A buy-sell agreement spells out a business partner(s)’ exit from their company by requiring the remaining owners to purchase the departing partner(s)’ shares. An important component in any agreement is determining which valuation method will be used to determine a fair buyout price. This may sound straightforward, however, without specific guidance, there is a lot of room for interpretation. In this blog, we’ll attempt to explain the importance of clearly defining a valuation method in your buy-sell agreement and how doing so will prevent future conflicts and disputes between co-owners.
Well-defined valuation terms help ensure a smooth ownership transition when a buy-sell agreement is triggered. The problem is most buy-sell agreements only mention that the company should be valued, not how it should be valued. Let me say it another way. While saying the company should be valued may seem detailed enough to the average business owner, the details of the valuation are just as important. Without specifics, the “how” is left up to interpretation and could be interpreted to yield a company value that grossly overstates company value, or grossly understates company value. So how should a company approach valuation? Well, there’s no one-size-fits-all approach; it depends on the business. We have, however, listed a few of the most common valuation approaches below.
- Book value – The simplest method based on assets and liabilities on the balance sheet. This is a great and simple approach, however, it may not accurately represent the true market value of the business. The assets of a business may be older and fully depreciated which would yield a lesser value than if the assets were new.
- Multiple of earnings – The value is based on a multiple of net income or EBITDA. The precise multiplier should be specified as well as what is included or excluded from the EBITDA calculation. If year-end discretionary officer bonuses are included in EBITDA, then the value of the company would be lower than if they were excluded.
- Market method – Finding comparable transactions for other businesses that are similar to your company sold recently and close in demographic and location.
- Formula-based – Apply a preset formula based on revenues, profitability, book value, etc. This formula can be based on any metric chosen and can be calculated in any way the owners feel is fair.
Of course, the above list is not exhaustive, but it’s meant to show that there are multiple ways to value a company. Each approach can result in a higher or lower value and it’s doubtful every owner will agree on using the same method when they have something to lose or something to gain. This is exactly why it is imperative to establish the way a company will be valued before a valuation is needed.
When considering a method, it’s also important to remember that the valuation places a financial burden on the remaining partners. A too-high buyout price can strain the company’s resources and remaining owners. But a price that is too low risks underpaying the departing partner, leaving them embittered or angry. Consulting with a valuation professional is highly recommended, but not absolutely necessary. As long as everyone agrees with the same valuation method, there shouldn’t be any issues in the future with receiving too little or too much for their ownership of the company. It also makes sense to periodically review and revise the valuation terms as the business evolves. The method decided today may be unfair in 5 years. Stating in the buy-sell agreement that these terms will be revisited every 5 years builds in flexibility.
Clearly defining valuation terms in a buy-sell agreement is essential to ensuring a smooth ownership transition and preventing future conflicts and disputes between partners. Both departing and remaining partners benefit when the process for determining a fair buyout price is transparent and defined upfront. Several factors should be considered when defining valuation terms, including the valuation approach, the specific method, and the frequency of review. With a bit of forethought and advice from professionals, business owners can establish valuation guidelines that allow for smooth, fair, and equitable future leadership transitions.