A lot of Buy Sell Agreements use a common valuation method called the “fixed price” method. It’s the easiest valuation method because the owners pick a number out of thin air and agree on a fixed value. The agreed on number determines the buy out price after a triggering event. Most Buy Sell Agreements state that the owners will review and update the value every year, but in reality few companies ever update the value.
People like Chris Mercer and me who understand how Buy Sell Agreements work or more often than not don’t work in the real world do not like fixed price valuation methods. Here are the reasons I do not recommend people use the fixed price valuation method:
- Unless the value is determined by an experienced appraiser the owners have no clue as to what the actual value of their company is. They are just guessing the company’s value. Do you really want your loved ones to be paid an amount for the company after your death that is based on a guess by a group of nonappraisers? The fixed value method always means that somebody is going to pay too much or too little and somebody else is going to be paid too much or too little.
- Once the value is agreed to and the Buy Sell Agreement signed, the chances are slim that the owners will review and revalue the company annually or whenever the value of the company changes significantly. See Chris Mercer’s article called “Fixed Price Buy-Sell Agreement Poster Child” in which he discusses a great bad example case where the owners of a company never updated the fixed price and it resulted in two lawsuits that took over ten years to resolve. The failure to update the value means that even if the original value was in the ball park the actual value of the company years later won’t even be close to the company’s real value.
- The Buy Sell Agreement needs to have an alternate valuation method that applies after a period of time such as one year, but many Buy Sell Agreements (not mine) lack this feature.
Buy Sell Agreement expert Chris Mercer says this about fixed price valuation methods:
“In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease. However, if you have a fixed-price agreement, you must have the discipline to update the price periodically. And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.”
If your Buy Sell Agreement has a fixed price valuation method I urge you to follow my advice listed below:
1. The owners must revalue the company not less than once a year and more often if something causes the value to increase or decrease substantially. It is not sufficient that the language of the agreement requires revaluations at least once a year. One or more owners must insist that all the owners actually revalue the company.
2. Make sure the Buy Sell Agreement has language that says: (i) the fixed price is eliminated after a period of time (such as one year) unless the owners agree that the price remains good or agree to a new price, and (ii) if the owners do not update the fixed price within the specified period the document contains a workable alternate valuation method.
3. Use an alternate valuation method that requires an experienced appraiser to determine the value as of the valuation date specified in the Buy Sell Agreement.
Recently a new client asked me to review his company’s Buy Sell Agreement because he and the other fifty percent owner of the company could not stand each other and were suing each other over the ownership of their four year old company that generated $20 million in gross revenue. One man did all the work and the other man had nothing to do with the company other than collect big checks.
The good news was they did sign a Buy Sell Agreement, but the bad news was the agreement was grossly deficient as to the terms and conditions of a buy out and its valuation method was what is called a “shot gun” buy out valuation method. Here is how a shot gun buy out method works:
1. At any time an owner (Owner 1) can notify the other owner (Owner 2) that Owner 1 invokes the shot gun buy out clause.
2. Owner 1 names the buy out price per share (if the company is a corporation) or per membership interest percentage (in the company is an LLC).
3. Owner 2 then has a specified period of time to tell Owner 1 if Owner 2 will be the buyer or the seller at the designated price.
4. Once the buyer and seller are determined the purchase and sale transaction is consummated per the terms and conditions set forth in the Buy Sell Agreement. Hopefully the terms and conditions of the sale are clear and workable.
In my 31 years of experience has a business lawyer who has formed 3,600+ companies I have had very few clients adopt a shot gun buy out clause. The main reason people don’t like this clause is because of the uncertainty it creates. Each owner lives in constant fear that the owner may have financial problems that would give the other owner an incentive to exercise the shot gun buy out clause and name a low price at a time the owner could not come up with the money needed to purchase the interest from the other owner.
I am aware of only had one client who actually exercised the shot gun buy out clause in a Buy Sell Agreement I prepared. It caused the other owner to immediately file a lawsuit to stop the process. This happened at a time when the owners where selling their 20 year old company for $4 million with $2 million on closing and the other $2 million ninety days later. The parties bickered some more then dropped the lawsuit and sold the business.
As for the recent client whose other owner invoked the shot gun buy out clause in their Buy Sell Agreement, the price was $7 million cash and my guy had the choice to buy or sell. He elected to buy. Fortunately for him the company was so successful he was able to borrow most of the $7 million.
Mercer Capital’s article discusses a very important topic – when is the best time to review your company’s Buy Sell Agreement?
“Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).
If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.
