Buy-Sell Agreements - Does Size Matter?

While traveling from Boston to Memphis yesterday I met a gentleman who was the "vice president, strategic solutions" for a sizable business. His company had been a $60 million services firm that had just recently been acquired by another services firm that was backed by private equity. The market value combined entity was perhaps $200 million or so.

I was reading a new book on buy-sell agreements (that I will review later), and we struck up a conversation. I was interested in his response to my assertion that problems with buy-sell agreements were probably limited to relatively small companies. His thought was that larger companies, or rather, their key managers and advisers, tended to be more sophisticated financially than folks in smaller businesses, and would not have such problems.

He was surprised at my response. What I told him was that, in my experience, company size does not matter when it comes to problems with buy-sell agreements. Big companies are not immune to the basic problems that plague buy-sell agreements everywhere. But fixing the problems does tend to be more expensive for larger companies than for smaller ones!

There are five things that must be in a buy-sell agreement to specify a valuation process in unambiguous terms. There is a sixth thing that, while not defining the valuation process, can raise havoc with that process if it is also not specified. What is important is that the participants to buy-sell agreements agree to these things. That's why they are called buy-sell agreements!

Standard of value. This element specifies the kind of value that is desired. Most buy-sell agreements specify fair market value as the standard of value. Fair market value is a willing buyer, willing seller concept where both buyers and sellers are acting without compulsion and with reasonable knowledge. However, other terms are often used, including "fair value" (whatever that is), "the value," the "going concern value" and others. If the parties desire fair market value as the standard of value, then the agreement should specify fair market value every time value is mentioned.



Level of value. This element specifies the value of what is to be valued. The question is, do the parties desire the buy-sell agreement valuation to specify the pro rata share of the value of the company, or the value of the specific interest in the company that is being purchased pursuant to the agreement? Confusion over this issue is found in agreements for companies of all sizes. And even if the intention was clear, the words on the pages of the agreements are often confusing. For a conceptual look at what confusion over level of value can mean, see the levels of value charts.



"As of" date. The "as of" date grounds the valuation in time, so appraisers can look at the company, the industry, the markets, the economy at that time for purposes of their valuations.



Qualifications of appraisers. Very few agreements, regardless of the size of the company, specify the qualifications of appraisers to be selected when they are triggered. In fact, the book I was reading yesterday includes these descriptions for appraisers: a certified public accountant, a professional business appraiser, the appraiser, and a disinterested appraiser. The bottom line is that with any of these descriptions of the appraiser, there are virtually no instructions to selecting parties regarding qualifications. Most agreements are written such that "any appraiser" will do, and that is simply not true.



Appraisal standards to be followed. If few companies specify the qualifications of the appraiser, virtually none specify the appraisal standards to be followed. If appraiser qualifications are specified, such as, for example, the selected appraiser shall hold the Accredited Senior Appraiser (ASA) Designation of the American Society of Appraisers," then such appraisers must follow specific standards. ASA appraisers must follow the ASA Business Valuation Standards and the Principles of Appraisal Practice and Code of Ethics of the American Society of Appraisers. They must also follow the Uniform Standards of Professional Appraisal Practice. Otherwise, you can specify which standards you want to have followed by all appraisers selected for purposes of your agreement. Appraisal standards provide comfort regarding how an appraisal will be conducted and the manner in which it will be reported.



Funding mechanism. The funding mechanism is critical for the successful operation of a buy-sell agreement. Most buy-sell agreements are triggered by life-time events. Many, if not most, agreements provide for the company to purchase shares with a promissory note. Most agreements do very little to specify the quality of the note. For many, there is no specification of collateral. For some, the interest rate is confusing. For others, the amortization can be interpreted in multiple ways. And for many, prepayment rights and obligations are not specified. But that's just one issue. Many companies carry life insurance on the lives of their key owners. If this life insurance is associated with a buy-sell agreement, it is critical that the agreement specify how the appraiser(s) will treat it for valuation purposes. It can be treated as a funding mechanism and not included in the valuation, or it can be treated as a corporate asset and included in the appraisal. These two treatments can lead to widely disparate results.

