It is important for any business with more than one owner to have a well drafted buy-sell agreement in place. These contracts, often referred to as buy-out agreements, govern what will happen in the event of an owner leaving the business for whatever reason.
Failing to properly value a business or misunderstanding the different valuation approaches in a buy-sell agreement could leave you in a bad position if one of the business owners suddenly wants out.
A buy-sell agreement is put in place to facilitate the transfer of business interests according to a predetermined formula. This formula is specified in the buy-sell agreement so that the transfer of ownership occurs as smoothly and conflict free as possible.
A problem however with many buy- sell agreements is that they are usually drafted at the start of a business and then never looked at again until an event triggers their use. Usually, at this point conflicts arise over the terms of the agreement and more often the valuation price of the company. Many businesses quickly draft a buy- sell agreement using cookie cutter forms and terms that later can become big headaches for all parties involved. It is important that you thoughtfully think through how your business will be valued as different businesses need different approaches to valuation.
Different approaches to valuation
- Fixed Price
-In this case, the buy-sell agreement sets the purchase price at a specific dollar amount
- Formula Based
-In this case, the purchase price is set based on a specific metric: an example would be using book value or and earning multiple like EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Methodology Based
-this method uses a valuation methodology such as market-based (based on selling prices of similar companies there were recently sold or acquired) or discounted cash flow (predicting future cash flows and discounting them back to present value)
- Independent valuation
This method uses a qualified appraiser to report on the business value by using his professional judgment over which methodologies should be used and the degree of analysis involved.
Every business is different and so should be their approach to valuation. Some companies may be capital intensive (Not holding a lot of assets) but they may have acquired a large and valuable customer base. They may also have other assets that are not recorded but still hold substantial value, things like a recognizable brand name or trademark. In companies like this, it would not be wise to use a fixed price valuation approach because these tangible assets are not included in the books.
Other companies buy-sell agreements may use a multiple of EBITDA to value the company. If the business has been generating low EBITDA but it is likely to rise in the future because of a new product release or planned cost reduction, then using historical earnings would not be ideal because the added value of the future outlook would not be included.
If you need assistance in drafting a buy-sell agreement or with any other business related legal issue, please call an experienced business Lawyer at The Law Offices of Michael Kuldiner, P.C.