted us because he was suspicious that their agreement was drastically understating the value of his company, and as a result his minority partners were expecting to one day purchase his majority interest at a drastically lower price. He was right to be suspicious.
Book Value Isn’t Always an Important Factor
His company’s buy-sell agreement stipulated a formula of 2.5x book value to determine the overall value for the company. The problem was that for a professional services firm, book value is next to meaningless.
Book value is commonly understood to mean the net value of the company if you simply sell off all the assets and pay off all the debts. Book value therefore ignores the potential value of the company as an ongoing enterprise, including its goodwill.
While book value can be an important factor in asset-heavy industries such as manufacturing and distribution, it usually has little relevance in service-oriented companies. Rather, this owner’s company would ideally be valued based on a multiple of its profits (or revenue in certain circumstances).
Because we have worked with other clients in the same industry, we knew the relative value of his company if he sold to an outside buyer in the open market. That number was about 10 times greater than what his buy-sell agreement stipulated. Needless to say, this majority owner had no intention of selling his company to his two minority partners for a 90% discount, which is exactly what the agreement stated would happen.
The gap between this owner’s market-based business value and what his buy-sell agreement called for was pretty dramatic. However, his situation is common. Many owners are unaware of what their company is worth — according to their own legally-binding buy-sell agreements.
Why Do Such Disparities Happen?
Too often, what the buy-sell says is considerably different than what the company could be worth to an outside buyer, creating the potential for serious problems should the agreement ever be invoked.
This disparity happens for several reasons. First, market conditions change. The value or valuation method used when the buy-sell agreement was written may be considerably different than a value based on current market conditions.
Even if a formula was used, presumably to allow for some change and flexibility, that formula may be out of date. At the speed with which markets change, it can only take a year or two at most for the buy-sell agreement valuation to become a problem.
Second, businesses change rapidly, too. Where your business was and what your business looked like when the buy-sell agreement was written might be materially different from what the company looks like today.
Needs and objectives change with time as well. That’s what happened to this particular business owner. At the time the buy-sell agreement was written, he was trying to get several key employees to buy into the company at an affordable price, thus his advisors wrote a discounted price into the legal document. That may have made sense at the time, but since then his company had dramatically increased in both size and value, making the 2.5x book value approach not only obsolete but even harmful.
How to Maintain a Good Buy-Sell Agreement
What do you need to do with your company’s buy-sell agreement to avoid a similarly contentious situation? Consider these steps:
- Review the agreement no less than annually. Do not let it grow stale.
- Get input from your advisors — not only your attorney (because this is a legal document) and accountant, but also exit planning advisors who can provide perspective and data on current market conditions.
- Be flexible. Your buy-sell agreement does not have to apply the same valuation methods to all situations. For example, if you want to sell a portion of your company to a key employee at a lower price, you likely can do so without hard-coding this lower price into every circumstance addressed in the agreement.
Also, your buy-sell agreement can apply different valuations to different events. For example, if a minority owner dies, the buy-sell agreement might call for a buy-out of that person’s interest at full price, but if a minority owner is fired for reasonable cause the same buy-sell agreement might apply a deeply penalized, discounted price when buying back those shares.
For more help on this issue and dealing with business partners and co-owners, download our free ebook, Creating Co-Owner Exit Alignment. Or contact us if you have a quick question about your buy-sell agreement.
1 Also called a shareholder agreement, a buy-sell agreement is a legal document that usually has provisions that predetermine how certain ownership-related situations will be handled, such as the buyout of one or more owners due to death, disability, or other separation from the company. In many situations the buy-sell agreement is a standalone document. However, sometimes the buy-sell provisions are embedded in another legal document, such as the operating agreement in the company if it is an LLC.