These elements are critical to the reasonable operation of your buy-sell agreement, regardless of the size of your company. If you know owners of large or even very large companies, please feel free to share this article with them. And of course, if you know owners of any company, please share the article, as well!

Buy-Sell Agreements - A True Story

More than a decade ago, three friends got together to start a company. They invested money and time into the start-up and got it going. Early on, they had a buy-sell agreement prepared.

Fast forward to late 2006. My friend was called in to discuss the prospects for selling the company. As part of his engagement, he priced the business for the owners, concluding that his best single-point estimate of value in a sale was $20 million for their collective equity, or about $6.7 million each. He reviewed the company's buy-sell agreement and found a troubling provision. The agreement had a fixed price, the value of life insurance taken out on each of the owners' lives, or $1.0 million per one-third share. This price had been set in 1994 and had not been updated since then.

Realizing the problem instantly, my friend alerted the owners of the disparity between the company's current value and their buy-sell agreement price. If one of them should die at the present time, the estate would have an agreed-upon value of $1.0 million for an interest worth close to $7 million. To the owners' collective credit, they all recognized the problem immediately and slowed down their sale discussion long enough to have their agreement price updated to a current value. Having done so, they've authorized my friend to pursue interested buyers and to conclude the sale of the business. The sale will occur or it won't. Things happen along the way to closings. But my friend's involvement with the owners of this company has been of enormous value to all three shareholders, regardless of the outcome.

The bottom line. Value per interest grew over time from $1 million to nearly $7 million. Had there been an untimely death of any of the three shareholders along the way, the agreement would not have protected his family. The real bottom line is that my friend's involvement with this company has had enormous value to its shareholders, regardless of the outcome of this current sale initiative.

Reprise. Fixed price buy-sell agreements are dangerous. Let me be clear about my recommendations:



If you have a fixed price in your agreement, revisit it now.

If you have a friend with a fixed price in his or her buy-sell agreement, encourage him or her to revisit the price now.

If you have a client who has a fixed-price buy-sell agreement, set up an appointment to talk about fixing the problem.

Don't Rely Upon Templates When Constructing Buy-Sell Agreements

This article is a warning against the blind use of legal forms, or templates, for developing buy-sell agreements. Parties to each and every buy-sell agreement need to take time to agree on the key business and valuation aspects of their agreements, then have a qualified attorney (who can also be involved in reaching agreement) draw up the document.

What could be simpler? All the parties have to do is to agree on the events that "trigger" the buy-sell agreement, on who buys stock, and on the pricing and terms of the purchase. Also, it is helpful if the funding for the transaction is specified, as well. The problem is, if my experience is any indication, these things are almost never agreed to at the level at which it is necessary for the shareholders to understand what will happen when their buy-sell agreements are triggered by the quitting, firing, retiring, death, disability, divorce, etc. of a shareholder.

Keep in mind that I am not a lawyer and do not draft buy-sell agreements. I am, however, a business appraiser who has seen hundreds of buy-sell agreements as part of our normal valuation practice - too many of which after failed valuation processes when litigation has already ensued. As such, I read and interpret buy-sell agreements from business and valuation perspectives in the normal course of my business and I can say that relatively few of them address the basic questions in unambiguous terms. Could this be because, in part, too many people rely upon standard forms rather than doing the sometimes difficult work of sitting down together to agree to the key business and valuation issues?

Over the 2009 New Year holidays, I did some fairly unscientific research. I Googled the terms "buy-sell agreements" and "buy-sell agreement forms." In searching quite deep into the rankings, six forms were found that were available on-line and free. There are numerous sites that charge for buy-sell agreement forms, and others that claim to offer templates "for free," but require a "membership" to access them. At another time, I'll set a budget and go form-shopping to see if the results are different. Of the six free templates found, I noted the following:

A cross-purchase agreement.

