Most buy-sell agreements are drafted at the beginning of a relationship, when the owners like each other and the company is worth relatively little. The valuation clause is often a paragraph someone agreed to quickly so the lawyer could finish the document.
It then sits untouched for fifteen years, and is finally read out loud on the worst day of the company’s life: a death, a disability, a divorce, a falling out, or a departure to a competitor. At that moment, that paragraph determines how much money changes hands and whether the business survives the transition.
The four common mechanisms, and how each fails
1. Fixed price with periodic update
The owners agree on a stated value and commit to revisiting it annually.
How it fails: almost nobody revisits it. A price set years ago at $2 million governs a company now worth $9 million, or the reverse. A stale fixed price is the most common defect in buy-sell agreements, and it produces the most extreme unfairness, sometimes to the estate of a deceased founder, sometimes to the surviving owners who must pay far above value.
If a fixed price is used, the agreement should specify what happens when it has not been updated within a defined period, typically defaulting to an appraisal mechanism.
2. Formula
A multiple of earnings, revenue, EBITDA, or book value, sometimes with adjustments.
How it fails: formulas do not adapt. A five-times-EBITDA formula set when the company was a stable distributor produces a bizarre result after the company pivots to a service model, adds debt, or acquires a real estate holding. Formulas also depend on defined terms that may be ambiguous. What counts in EBITDA? Which owner compensation is added back? Which year, or which average?
Formulas are attractive because they are cheap and objective. They are dangerous because they are objective about the wrong thing after circumstances change.
3. Appraisal at the time of the triggering event
The agreement specifies that a qualified appraiser will determine value when the event occurs.
How it fails: only through poor drafting. This is generally the most robust mechanism, but it must specify the mechanics or it becomes its own dispute:
- Who selects the appraiser, and what happens if the parties cannot agree
- The required qualifications of the appraiser
- The standard of value: fair market value or fair value
- Whether discounts for lack of control and lack of marketability apply
- The valuation date relative to the trigger
- Whether the conclusion is binding
- Who pays
4. Multiple-appraiser mechanisms
Each side appoints an appraiser; if the two conclusions are within a defined percentage, they are averaged. If not, the two appraisers select a third, whose conclusion controls or is averaged with the closer of the first two.
How it fails: cost and time. It is thorough and reduces the chance of a one-sided result, but it can take months and consume significant fees. It suits larger companies where the dollars justify the process.
The clauses that get litigated
Beyond the mechanism itself, disputes cluster around a handful of drafting choices.
Discounts. If the agreement is silent on whether minority and marketability discounts apply, expect a fight. A departing 20% owner will argue for a proportionate share of enterprise value; the remaining owners will argue for discounts. State the answer explicitly.
Different triggers, different terms. Many agreements sensibly distinguish between events. Death and disability are involuntary and often priced at full value with insurance funding. Voluntary departure to a competitor may be priced lower or with longer payment terms. Termination for cause may carry a further reduction. If you intend these distinctions, the drafting must carry them.
Payment terms. A correct price the company cannot pay is not a solution. Terms should address the down payment, the note term, the interest rate, security, subordination to bank debt, and acceleration on default. Many agreements also include a covenant limiting payments where they would breach a lender covenant.
Life insurance and the value it creates. Where a company-owned policy funds a redemption, the agreement should address whether the insurance proceeds are included in the value of the company for purposes of setting the price. Courts have reached different results in the absence of clear language, and the difference is meaningful.
The tax overlay. For family businesses, IRC §2703 means a buy-sell price will not automatically be respected as the estate tax value unless the arrangement is a bona fide business arrangement, is not a device to transfer value to family for less than full consideration, and has terms comparable to arms-length arrangements. Agreements among family members deserve particular attention on this point.
Redemption versus cross-purchase
Redemption: the company buys the interest. Simpler with several owners, since one policy per owner suffices. The surviving owners generally do not receive a basis step-up in the acquired interest.
Cross-purchase: the remaining owners buy individually. More policies required as the owner count rises, but the purchasers receive basis in what they buy. Trusteed and partnership arrangements exist to reduce the policy count.
The choice has real tax consequences and belongs to counsel and the tax advisor. The valuation mechanism should work the same either way.
A maintenance discipline that actually works
- Review the agreement every two to three years, and always after a material event: an acquisition, a new owner, a large debt facility, a change in business model.
- Obtain a valuation on a defined cycle, even where the agreement calls for appraisal at the trigger. Knowing the number in advance informs insurance amounts and estate planning, and it removes the shock element from the eventual event.
- Test the funding. Compare insurance face amounts and available borrowing capacity against the current indicated value. Under-funding is extremely common in companies that have grown.
- Run the scenarios. Model what happens on each trigger for each owner. If a scenario would leave the company insolvent, fix the terms now rather than later.
- Make sure everyone has read it. Owners who have never read their own buy-sell are the norm, not the exception.
FAQ
Is a formula ever the right answer? For very small, stable companies where the cost of appraisal is disproportionate, a well-defined formula with an appraisal backstop can work. It should be reviewed regularly and should define every term it uses.
Should we set the price ourselves? Owner-agreed prices are permissible, but they should be documented, dated, signed by all owners, and refreshed. Undocumented informal agreement is worth very little in a dispute.
Do discounts apply to a buyout under our agreement? Only if the agreement says so, or is silent and the applicable law fills the gap in that direction. Do not leave it to inference.
How much life insurance do we need? Enough to cover the interest at current value, plus consideration of the tax treatment of the proceeds and the redemption. That requires knowing the value, which is why the periodic valuation matters.
