Written By: Ryan M Gamaunt, FSS, LUTCF
A Buy Sell agreement is essential for any business owner. As one of my clients said during a planning session, “If I don’t set up and fund a proper Buy Sell Agreement, I shouldn’t be in business!” Unfortunately for many business owners, they learned this lesson the hard way.
Good partners fit together for the greater vision.
By taking advantage of a proper buy sell contract, you can make sure the business stays financially viable; protecting the remaining owner/s, employees and customers. Avoiding costly conflicts and litigation, loss of profits and maintaining customer goodwill in the event that one of the owners departs, is imperative for a business to continue. A buy sell plan for a business can protect the business when an owner sells their interest, with predetermined and agreed upon values. It is a vital contract to use when you plan a business or form a partnership agreement. Knowing what the risks and costs are when you begin the business is critical to a business’ success or failure. Or to put it another way, beginning with the end in mind, is more than good advice, its good business.
When is a Buy Sell Agreement Needed?
A buyout can occur for many reasons. Some of which are unforeseen. The sale of a business interest can be triggered due to any of the following circumstances:
- Internal disagreements
- Desire to sell to a third party
Important Considerations in a Contract.
When selling a business interest, there are certain basic needs that need to be specified.
Who will the options to purchase the interest be given to? You will want to make sure that control of the company stays with those who are qualified and have the best interests of the company in mind. Surviving spouses, heirs and others may not be the best business partners. If they were, they would already be a part of the day to day operations. There needs to be some type of restriction in the agreement to purchase to ensure that remaining owners don’t lose control over the company. The contract may provide for remaining owners or business to match a third party’s offer, or have the right to buy the interest, according to a specified valuation and payment method.
How will the contract to purchase be funded?
Buy sell agreements often provide that life insurance will be purchased when possible, so that the proceeds can be used to buy the selling owner’s interest. This can be one of the most efficient and effective methods of funding. The contract needs to specify who the policyholder and beneficiaries will be, and who will pay the premiums for the buy sell insurance. Tax considerations will also affect the agreement contract, so an accountant should be consulted.
You must weigh the options when choosing your valuation method.
Not all Valuations are created Equal!
The method of valuation and how an appraisal will be conducted need to be described and stated in the agreement. There are many different methods but the three most commonly accepted methods are:
- Valuation of Assets:
Often used for retail and manufacturing businesses because they have a lot of physical assets in inventory. Usually it is based on inventory and improvements that have been made to the physical space used by the business. Discretionary cash from the adjusted income statement can also be included in the valuation.
- Adjusted Book Value:
One of the least controversial valuation methods. It is based on the assets and liabilities of the business.
- Multiple of Earnings or Capitalized Earnings Approach:
One of the most common methods used for valuing a business. In this method, a multiple of the cash flow of the business is used to calculate its value.
Other types of Valuations are but not limited to:
- Capitalization of Income Valuation
- Cash Flow Method
- Cost to Create Approach (Leapfrog Start Up)
- Debt Assumption Method
- Discounted Cash Flow
- Excess Earning Method
- Multiplier or Market Valuation
- Owner Benefit Valuation
- Rule of Thumb Methods
- Tangible Assets (Balance Sheet) Method
- Value of Specific Intangible Assets
- Wait and See
A proper valuation of the business needs to identify and take current conditions into account. Therefore, one value over another may not determine a fair price. Since an agreement may base the valuation on many various methods, knowing your options and understanding the most appropriate method is critical when choosing the best method.
Get professional assistance when determining which method is right for you and your business. While hiring an appraiser to complete an audit and review can be both timely and costly, the initial cost of such an in-depth appraisal can save more than future expenses, it can save the emotional and literal costs to improper valuations. It the end, it may just save your business. Contact me if you have questions.
Ryan M Gamaunt, FSS, LUTCF is not an attorney or tax advisor. Information in this article is not to be taken as legal or tax advice. Seek the counsel of an attorney and tax advisor before entering into any contract. Ryan is a Business and Senior Planning insurance advisor in the greater Seattle, Washington area.