4 Items to Consider When Developing Valuation Formulas for Buy-Sell Agreements

A buy-sell agreement is an arrangement amongst owners of a business that accomplishes many objectives. Its primary purpose is to provide a process and structure for an orderly business succession in the event an owner decides to transfer their interest due to a voluntarily event, such as retirement, or an involuntary event, such as death or disability.

In most cases, a buy-sell agreement includes a formula which dictates the value of an ownership stake. The buy-sell formula is also helpful in providing an owner insight as to the value of their ownership stake, which allows for better retirement planning. Additionally, a defined buy-sell formula will remove the inevitable strife which occurs in the absence of one. Without a mechanism to define the value of a privately-held business interest, the determination would be left to the vices of the exiting and continuing owners.

Below are four considerations for the development of buy-sell formulas:

1. Make sure it is supportable by the company’s cash flow. Whatever the buy-sell formula turns out to be, it should be supportable by the operating cash flows of the business. Typically, shareholder buy-outs are financed with a cash down payment along with a note payable to the exiting owner. Basing the buy-sell formula on historical cash flows helps ensure the company will be able to meet its debt-service obligation to the former owner. Conversely, if a valuation formula was solely developed on market- based multiples, which are derived from actual transactions within the marketplace, the buy-sell value could contain synergistic elements and create too high of a valuation for the company to support.
2. Include a claw-back provision. Claw-back provisions provide a mechanism to protect a former owner from a third-party sale occurring shortly after their buy-out at a much more lucrative valuation. A claw-back provision will essentially make the former owner whole, as if they were still an owner at the time of the third-party sale. However, claw-back provisions are only valid for a specified time period (e.g., two years, depending on the type of business). Otherwise, the former owner could benefit from growth occurring after their redemption for which they were not a contributor.
3. Obtain independent expertise. When determining the proper buy-sell formula, it is best to obtain professional assistance and not have existing shareholders figure it out themselves. An independent third party can take an objective look at the company and is best suited to derive a fair valuation formula, with the input of ownership.
4. Review periodically. Businesses, markets, and economies change, and so should a buy-sell formula. Do not get caught with having a buy-sell formula that is stale and results in a clearly undervalued or overvalued equity transition. It is best to have a buy-sell formula reviewed at least every five years. In the event the formula requires an update, the buy-sell agreement can be easily amended.

If you would like to discuss how to develop the valuation formula for your buy-sell agreement, please contact your Kreischer Miller relationship professional or any member of our Business Valuation team.

Brian J. Sharkey is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email. 

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