Risk management is a pretty common objective for small business owners. Once a business becomes viable, protecting what you worked so hard to build is usually a priority. As COVID-19 has shown us, so many things could go wrong in the life cycle of a small business that it makes sense to limit risk wherever possible.
The first place many business owners will look is to the insurance industry. Errors & omissions, malpractice, general liability, and standard business owner’s policies can be great ways to limit risk in specific areas of your business. Insurance usually won’t help you much with planned or unplanned successions, though.
What happens when it’s time to retire? Who might be willing to buy your stake in the business? How do your partners feel about that? How will your business be valued at the time? And what happens if you’re forced into retirement involuntarily?
This is where buy sell agreements come into play. They may seem mundane, but buy sell agreements are an important component of risk management in any small business.
In our financial planning practice there are a few common mistakes we see with buy sell agreements. This post will cover those mistakes, as well as the standard provisions we tend to see in effective agreements.
Common Provisions in Buy Sell Agreements
Buy sell agreement serve a very important role within a business. At their core, they provide a mechanism for orderly succession when it’s time for you to exit your business – planned for or not.
The obvious risk here is if you were incapacitated in some way and couldn’t continue running your business. If you were hit by a bus, who would step in to run the company? What would happen to your stake in the business? How would you & your family reap the benefits of what you’ve built? The dangers of an unplanned succession are many, and a buy sell agreement allows you to spell out in advance who might step in and how you’d be compensated.
It’s not just a benefit for you and your family, though. If you have partners, picture what might happen if one of them passes away unexpectedly. Their family may be in line to inherit their stake in your business. How would you feel about a partners’ spouse stepping directly into the ownership group? And worse, what happens if they decided to sell to an undesirable third party? These are all very real risks surrounding planned and unplanned succession. And they’re exactly what a buy sell agreement is meant to help manage.
Good buy sell agreements will be customized for your business, ownership structure, and wishes. This is not a boilerplate document you can download off the internet. (Effectively, at least). This is part of the ongoing process of prudent business & risk management. The right buy sell structure for your company now might be different than it was five years ago and different than it’ll be five years in the future. As you add and subtract owners from your partnership group, and your company grows and shrinks in size, your agreement may need to change.
Depending on the specific needs of your business, there are a few provisions we commonly see in effective buy sell agreements:
Call right enable the business entity to purchase your stake in the business at a premium to fair market value, say 125%. This provision can be helpful to keep a partnership group in check, and often coincides with certain triggering events.
For example, how would you feel if one of your partners took their clothes off and streaked across the field at a Giants’ game? Could that be detrimental to your company? Call provisions often include options for the business to buy a partners’ stake for less than fair market value if certain events detrimental to the company occur. Otherwise, the purchase price is more closely related to 100% of fair market value. (Think retirement disability, etc.)
With a put rights, owners have the option of “putting” their ownership share back to the company. This is usually included at a discount to fair market value, such at 75%. If you aren’t ready to retire but need to leave the business voluntarily, this option is a helpful mechanism for orderly exit.
Just as owners will sometimes need to exit a partnership group prior to retirement, there are times when partnership groups and businesses need to be dissolved entirely. Splitting up company assets can be tricky, and deadlock provisions offer rules and guidelines to support the process if necessary.
Right of First Refusal
This is an often overlooked provision in buy sell agreement, but undoubtedly an important one. Right of first refusal gives any remaining partners the first opportunity to purchase an exiting partner’s stake. Outside buyers may ONLY be permitted if existing owners turn that offer down. It goes without saying that you probably want some control over who enters your partnership group. This mechanism gives you the opportunity to block third party buyers.
Valuation In A Buy Sell Agreement
An important part of any buy sell agreement is the arrangement for how equity is to be valued in a succession. Based on the mix of provisions above, some circumstances might call for a premium valuation (company calls partnership interest) or discount valuation (your partner streaks at the baseball game).
Whether the circumstances call for a discount or premium to the value of your share, the agreement still needs to spell out how value is to be determined. There are two primary ways to do this: formualic and non-formulaic. Formulaic valuations will use one or more predetermined measures in a cold, hard calculation.
Common methods used here are:
- Book value of equity
- Multiple of revenue
- Multiple of EBITDA
- Multiple of earnings
Blends & composites of the above are used sometimes too. The formulaic approach is popular because its easy to understand and easy to implement. The drawback is that it’s also simplistic.
This is where non-formulaic approaches come into play. Rather than rely on a preset, surface level valuation measure, non-formulaic valuations incorporate an objective, independent appraisal. This allows a business to incorporate unique features into valuation that wouldn’t otherwise be captured in a revenue or earnings multiple.
It’s common that we see businesses have an appraisal done once or twice, and then not again until there’s a triggering event. This is a mistake, and often results in conflicts within the partnership group. If a non-formulaic method is to be used, a better approach is to have one run every year or every few years. This allows partners to assess their risk if a triggering event were to occur. In short, determining business value before you need to tends to diffuse conflicts down the road.
Common Buy Sell Agreement Mistakes
Even though good buy sell agreements will be customized to your business and your circumstances, there are a few common mistakes we tend to see. Be sure to avoid these when drafting or updating yours.
Failing to Fund
Creating a buy sell agreement is an important step, but it’s not the only one. Funding an agreement with appropriate bank financing or life/disability insurance can be just as important. Agreements can crumble without them.
For example, take an early stage start up that creates a buy sell agreement on day one. During the start up phase the business may not be worth much more than what the founders put in. But over time, if successful, the value will grow steadily. Whatever the funding mechanism, it must grow alongside business value. If insurance only covers 50% of the amount changing hands after a triggering event, ownership may have to kick in funds to buy out the exiting partner’s stake, the exiting party may be forced to take less than what’s owed, or some combination of the two.
Obviously this is not an ideal outcome. The better approach is to make a review of the buy sell agreement part of the firm’s annual planning. Review what the business is worth, review the funding of the agreement, and make changes as appropriate.
Ambiguous Language & Using Templates
Ambiguity in a buy sell agreement is a recipe for conflict. Triggering events, resulting procedures, valuation terms all need to be crystal clear. Otherwise the buyer, seller, or both will fell like they’re getting cheated following a triggering event. In general, a good buy sell agreement will be written by an experienced attorney (which again, I most certainly am not!). I’ve seen several businesses try to skate by using template documents they found on the internet or services like LegalZoom. This is a mistake. The nuances of your business and state laws require a thoughtful attorney’s help. Yes, it’s more expensive. But a few thousand dollars now could save you millions in the future.
Just like the funding of a buy sell agreement can become out of date, so too can the terms of the agreement itself. For example, you may only need a simple agreement when you first start a company. At this point a simple formulaic valuation measure, like multiple of revenue, may be sufficient for your needs.
Over time your business will grow more complex. More thoughtful valuation measures may be more appropriate, making a review of the terms of your agreement necessary. Another good reason to include this in your annual review.
Summing all this up, buy sell agreements are a must once a business becomes viable. We never like to plan for an unwanted exit from a business, but doing so is a benefit to your family, your employees, your customers, and yourself. Please don’t rely on template documents found on the internet – I can’t stress this point enough. Spend a few thousand dollars, work with your attorney (or find one), and make this part of your annual planning.