True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.
For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.”
The article explains the Six Things That Should Be Clear in Any Valuation Process Agreement: Continue reading The Ideal Time to Review Your Buy-Sell Agreement
The 2011 New Jersey appellate court case of Estate of Cohen v. Booth Computers is the perfect bad example that should scare the * out of every owner of a valuable business that is owned by multiple owners. I try and try to explain to my clients with valuable businesses how important a properly drafted and funded Buy Sell Agreement is to their loved ones, but more often than not people fail to address today the reality that they will die in the future.
When people go into business together or invest in valuable real estate together their most important document is a Buy Sell Agreement signed by all of the owners. This is true regardless of the type of business, i.e., a corporation, a limited liability company, or a limited partnership. For more read my article called “A Multi-Member LLC’s Most Important Document.”
The Estate of Cohen is the best example to illustrate the following Buy Sell Agreement facts of life:
- The owners of the business must read and understand the language in their Buy Sell Agreement. Words have meanings and economic consequences. Parties to a Buy Sell Agreement should go over the agreement line by line and word by word with the attorney for the company and their attorney and make sure they understand how the Buy Sell Agreement will work after a triggering event.
- The most important provision is the language that defines how the value of an interest to be bought and sold will be determined. A great amount of thought and effort must go into the valuation definition language.
- Regardless of the language in the Buy Sell Agreement, the owners of the company must, absolutely must, review the agreement not less than every two years (annually would be better) and revise it if necessary.
Had Claudia Cohen known of and followed the above advice her heirs probably would have been $11 million richer. Unfortunately for Ms.Cohen’s heirs, her Buy Sell Agreement is what nationally know business appraiser Christopher Mercer calls a “ticking time bomb.” Is your company’s Buy Sell Agreement a ticking time bomb? If you don’t know the answer to that question you probably need to take action and get an answer. Continue reading Estate of Claudia Cohen — Deceased Partner’s Failure to Update Buy Sell Agreement Cost Her Heirs $11 Million
ESTATE OF CLAUDIA L. COHEN, by its EXECUTOR RONALD O. PERELMAN, Plaintiff–Appellant,
BOOTH COMPUTERS and JAMES S. COHEN, Defendants–Respondents.
DOCKET NO. A–0319–09T2
July 13, 2011
On appeal from the Superior Court of New Jersey, Chancery Division, Bergen County, Docket No. C-135-08.
Michael R. Griffinger argued the cause for appellant (Gibbons P.C. and Greenbaum, Rowe, Smith & Davis, L.L.C., attorneys; Mr. Griffinger, Kevin McNulty, Lan Hoang and Paul A. Rowe, on the brief).
Benjamin Clarke argued the cause for respondents (DeCotiis, FitzPatrick & Cole, L.L.P., attorneys; Frank Huttle, III, of counsel; Mr. Clarke, Russell J. Passamano and Erik Corlett, on the brief).
The opinion of the court was delivered by CARCHMAN, P.J.A.D.
In this appeal, we address the question of whether, under the facts presented, a family partnership agreement that provides for a buyout based on net book value may be enforced where the disparity between book value and market value is significant. In deciding this issue, we consider the difference between book value and market value as well as addressing the issue of whether the disparity between the two renders the agreement unconscionable and unenforceable.
We conclude, as did the trial judge, that the formula utilized in calculating net book value was appropriate, the buyout agreement was enforceable, and the disparity between book value and market value does not render the agreement unconscionable.
Plaintiff Estate of Claudia 1 Cohen, by its executor, Ronald Perelman, appeals from a judgment awarding $178,000 for Claudia’s interest in defendant Booth Computers (Booth), a family partnership in which her brother, defendant James Cohen, was also a partner. Plaintiff argues that the trial judge erred in finding that, under the buyout provision of Booth’s partnership agreement, it was entitled to only the net book value of Claudia’s interest in the partnership, as reflected in Booth’s financial statement at the time of Claudia’s death, rather than the fair market value of that interest, which plaintiff claims was $11,526,162.
Judge Contillo, in the Law Division, concluded that the value set forth in the financial statement was the “net book value,” the language of the buyout clause was not ambiguous, and was supported by substantial credible evidence in the record. The award did not render the partnership agreement unconscionable because of the disparity between fair market value and book value; moreover, there was a similar buyout after the death of the other Booth partner ten years prior. Continue reading Estate of Cohen v. Booth Computers & James S. Cohen
Why Multi-Member LLCs Must Adopt a Buy Sell Agreement
A Buy Sell Agreement is the Members’ Exit Strategy. Don’t Go Into Business With Unrelated Parties Without an Exit Strategy
Bottom Line & Number 1 Reason Multi-Member LLCs Need a Buy Sell Agreement: Members of a multi-member LLC who DO not sign a Buy Sell Agreement are stuck with each other FOREVER unless they can agree on how to split the LLC pie when they cannot agree on anything else.
