Driving Your Company's Value

Simple (but fair?) Valuation Methods

One of the key components to any buy-sell agreement is the valuation method employed.  How will the business, or an ownership interest in the business, be valued for purposes of executing a transaction governed by the buy-sell agreement?

Two valuation methods exist that I will refer to as "simple" valuation methods.  The first of these methods is the fixed price method, whereby the owners agree in advance what the valuation will be.  Simple? Yes.  Accurate? Probably not.  Things change daily in business, and that usually means the value of the business is frequently changing.  The day after a fixed price is agreed to, events could occur that render that value worthless.

Another "simple" valuation method is to use a pre-defined formula.  For example, "the value of the business will be equal to annual revenue times three."  This method isn't quite as simple as a fixed price, but is not far from it.  Accurate? Possibly.  Fair? Hard to say.

Let's consider a situation that could be problematic.  Let's say a company formed another business unit that Shareholder A ran by themselves with no input or involvement from Shareholder B.  Further, let's assume this business unit and its financial results are not reported separately, where it would be easy to carve this business unit out for purposes of applying the formula.  The real question is, though, should the unit and its financial results even be considered if Shareholder B were being bought out?  Chances are the two shareholders would have different views of this.  Unfortunately, our simple formula provides no guidance in a situation like this.

Simple methods of valuation achieve many desirable objectives.  But if the overriding objective of your buy-sell agreement is fairness to all owners, these methods may not achieve the goal.

Resource for In-Depth Information on Buy-Sell Agreements

For those of you who are really interested in the topic of buy-sell agreements, let me direct you to a wonderful source of information.  Chris Mercer, founder and Chief Executive Officer of Mercer Capital, has written a great book entitled Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?  The book covers a wide range of topics and considerations for forming and executing effective buy-sell agreements. 

Learn more about the book at:

http://www.mercercapital.com/index.cfm?action=page&id=273

Factors to Consider in Buy-Sell Agreements

Some factors to consider in forming a buy-sell agreement for your business:

1) Restrictions based on the business entity type- some types of business entities have restrictions related to the size or characteristics of the ownership group.  For example, S-corporations have restrictions on the number of shareholders.  A buy-sell agreement might require the repurchase of shares if the corporation would otherwise lose its S status.

2) Distribution of ownership- your agreement might specify different provisions for the buy out of a majority (controlling) interest versus a minority (non-controlling) interest.

3) Funding options- the agreement may or may not specify how a repurchase will be funded.  If the repurchase will be funded using company assets, restrictions might be put in place so as not to hurt the financial strength of the business.  For example, the agreement could specify that funds used to repurchase shares may not exceed a certain percentage in net income or cash flow in a given period.

These are just some of the many considerations to think about when putting a buy-sell agreement in place.  The more situations and considerations that can be contemplated at the formation stage, the more the agreement can be crafted to provide the appropriate guidance when needed.

Do You Want To Be In Business With Your Partner's Spouse?

I'm sure the headline of this posting is an attention grabber for a lot of you. I can hear many of you saying, "Don't get me wrong, he/she is a great person to visit with at a party, but I'm not interested in running a business with them." Why do I even bring up this hypothetical scenario? Because it isn't so hypothetical. We've all lost people close to us before we were ready to be without them. This happens every day in business situations. The contingency plans that you and your fellow owner never quite got around to talking about or formalizing can leave the surviving business owner in a tough situation. In many cases, that situation involves having a new co-owner or co-owners: your former partner's spouse and/or children. A buy/sell agreement between owners can help you continue running the business the way you and your partner intend for it to be run in the absence of the other. The agreement simply says what will happen with an owner's interest upon their death, disability, divorce or other situation that removes them from the business. Think of it as a "last will and testament for your business". Sometimes these situations are covered by language in a partnership agreement or shareholders' agreement. But in many cases, the language is unclear and doesn't provide the guidance needed to execute the desired transaction. This can lead to disputes and legal proceedings- precisely what most people who put these types of agreements in place are trying to avoid.

We believe very strongly in buy/sell agreements, and will have postings from time to time with considerations and suggestions for how to draft an effective buy/sell agreement.