One was a cross-purchase agreement template calling for each of two shareholders to purchase life insurance on the life of the other. They had to agree on value periodically. Did I say that shareholders almost never do this? There was no other pricing mechanism.

A (valuation) process agreement.

This template addressed only death and termination of employment and no other trigger events (e.g., divorce or disability). The pricing mechanism read as follows:

"Unless the parties agree to another price in writing, the price for each share of capital stock shall be equal to its fair market value as an ongoing business concern as determined in the sole discretion of the company's Certified Public Accountant (CPA), and such determination shall be binding and conclusive upon the parties hereto."

"Fair market value" is generally thought to be a defined term among business appraisers, but what if the company's CPA is not an appraiser? The definition above leaves open to the sole discretion of the CPA, who may not be qualified as an appraiser, as to whether valuation discounts, such as minority interest or marketability discounts, should be considered and/or applied in the determination of price. Would you want an unqualified CPA making such decisions? Would he or she want to make them?

This agreement also had a deadlock provision in the event that the parties could not agree on the company's CPA. In that event, the shareholder's estate and the company would each select a CPA, the two of which would select a third CPA. The price would be the average of the three conclusions. Note that there is no requirement that the other CPAs be business appraisers or have appraisal credentials.

It was not clear whether the life insurance the company might purchase (at its election) should be considered to be a corporate asset (and added to value in the determination of price) or as a funding mechanism only, and not added to value. The CPA would, in his or her sole discretion, have to make that decision.

This agreement, if implemented, would be a disaster waiting to happen.

An identical form was found on another website.

A corporate buy-sell agreement.

This agreement template suggested either an agreed value, or a formula value, but only blanks for the formula were provided. The most likely valuation mechanism was then defined:

"Purchase Price in Lieu of Establishment of Current Agreed Value. In the event the Shareholders do not establish an Agreed Value for more than two (2) years prior to the Date of Death or Withdrawal or Date of Occurrence, then the Agreed Value shall be calculated by an independent Certified Public Accountant acceptable to a majority of the shareholders. The accountant shall determine the fair market value of the Stock as of the Date of Death or Withdrawal or Date of Occurrence, as appropriate, by whatever means he deems appropriate. This fair market value shall then become the Agreed Value. The accountant may apply whatever discounts he believes appropriate, including discounts for lack of marketability. The fees and expenses of the accountant shall be paid by the Company." (emphasis added)

Should the CPA have appraisal credentials? Is the appropriate "fair market value" that of the entire company or of just the interest in the company subject to the agreement? Note that a minority shareholder subject to the agreement might have no say whatsoever in the selection of the CPA, since the selection will be determined by a majority of the shareholders by number. If there are at least three shareholders, this situation could easily occur.

A right of first refusal.

Another agreement template entitled "Buy-Sell Agreement Between Stockholders" was nothing more than an onerous right of first refusal and was not a buy-sell agreement at all.

A public company voting trust.

The last free buy-sell agreement template found involved the creation of a voting trust of a presumably public company. The pricing for transactions pursuant to the agreement was the average of the opening and closing prices on the specified notification date. There were voting and nonvoting shares. The agreement did specify that there would be no differential in pricing between the two types of shares.

There's an old saying: "There's no such thing as a free lunch." My search for buy-sell agreement template language would suggest that there's no such thing as a free and workable buy-sell agreement form. Perhaps the forms that carry a price are better. Those ranged from $2.99 to $79.00. Given this pricing, keep in mind another saying: "You pays your money and you takes your chances."

In conclusion, if the shareholders agree on the pertinent business and valuation points, any experienced business attorney should be able to reflect that appropriately in the buy-sell agreement. My business and valuation advice is straightforward. Do not blindly use any template when creating a buy-sell agreement. Rather, get agreement on critical issues and then modify whatever form is used to reflect the actual agreement of the parties. And in the likely event that you have a buy-sell agreement and don't know the answers to the basic questions mentioned above, now would be a good time to convene a meeting of the shareholders to consider revising the buy-sell agreement.