Although Arizona LLC law does not require that members of an Arizona LLC enter into a Buy Sell Agreement, I recommend that the members of every multi-member Arizona LLC (other than a husband and wife owned company) sign a Buy Sell Agreement. The purpose of a Buy Sell Agreement is to create a mechanism for the orderly acquisition of the membership interest of a member of the LLC on the happening of a specified triggering event. Without a written agreement that contains an exit plan, the members of an Arizona LLC are stuck with each other in sickness and in health and even after death because Arizona LLC law does not provide for the mandatory acquisition of members’ interests in an AZ LLC.
I have formed 3,400+ Arizona LLCs. As a business lawyer who began practicing in Arizona in 1980, I have seen the unfortunate results of too many companies (corporations and LLCs) where over time the owners became at odds and desperately needed a “company divorce,” but were forced to “cohabitate” indefinitely together in the business because they never signed a Buy Sell Agreement that contained a mechanism for a mandatory buy-out of an owner.
An Actual KEYTLaw Client Bad Example Continue reading A Multi-Member LLC’s Most Important Document
Exciting Developments in Buy-Sell Planning
This issue of the estate planning newsletter examines exciting new developments in business succession planning – specifically, the use of LLCs to own life insurance for buy-sell planning purposes. Such a structure obtains the advantages of cross-purchase and membership interest redemption buy-sell agreements without many of the disadvantages of either traditional structure. This development is significant to all small business owners.
For many business owners, the business itself is their primary source of income both during working years and in retirement. Thus, buy-sell planning is critical for not only death planning but also disability and retirement planning during lifetime.
Unfortunately, the two traditional types of buy-sell agreements, entity purchase and cross-purchase agreements, have significant limitations and disadvantages that often prevent business owners from adequately preparing for many business succession issues.
With a redemption arrangement, the entity owns the life insurance and agrees to redeem the interest of a deceased owner at that owner’s death. The owner in turn agrees that his or her estate will transfer the interest in the entity back to the entity for an agreed-upon price. Continue reading Funding a Buy-Sell Agreement With Life Insurance
Buy-sell agreements are some of the least understood, yet most important corporate documents in your client’s corporate files. Nearly every business of any size with more than one shareholder has – or should have – a buy-sell agreement. These agreements establish the mechanism for the purchase (and corresponding sale) of equity interests upon the occurrence of certain “trigger events.” Trigger events can be remembered by an acronym, QFRDD:
If you think about it, these events are called “trigger events” because someone almost certainly has a gun to his or her head, whether your company or a shareholder when they happen.
Buy-sell agreements come in three types: cross-purchase agreements, entity-purchase agreements, and hybrid agreements. Cross-purchase agreements call for individual shareholders to carry life insurance on the lives of other shareholders. This may not be economical (if a company has substantial economic value) or workable (if there are many shareholders).
Entity-purchase agreements call for a company to purchase shares when a shareholder leaves as result of any of the trigger events.
Hybrid agreements provide for the company to pass purchase rights to shareholders under certain circumstances. Most buy-sell agreements that we see in our practice are entity-purchase agreements.
There are really four ways an agreement can determine value when trigger events happen. Continue reading Your Buy-Sell Agreement: Ticking Time Bomb or Reasonable Resolution?
Buy-sell agreements are designed to accomplish one or more of the following objectives from one or more of several viewpoints: the corporation, the employee-shareholder, the non-employee shareholder, and any remaining shareholders. The buy-sell agreement provides for what happens to the shares of owners who leave, for whatever reason, whether favorable or unfavorable.
From the corporation’s viewpoint, the agreement may prevent the departing shareholder from retaining his shares. By requiring a departing shareholder to sell his or her shares to the corporation, the corporation and remaining shareholders eliminate any potential for conflict over future corporate policies with the departed shareholder. They also eliminate the potential for the departed shareholder to benefit from future success of the business created by the remaining shareholders. Finally, the agreements prevent a shareholder (or his or her estate) from selling shares to “undesirable” parties, enabling the remaining shareholders to decide who the next shareholder will be, if any. These reasons for buy-sell provisions apply to virtually all trigger events.
