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Buy-Sell Agreements

Business owners are faced with numerous challenges on an almost daily basis…”Should I purchase this
equipment?”, “Do I need to increase my prices?”, “What are my staffing needs for the next year?”, “Am
I using the best suppliers for my products?”, “How much working capital should I keep on hand?”, “Am I
meeting my customer’s needs?”, etc. If you have a business with multiple owners, one very important
discussion needs to be held regarding how, when, and why owners are bought out (i.e. a Buy-Sell
Agreement). There are several significant things to consider including: defining the triggering events
that prompt a sell, how the company’s value is determined, and how the buy-out will be funded.

Triggering Events

The triggering events can vary greatly from company to company. One of the determining factors
regarding the triggering events is whether the owner is also an employee or otherwise actively involved
in the day to day activities. If the individual is actively involved, the more common triggering events
include:

Retirement Death

Disability Employment Termination

Employment Resignation Divorce

Bankruptcy

While each of these events may trigger the sell of an ownership interest, the results and/or
consequences may vary greatly.

Determining Value of the Company

There are generally three methods used to determine the price for a Buy-Sell Agreement. The first
method is to set an agreed-upon fixed price which can be adjusted for inflation. Although simple, the
obvious problem is the fixed price could be substantially higher or substantially lower than the actual
value.

The second method is a formula approach. This method is fairly popular and for some industries can
give you a very good approximation of value. However, there are two primary problems with this
method. The first issue is that it is extremely difficult to arrive at a formula that will consistently give
you a good valuation. This approach will not give credence to the overall economic conditions, the
industry life cycle, the strength of the management team, and frequently will not consider the debt load
of the company. The second issue is that the formula can be susceptible to manipulation. The selling
owner may or may not have much control over the timing of income or the timing of expenses. Other
challenges include deciding which income figure to use (gross, net operating, EBITDA, EBIT, net), how
many years to include (most recent year, average of last five years, weighted average of the last five,
etc), and whether to consider debt or working capital in the equation.

The final method is the appraisal approach. Basically, the parties agree to hire a company or individual
to value the company. In some cases, multiple appraisers may be used. The appraisal approach does
give the parties the most accurate value, but will be more expensive and will require additional time to
finalize the transaction. This is amplified if the parties decide to use multiple appraisers rather than
agreeing to use only one.

Funding the Buy-Out

The three mechanisms for funding the buy-out are: cash (company assets or external borrowings),
shareholder loan, and life insurance. Life insurance can work great…but it requires the triggering event
to be death. It’s important to consider the other two mechanisms or a combination of cash and loans. If
a shareholder loan is to be utilized, the terms (including the interest rate) should be defined in the Buy-
Sell Agreement.

Many times the execution of a Buy-Sell Agreement is done under stressful circumstances. It’s important
that the significant issues be agreed upon ahead of time to minimize the stress and potential hostility. If
you should have any questions regarding Buy-Sell Agreements, or if you would like us to review your
current agreement, contact our office.

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Buy Sell Agreement

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