In this month’s Feder Law Firm newsletter we address a few basics of buy-sell agreements among owners of a business. Buy-sell agreements are akin to prenuptial agreements; indeed, in business it seems that “divorces” amongst business owners are even more common.
Best to Have at the Outset of the Business
A buy-sell agreement is an agreement among the owners of a small business that establishes a framework for the purchase and sale of interests in the business when triggering events occur. Common triggering events are the death or disability of an owner, divorce of an owner requiring the transfer of company interests to the ex-spouse, or departure of an owner from the business. Often when founders are starting a new business they are more concerned with getting the business off the ground than they are with the hypothetical exit of a co-owner sometime in the future. However, establishing a simple-to-follow framework at the outset addressing owners’ exit from the business will eliminate future expensive legal and financial headaches.
A buy-sell agreement should determine how compensation will be paid to a departing owner in exchange for their ownership interest in the company, and can be used for all types of entities including corporations, limited partnerships, limited liability partnerships, and limited liability companies. The buy-sell agreement typically includes restrictions on transfer and rights of first refusal that allow remaining owners to purchase the departing owner’s interest and a time frame for payment. For business owners, the ability to choose who they start (and remain) in business with is an important factor in determining the success of the business.
Valuing Ownership Interests
One of the central functions of a buy-sell agreement is to provide a methodology to value the departing owner’s interest. Generally, a buy-sell agreement will value ownership interests in one of three ways: (1) fixed price, (2) formula price, or (3) valuation-based price. A fixed-price per ownership interest is the most straightforward valuation method, but it is also the least flexible because the value of the business’s ownership interests will be fixed at a certain price even as the business expands over time. This is seldom the best option. A formula-based valuation is less rigid and is typically based on a multiple that captures a business’s profitability, such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). A formula-based valuation is designed to capture the business’s value at the time of a triggering event. Finally, there are outside valuation-based methods, which are the most holistic. However, valuation-based methods are also the most expensive and time consuming because one or more third-party valuators will need to be retained to examine the business’s earnings and assets, including goodwill. Each of these valuation methods and time frames for the payout can be used to cover different scenarios. For example, owners may wish to use a different valuation and payout schedule for death compared to an owner who simply quits the business.
Contact Us with Questions
If you own a small business and have questions about buy-sell agreements, and whether now is a good time to update or add an agreement to your company’s ownership structure, don’t hesitate to contact us with questions.
Thank for reading this month’s Feder Law Firm newsletter. We hope you found it useful. As always feel free to share this newsletter with anyone else who might find it helpful.