Business Valuation for a Buy-Sell Agreement
An unexpected departure of a shareholder may have a significant impact on your business. To ensure continuity, preparing a buy-sell agreement (or buyout agreement) in advance will help reduce business disruptions when a transfer of ownership does happen.
So, a buyout agreement is a legal contract that delineates the rights of all partners if the business gets sold. Some of the terms that are typically covered in the agreement include:
- Situations when a partner can sell his or her stakes in the business;
- Limitations with the acquirer (for example, whether outsiders can buy the stakes, or if other co-owners have the first right for the purchase);
- Business Valuation methods that can be used to determine the price;
- All mechanisms for liquidating ownership interests;
- The source of funds for the buyout;
- Specific events that can elicit a buyout, such as death, divorce or retirement.
Without a buy-sell agreement, the separation process may get lengthy and costly, especially if there are disagreements between shareholders.
The valuation of the owner’s stake in the business is typically the main point of dispute in most buyout scenarios. Hence, it is important to consider all shareholders in terms of fairness, the costs of the entire process, and the taxes when preparing the valuation clause in the buy-sell agreement.
An effective business valuation clause would state the approach needed to reach a valuation price. Some methods include:
- A value that is agreed upon by all shareholders. The value should be revisited on a yearly basis, at least once a year.
- An agreed business valuation calculation method, such as a pre-determined multiple of earnings (e.g. 4 times EBITDA), or the direct cash flow (DCF) method. Other ways could be using comparable firms or looking at recent transactions, or perhaps using a combination of these methods.
- Engaging an external business appraiser to perform the business valuation process.
After establishing the business value, another important consideration would be apportioning the value among shareholders. For example, if a business has two owners, and if the departing shareholder is a minority stakeholder, the owner’s stake may be subjected to a minority discount, as he or she may not be able to override key business decisions made by the majority stakeholder. Similarly, if the departing owner is in fact the majority shareholder, his or her stake may be worth more and a control premium may be applied to reflect the benefits of key decision making.
Other qualitative factors to deliberate on would be the departing partner’s influence on the business: if the said owner is a key decision maker, his or her departure may be of significant impact to all business operations going forward.
Even with a valuation clause in a buy-sell agreement, shareholders may still disagree if the clause is not well-defined and updated to reflect the current business situation. To have a smooth transition when any kind of separation does happen, it is ideal for:
- Co-owners to come together regularly to update the buy-sell agreement and the valuation clause to reflect present-day business conditions and their personal needs;
- Valuation professionals should be consulted when the buy-sell agreement is drafted;
- The valuation clause should allow external valuation appraisers to conduct the valuation, rather than using a fixed multiple or formula, as multiples and business situations do tend to change.
All in all, it is recommended to have professionals by your side to advise on all business valuation related issues based on your requirements. Contact AM Corporate Services today and we’ll figure out a way to help you with this.