Bringing awareness of potential issues in buy-sell agreements to business owners
September 16, 2020
Without a periodic review, many business owners find gaps in their buy-sell agreements that can lead to confusion, missed opportunities and even unintended outcomes. Some agreements are missing clarity or examples of particular provisions, some may have outdated purchase price determination and/or purchase price payment provisions that don’t provide a reasonable resolution in the event of a triggering event, and many other issues. Honkamp Krueger (HK) sat down with Steve Campana, construction practice team leader, and asked him about helping clients with buy-sell agreements and provisions within these documents.
Q: Steve, why is it so important for business owners to periodically review their buy-sell agreement?
A (Steve): We use the term “buy-sell provisions” because these provisions may reside as a stand-alone document, or within other agreements such as a partnership, operating, stock transfer restriction or buy-sell agreement. These provisions define what happens during a triggering event such as death, disability, retirement, separation of service or marital dissolution.
These agreements generally address:
- Triggering events and date of purchase price determination,
- purchase price determination,
- purchase price payment terms, and
- restrictions on transfers of ownership.
These agreements are beneficial for:
- Restricting transfer of ownership within the enterprise,
- creating a market for stock of a closely held company, especially for minority ownership interests,
- succession planning,
- retirement planning, and
- clarity on actions required in the result of a triggering event.
We believe these provisions need to be reviewed periodically, if not annually. Circumstances change and those provisions may no longer have economic substance. Upon a triggering event, those documents can either provide a reasonable resolution (if they’re kept up to date) or can potentially lead to unintended and unfavorable outcomes.
For example, the purchase price provisions sometimes require an appraisal and have agreed values or a reference to book value, all of which may not capture goodwill or other intangible value the company may have, or may be based on an outdated formula. Those provisions, while adequate at the founding of the company or in the past, may no longer reflect the economic substance of an ownership interest.
Q: Can you provide an example?
A (Steve): Let’s take a look at the purchase price determination provision. If it’s determined by an agreed-upon value or formula, when was the last time you calculated the purchase price using this formula? Do those results still reflect the economic value of the enterprise? Alternatively, in the event of a triggering situation, the agreement often requires an appraiser be hired to determine value. Frequently, if one party disagrees with the valuation, that party can hire an additional appraiser to determine value. Not only is this process costly and time-consuming, it still might not produce intended/expected result(s).
For example, do the parties want to consider any discounts that may be appropriate when valuing a minority interest under a standard of fair market value? Or is it the intent of the parties that a minority owner simply receive a pro-rata interest in the value of the company on a controlling interest basis? Absent language contrary to an appraiser will need to consider these discounts in determining the conclusion of value.
While we certainly enjoy the opportunity to perform valuation engagements (and do them well), I’m personally not a big fan of the two-and-a-tiebreaker language or acquiring an appraisal at the time of a triggering event. What we prefer is the opportunity to value the company while all parties are available to fully understand what drives the value. During our review of the value conclusion, we consider the impact on the company based upon purchase price determination, and from there we assist the parties in determining an agreed upon value used in the buy-sell agreement.
We also recommend this value be updated annually, but no more than 24 months ahead of time, and sunset that value if the update isn’t made. For example, if at the time of a triggering event the last agreed upon value is older than around 24 months, the agreement defaults to the use of a qualified appraiser to determine value.
I’d much rather see the parties within the agreement hire the appraiser now and avoid the potential two-and-a-tiebreaker process later. You still have the final say while everyone’s at the table to agree on a value, either using or based upon the appraised value. Other factors may influence the determination of an agreed value, such as the handling of life insurance, repayment terms and interest rates, etc., so it’s best to get it done so it’s ready when you need it, not do it when it’s needed.
Q: What’s the point of revisiting your agreement if it’s perceived as accurate?
A (Steve): It’s important to know ahead of time the value of ownership interest prior to a triggering event and decide if the value – as currently determined – has economic substance and reflects the intent of all parties. We encourage you to consider the merits of hiring a valuation analyst or appraiser if you’re uncertain as to the value required by your agreement, and then reviewing that value every 12 or 24 months.
If the owner’s and executive team’s job is to grow profits, people, value and volume, how do you know if you’re growing value if you’ve never had a professional valuation of your business?
There are many ancillary benefits to knowing the value of your company and having a target. Lou Holtz once said, “No one would play a game of basketball in pitch black darkness with a target they can’t see, yet they are willing to go through life with targets they don’t even have.” Knowing your value gives you a benchmark; something to measure and a basis to measure the gain.
We want your business to succeed, which is why we are passionate about helping review these provisions within your agreement(s). We can help blueprint provisions that make sense for you and your company and share them with legal counsel for their input before crafting a final document.
Q: Do you have any advice for business owners who aren’t sure about the provisions contained within their agreements?
A (Steve): Test drive your agreement yourself or bring it to Honkamp Krueger for a complimentary review of your document, where we conduct a seven-step evaluation. If you are uneasy or confused in any way, let us bring awareness to the provisions in your agreement and the impact on your company, and make sure your agreement provides a reasonable resolution.
For assistance, questions or to take advantage of a complimentary review, contact your account manager or Steve Campana at 888-556-0123 or firstname.lastname@example.org.