Summary
A well-written Buy-Sell Agreements have triggering events that call for a third-party business valuation. Business Appraisal FL|GA|HI has deep experience valuing companies for buy-sell agreements.
How to Value a Company for Buy-Sell Agreements
Table of contents
- How to Value a Company for Buy-Sell Agreements
- Life Insurance as a Funding Mechanism
Buy-Sell Agreements for Closely Held Companies and Their Value
As a business owner, you know the importance of a well-written buy-sell agreement. Business owners execute these buy sell agreement contracts with each other. They establish the guidelines that allow for exits, shareholding, and funding for purchases. Certain events trigger the need for a 3rd party business valuation or business appraisal.
These buyout agreement guidelines, however, are especially important for owners. They enable you to plan for parting ways with partners. Events include purchasing life insurance, death, disability, divorce, family disagreements, converting to an LLC, or retirement. Please read our article on common business partner issues.
Drafting a Buy-Sell Agreement with a Business Valuation Provision
The business and any co-owner should work with an attorney to draft business interest agreements. This ensures that owners minimize financial risk should one of the triggering events occur. The company’s operating agreement should reference the buy-sell agreement.
Ideally, the agreement should be drafted when the business is initially created. This is because the interests of the business owners most closely align at that point. However, as time goes on, the interests of each business owner may diverge, resulting in a more complex negotiation process for drafting the buy-sell agreement.
Please read our article on LLC agreements with missing or bad terms.
Regardless of when drafted, an effective buy-sell agreement will include the following components:
- This list of events will trigger an optional or mandatory sale of an owner’s ownership interests to the company or the other owners.
- A description of how ownership interests will be valued when a triggering event occurs.
- An explanation of the terms of purchase and an agreement as to where the money for the purchase will come from.
- Valuation provisions that discuss the ownership interest and what market approach methods and discounts will be used.
In addition to the components, a buy-sell agreement will also require an assessment of the business value. A business appraisal, or business valuation, reflects the current economic value of a business. Please read our article on the business valuation process.
The approach to conducting an appraisal may vary among evaluators and industries. However, the factors included in such analysis tend to be the same. You can calculate a business’s financial health by assessing its team, assets, earnings, growth, and losses within its specific industry.
Assessments for buy-sell agreements tend to assess the business value in one of three ways: determining an agreed-upon value among the business owners, assessing the fair market value at the time of the sale, or approximating value based on formulas.
Regardless, when drafting a buy-sell agreement for your business, it is best to work with expert analysts like BA FL|GA|HI, who can help you at every stage of the valuation process.
1. An agreed-upon value in a buy-sell agreement
This method is the simplest way to appraise the business entity when executing a buy-sell agreement. The business owners would need to agree upon the dollar amount to value the business and include that figure in the agreement.
However, valuing the business this way fails to account for potential changes in value as time progresses between the agreement’s drafting and the occurrence of a trigger event that would initiate a sale.
Because of this, we don’t typically advise assessing the value of all businesses this way. Instead, relying on an agreed-upon value may be suitable for small and predictable businesses. Using several valuation methods and picking the appropriate method(s) is fairer for all parties.
2. Fair market value at the time of sale
The most accurate way to conduct the appraisal is to determine your business’ fair market value at the time of sale. Professional appraisers like BA FL|GA|HI can work with you to determine the value of a potentially departing owner’s ownership.
Additionally, this method ensures that you account for certain factors, like growth and intellectual property, that may increase or decrease your business’s true worth when dealing with a business partner.
3. Using a formula to determine the value of the business
Employing this method, appraisers can help you determine valuations specific to your business and industry. Tax consequences should also be considered when buying out a business partner.
Typically, the valuation will consider earnings before tax, depreciation, and amortization (EBITDA) to account for the assets minus the liabilities. Additionally, a multiple of earnings, adjusted seller discretionary earnings, or book value may be considered.
Life Insurance as a Funding Mechanism
In a buy-sell agreement, life insurance is often used as a funding mechanism to ensure the smooth transfer of business ownership in the event of an owner’s death. Business continuity can be maximized. Here’s how it typically works:
1. Policy Purchase: Each business owner buys a life insurance policy for the other owners. Alternatively, the business itself may purchase policies for each owner. It is more likely that an owner becomes incapacitated from an illness or car accident. Policies should be read to cover the most probable event since no one can predict the future.
2. Payment of Premiums: The business or the individual owners pay the premiums for these policies.
3. Death or Accident Benefit: The life insurance policy pays out an accident or death benefit if an owner dies or becomes incapacitated. The proceeds can also be used to pay the estate tax.
4. Buyout Shares: The death benefit is used by the surviving owners or the business to buy out the deceased owner’s share from their heirs or estate
This arrangement ensures that the business remains stable and that the deceased owner’s family receives fair compensation for their company share, including the tax implications. It’s a practical way to provide liquidity and avoid potential conflicts of business interests during a difficult time.
Please see our article on maximizing business value.
Buy-Sell Agreement Valuation Conclusion
A buy-sell agreement is essential because it restricts the owners’ ability to transfer their interests to unwanted individuals. To facilitate this restriction, the buy-sell agreement tends to specify the events in which owners can liquidate their assets. Essentially, an exit strategy is created for the co-owners to avoid potential conflicts if a triggering event occurs. It will list the valuation provisions, ownership interest discounts, and the valuation method or methods.
Business owners must determine the business entity’s value to create a buy-sell agreement. To do so, they should consult expert appraisers like those at BA FL|GA|HI. Doing so ensures that your appraisal is accurate and complete, which will be needed to execute the buy-sell agreement of your small or medium business.
Add the dynamics of family members to the above, their interest in the business, and who the remaining owners are, and it gets even more complicated.
Contact BA FL|GA|HI today to meet with our expert and eager business appraisers. We are ready to discuss your owner’s interest situation and the valuation services that are best suited for your business.