August 13, 2007
If you are a partner, shareholder or member of a limited liability corporation in a business or a professional practice, or an attorney, an accountant, a financial advisor, a financial planner or agent with clients who are partners, shareholders or LLC members in a business or professional practice, there are questions you should be asking.
1. Is there a buy-sell agreement in place? If not, why not?
2. If there is a buy-sell agreement in place, how long has it been since it was last reviewed and how often is it reviewed?
A buy-sell agreement is a contract between the entity (corporation, partnership, LLC) and its owners/investors that defines at what price and under what terms owners, their heirs, and/or estates are to be bought out if certain events are triggered. Remember: IRS rules determine whether the buyout price represents fair market value for estate purposes, regardless of what the agreement says.
Typically, when multiple-ownership businesses or professional practices are bought or started, the owners and investors think their work is done. They rarely consider that, while things are rosy at the beginning, situations change. People get divorced, they die, they retire, and a myriad of other things.
The experienced business attorney will say to new owners and investors, “We now need to put a buy-sell agreement into place.” Typical owners and investors will often say these fateful words, “We’ve been in business before. We know what buy-sell agreements are all about. Don’t you have one in your word processor? Besides, we’re all friends. There’ll never be a problem, anyway” (Famous last words!). At that point the attorney may just pull a buy-sell agreement out of his word processing boilerplate. After signing it, the owners/investors may never see it again until five, 10, 15, 20 years later when there’s a trigger event.
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Question: When that trigger event occurs, will the valuation mechanism in the buy-sell agreement represent the current value of the corporation, partnership, LLC, and the interests of the owners/investors, or will it represent the values of five, 10, 15 or 20 years ago? Or will it represent something that makes no sense at all?
Christopher Mercer, one of the nation’s leading financial consultants and president of Mercer Capital Corp., says, “If you are a business owner or shareholder and your buy-sell agreement has not been updated within the last year (or if you don’t understand it), run, don’t walk, to your attorney to talk through these issues. If you or your attorneys don’t understand the valuation nuances of your buy-sell agreement, don’t hesitate to bring in a qualified business appraiser to read the agreement from a valuation perspective and to tell you what he or she thinks, and what aspects of the document may represent legitimate room for misunderstanding between appraisers.” What may seem clear to one party may be cloudy to another party. There must be no question as to intent or interpretation.
A “trigger event” is an action that sets things in motion. In the case of a business or professional practice, trigger events usually include one of the following, often referred to as “QFRDDD:”
Q: Quits. Bill, a hard-working 20-year employee and minority owner has repeatedly been promised by Jim, the controlling owner, that someday he would sell the entire business to him. Suddenly Jim’s nephew emerged out of nowhere and is being groomed to take Jim’s place. There is no buy-sell agreement. Bill, offered a token for his interest, quits and starts a new company in competition. Lawsuits are flying. A buy-sell agreement would have resolved this situation before it even began.
F: Fired. Two equal owners have built a successful manufacturing business. Ten years later, with profits booming, one owner becomes greedy and locks out his partner. There is no buy-sell agreement. Lawsuits are flying.
R: Retire. Dr. Jones, a shareholder in a six owner medical clinic, decides to retire from practice. Based on a 20-year old buy-sell agreement, his interest is worth one-sixth of the accounts receivable, or $35,000. Based on earnings his interest is worth $500,000. When the buy-sell agreement was first put in place, the doctors never dreamt that the practice would grow so large. In 20 years, the buy-sell agreement was never reviewed or updated.
D: Disabled. Smith, a majority owner and operator of a very profitable company, is injured in an accident and is no longer able to work. He decides to trigger the buy-sell agreement before he’s forced out. After reviewing the buy-sell agreement, and consulting with a qualified business appraiser, he realizes that the “buyout formula” in the buy-sell agreement is not really a formula and it does not comply with professional valuation standards. He and his partners cannot agree on the proper methods for valuing the business. It should have been spelled out in the buy-sell agreement. Now a judge will decide the matter.
D: Death. A shareholder has died, leaving his elderly wife his 25 percent interest in a business. The remaining shareholders do not want her as an owner and trigger the buy-sell agreement that says she should receive 25 percent of the net book value, or $125,000. The fair market value of her interest based on an appraisal is $2.5 million. The IRS says, “We don’t care what the buy-sell agreement says. The fair market value of your interest is $2.5 million and you will be taxed accordingly.” There is a major controversy as to the fairness of the buy-sell agreement.
D: Divorce. A shareholder is sued for divorce. The non-owner spouse ends up owning an interest in the business. The other shareholders have a new, unexpected partner that they do not want. They trigger the buy-sell agreement that says the business “shall be appraised” but goes no farther. The accountant appraises the business. A controversy develops over appraiser independence and appraiser qualifications. The matter ends up in court.
There are many categories of buy-sell agreements, including cross-purchase agreements, entity-purchase agreements and hybrid agreements.
There are many types of buy-sell agreements such as fixed-price agreements, formula agreements, shotgun agreements, rights of first refusal, process agreements, multiple-appraiser agreements, and single-appraiser agreements.
Each has advantages and disadvantages. They are of significant importance to warrant examination and discussion. There is also a buy-sell agreement check sheet that attorneys should use if they deal with buy-sell agreements. Call us for a copy.
Jerry F. Golanty of Reno is Nevada’s only Master Certified Business Appraiser, and is regional governor of the Institute of Business Appraisers. Contact him at 332-4881or firstname.lastname@example.org.