We use “QFRDD” to denote common trigger events for buy-sell agreements. Continue reading Buy-Sell Agreement Trigger Events
This short article is a warning against the blind use of legal forms, or templates, for developing buy-sell agreements. Parties to each and every buy-sell agreement need to take time to agree on the key business and valuation aspects of their agreements, then have a qualified attorney (who can also be involved in reaching agreement) draw up the document.
What could be simpler? All the parties have to do is to agree on the events that “trigger” the buy-sell agreement, on who buys stock, and on the pricing and terms of the purchase. Also, it is helpful if the funding for the transaction is specified, as well. The problem is, if my experience is any indication, these things are almost never agreed to at the level at which it is necessary for the shareholders to understand what will happen when their buy-sell agreements are triggered by the quitting, firing, retiring, death, disability, divorce, etc. of a shareholder. Continue reading Don’t Rely Upon Templates When Constructing Buy-Sell Agreements
Many buy-sell agreements are funded, in whole or in part, by life insurance on the lives of individual shareholders, who may be key managers, as well. Life insurance is a tidy solution for funding when it is available and affordable. It is important, however, to think through the implications of life insurance from a valuation perspective whether you are a business advisor, business owner, or a valuation expert.
The proceeds of a life insurance policy owned by a company naturally flow to the company. When this occurs:
- Should life insurance proceeds resulting from the death of a shareholder be considered as an asset to be used solely for the purpose of funding the repurchase liability created by a buy-sell agreement?
- Alternatively, should the life insurance proceeds be considered as a separate corporate asset, i.e.,as a non-operating asset, to be included in the calculation of value for the deceased shareholder’s shares?
This decision as to the treatment for any particular buy-sell agreement is one that warrants discussion and agreement while all parties to the agreement are alive. Absent specific instructions in a buy-sell agreement, business appraiser(s) may have to decide how life insurance proceeds are to be considered in their determination(s) of value. What they decide will almost certainly disappoint at least one side and may surprise both. Surprisingly, many buy-sell agreements are silent or ambiguous on this issue.
Let’s consider the two different treatments specifically, and then look at examples of their treatment and the differing impacts that the treatments have on all parties to a buy-sell agreement. Continue reading Treatment of Life Insurance Proceeds in Valuation
Check out Chris Mercer’s blog post on four types of Buy Sell Agreement problems.
Mercer Capital: “The Single Appraiser, Select Now and Value Now buy-sell agreement valuation process is the one I recommend for most successful closely held and family businesses. I prefer this single appraiser process as the best available alternative for fixed-price, formula, and multiple appraiser agreements.
In the Single Appraiser, Select Now and Value Now, the appraiser is not only named in the agreement, but he or she is engaged to provide an initial appraisal for purposes of the agreement.
- Select now. I have long recommended that parties creating buy-sell agreements name the appraiser at the time of agreement. This way, all parties have a voice and can sign off on the selection of the appraiser no matter how difficult the process of reaching agreement.
- Value now. Once selected, the chosen appraiser provides a baseline appraisal for purposes of the agreement. I suggest that the appraisal be rendered in draft form to all parties to the agreement, and that everyone has a reasonable period of time to provide comments for consideration before the report is finalized.
- Value each year (or two) thereafter. Ideally, the selected appraiser will provide annual revaluations for buy-sell agreement purposes.”
I recommend Chris Mercer’s excellent article on Buy Sell Agreements in the June 2011 edition of the CPA Journal.
Mercer Capital: “Promissory notes are used frequently as a funding mechanism when buy-sell agreements are triggered. However, most buy-sell agreements reflect very little thought or negotiation regarding the promissory notes that they contain. . . . Promissory notes issued pursuant to the operation of buy-sell agreements are fairly common and often do not provide equivalent fair market value for the stock that is sold by shareholders. This raises a number of issues:
- For companies. The promissory note found in your buy-sell agreement may provide flexibility to the company if and when issued in a transaction. However, the question remains, is it “fair” and reasonable for all shareholders?
- For shareholders who remain after a transaction. You will benefit from the repurchase with favorable (to the company) financing for the purchase. That’s positive, perhaps.
- For the selling shareholder. Selling shareholders do not receive what they bargained for, i.e., the fair market value of their stock when sold at a trigger event. That’s certainly not positive from their perspectives.
- For all shareholders. There is risk here since no one knows in advance who will be the selling shareholder.
It is a good idea to look at the promissory note in your buy-sell agreement (or your clients’ buy-sell agreements) to determine if it is reasonable for all the parties under reasonably foreseeable circumstances.”