Are you really prepared for all of the possible scenarios?
I coach softball and before every game I make sure that I'm prepared for anything that may happen. I have all of the softball gear that the team should need. I have drinks and a parent bringing snacks after the game. I have a first aid kit.
On a beautiful Saturday afternoon, our team has a runner on second base and the batter hits the ball near the shortstop. The runner coming from second base slides hard into third to avoid the out. She's safe on base, but has a skinned knee. I'm prepared and grab the first aid kit. When opening the kit for the first time, I realize that it didn't include everything I need to properly clean and bandage up the runner's knee. Was I really prepared?
Having a buy-sell agreement in place for your business is a lot like having that first aid kit. You expect it to be effective when it needs to be relied on. Does the agreement really contain what it needs and are situations sufficiently defined so it can be implemented as the parties intended? Consider the following scenarios:
Two owners have 50 percent interests in an equipment leasing business. They have a buy-sell agreement in place that states in the event of a stock transfer the stock should be valued at book value. The leasing business is a highly profitable pass-through entity and the owners distribute most of the earnings from the business. One of the owners turns 70 next year and wants to retire. Is book value going to give the retiring owner a desired payout of the value of the business?
Let's assume that the buy-sell agreement instead relies on a formula method to determine the value of the stock. The agreement states that the stock's value is calculated based on a formula of three times the average of the past five years' financial results. Although this is an improvement over book value, it ignores the need to normalize unusual activity and doesn't consider the current condition or future outlook of the business. It is merely a calculation using historical financial results. As valuation is inherently forward-looking, the buy-sell agreement could have stated that the business would be valued using the fair market value standard. This will allow an appraiser to select the appropriate method or methods that consider the special characteristics of the business and include its future potential.
Consider a second scenario in which four siblings have equal 25 percent interests in a manufacturing business. One sibling wants to sell her stock to the other siblings on a pro-rata basis for 25 percent of the value of the business. The other siblings believe that the value of a 25 percent interest should include discounts since it is a non-controlling minority interest in the business and there is no market for selling the stock. The fair market value of the 25 percent interest using the three siblings' approach is half the value of the other sibling's amount. Which value is correct in this situation? The buy-sell agreement was silent on whether discounting should be considered. A better agreement could have addressed the levels of control and marketability to be used when valuing the stock.
In the last scenario, three owners equally own a printing business. The business is the beneficiary of life insurance policies on the three owners. When one of the owners dies unexpectedly, should the proceeds be considered when valuing the company's stock? The agreement doesn't address whether the life insurance proceeds should be included in the value or if it is only a source for funding the buyout of a deceased owner. This is a potential issue that the buy-sell agreement could have prevented.
Creating a buy-sell agreement is a great way to prepare the business and its owners for a future stock transfer. The previous scenarios represent only a few of the issues that we have encountered related to buy-sell agreements. We recommend having your attorney consult with a certified valuation professional when they are drafting your buy-sell agreement. This agreement should be reviewed periodically and all owners should be included in the process. Considering possible scenarios and customizing the agreement to the business can help avoid many headaches and potential lawsuits when the time comes to rely on the agreement. Tailor your buy-sell agreement before you need it so it can be implemented as you intended.
Gregory R. Ward, CPA/ABV, is with Swartz, Retson & Co., P.C., in Merrillville.
