Starting a new company with business partners requires a careful understanding of each partner’s expectations and goals. Lengthy and detailed discussions amongst the prospective partners are common. Unfortunately, these expectations and goals aren’t always adequately memorialized in writing. Too often, partners rely on oral agreements – sometimes with respect to the entire partnership. See “Why Oral Partnerships Are a Bad Idea.” Seasoned business men and women understand that oral agreements are problematic. They understand the importance of a formal written agreement and in today’s climate usually opt to form a business entity such as a corporation or limited liability company (“LLC”). However, even with well drafted corporate by-laws or LLC operating agreements, the partners are sometimes still surprised by the result when one of the partners dies, goes bankrupt or merely decides that he or she wants out (perhaps because the sale price for the exiting partner’s share in the business was based on a set value which is now too low given a change in the fair market value of the business). For whatever reason, the owners neglected to ensure that a buy-sell agreement was included, or, if one was included, that it embodied the expectations they had originally discussed. A well drafted buy-sell agreement addressing every contingency will govern precisely how shares of the business will be transferred upon the occurrence of triggering events and how the price of the shares will be determined. This article briefly discusses important issues with respect to buy-sell agreements. It is not a comprehensive analysis however. Given the complexities of buy-sell agreements, it is best to work with an experienced corporate attorney.
Triggering events include the death, incapacitation, bankruptcy, divorce or retirement of a partner or the desire of a partner to sell his ownership interest. A good buy-sell agreement will clearly define precisely what happens upon the occurrence of any of these triggering events. It may call for the immediate purchase of a deceased, incapacitated or bankrupt partner’s ownership interest by the company itself (Redemption Agreements), or it may grant the remaining partners a right of first refusal before the company itself is required to purchase the interest. It might also call for the remaining owners to purchase the ownership interest (Cross Purchase Agreements). In cases of divorce, the buy-sell agreement might require that any claimed interest of the non-partner spouse automatically transfer to the partner (the non-partner spouse will have signed a spousal consent when the buy-sell agreement was originally executed). When one partner wishes to sell his interest in the company, the buy-sell language will usually require that the remaining partners approve of the sale or at least maintain a first right of refusal in which case the buy-sell agreement will detail the mechanism by which this right will be exercised.
By far the most important issue in any buy-sell agreement is determining the value of the shares being transferred. There are numerous mechanisms for determining the value of a partner’s share in the company, including fair market value (determined via a professional valuation), book value and pursuant to a preset formula. The partners may also use different valuation methods for different situations. Using the fair market value of the company usually results in a most equitable result. It includes intangible assets such as goodwill and if appraised correctly should be the actual value others would be willing to pay to purchase the business at the time of transfer. The actual price for the departing member’s shares would be adjusted depending on his or her percentage ownership and control of the company. Clearly, a controlling interest would fetch a greater price. However, obtaining a fair market appraisal can be expensive and time consuming often costing tens of thousands of dollars. To reduce the valuation expense, buy-sell agreements sometimes provide for an informal determination of the appraised value by the partners and call for a professional valuation only as a last resort. If the partners cannot agree, the buy-sell agreement may contain mediation or arbitration language detailing an informal dispute resolution process for determining the value of the company without the need for a professional appraisal. In some cases, the buy-sell agreement will call for the owners to set the market value at the beginning of each year, and each owner may be required to sign an annual valuation certificate. Upon the occurrence of a triggering event, the price is the price the partners agreed to at the beginning of the year. The key benefit of this method is that the owners are able to reassess the value of the company annually based on its performance.
The book value of a business is determined by its accounting records. The book value is simply the value of the assets less the value of the liabilities as recorded in the company books. It is readily determinable and as such is far less expensive and time consuming than a formal appraisal. Typically, the book value is rarely the fair market value of a business. While less expensive and time consuming, it is not usually the most equitable valuation, particularly for withdrawing members. For instance, goodwill, which can have significant value, is not recorded in the company books and depreciation can skew the gap between fair market value and book value.
Alternatively, preset formulas designed to approximate the fair market value of a company can be written into buy-sell agreements. Preset formulas don’t require expensive appraisals and are typically less skewed than book values. For example, a preset formula might be the book value of the business plus some arbitrary percentage designed to approximate the departing owners share of goodwill. In some cases, preset formulas are designed to fit a particular industry. There are numerous formulas that can be used, some more complicated than others, and its best to discuss these varied and complicated options with an accountant.
The options for valuation methods are endless. Whatever method is chosen, periodic reassessment of the valuation method is prudent. When the owners first negotiate the terms of a buy-sell agreement, they are usually on good terms and they don’t know who in the future is likely to be the withdrawing member. They also do not know how each owner’s role in the company will change over time. Periodic reassessment of the valuation method helps ensure that the original method does not get stale. It’s also important, regardless of the valuation method chosen, to consider funding of Redemption and Cross Purchase agreements. Such clauses are problematic if the company or its owners cannot afford to pay. The buy-sell agreement may call for the purchase price to be paid over time or it may require that all of the owners are insured to cover the purchase upon the occurrence of a triggering event.
Contact a San Diego corporate lawyer for more information on buy-sell agreements.