Author: Blaine M. Peterson
Closely-held business owners are typically advised to have a Buy-Sell Agreement in place to assure a smooth transition of the business upon the eventual exit of an owner.This process requires that the owners agree on key terms, including triggering events (e.g. death, disability, divorce and retirement), purchase price and the funding mechanism.Frequently, the most difficult issue for owners to resolve is how to establish a purchase price for the eventual transition of the business.
While most business owners cannot quote the definition of “fair market value” as stated in Revenue Ruling 59-60, most believe that the purchase price under the Buy-Sell Agreement should approximate the fair market value of the business. The difficulty lies in how to determine fair market value under the agreement.This is where a CPA can play a vital role in helping business owners understand the benefits and pitfalls associated with the various valuation methods.
Most Common Methods
Buy-Sell Agreements typically incorporate the following methods to determine purchase price.
1. “As of” (or Fixed) Price. Under this method, the owners agree on a fixed price as of a specified date.Upon the occurrence of a triggering event, the price is already established and the transition can proceed virtually immediately.This relatively simple approach is designed to eliminate speculation and disputes over purchase price.However, this method can be problematic as the owners often fail to update the agreed-upon price as the value of the business changes.As a result, the purchase price may be significantly overstated or understated.
If this method is utilized, the owners must be diligent in updating the agreed purchase price on an annual basis and including a certificate of the updated price to the agreement.The agreement should also provide an alternate valuation method (such as a business valuation) in the event the price has not been updated over an extended period of time.
2. Predetermined Formula. The next method involves the owners agreeing to an established formula used to compute the purchase price.The most common formulas are:
Book Value.The price is equal to the book value reflected on the financial statements.Typically this method does not result in a price reflective of the fair market value of the business and is typically used when the goal of the owners is to maintain an arbitrarily low purchase price.
Adjusted Book Value.The price is equal to the net assets as adjusted to current market values.This method is most appropriate for investment or holding companies that do not generate significant net cash flows.
Capitalization of Earnings or Cash Flows. The price is determined by multiplying the earnings or cash flows over a specified number of years.This method allows the purchase price to fluctuate alongside the value of the business and avoid the significant discrepancies that can occur with the “as of” pricing option.Also, the owners are able to estimate the value of their interest prior to the occurrence of a triggering event.
The formula should be clearly specified in the agreement and include an example of the calculation.The owners should evaluate the adequacy of the formula on an annual basis by computing the value of the business utilizing updated data and modifying the formula as needed.
3. Business Valuation. The third method requires a business valuation of the by one or more independent valuation professionals upon the occurrence of a triggering event.This method provides maximum protection against purchase price overstatements or understatements as the valuation is based on the most current financial data available.The disadvantages to this approach is the additional costs incurred for the valuation and the uncertainty of not knowing the value of the business prior to the occurrence of a triggering event.
The agreement should clearly identify the qualifications required of the appraiser (e.g. CVA or ABV) as well as mandating the standard of value and premise of value. Doing so will enhance the reliability of the valuation and minimize disputes regarding the application of valuation discounts. Since valuation discounts for a non-controlling interest in a private company can exceed 30%, it is wise to consult a valuation professional early in the process to illustrate the financial impact of the various valuation methods. This practice can ensure that the owners are fully advised and consent to the chosen methodology.
Regardless of the chosen method, owners need to understand the risk of understating the value of the business for purposes of the Buy-Sell Agreement. Since the IRS is not bound by the value mandated in the agreement, the estate of a deceased owner could find itself in the unenviable position of receiving far less under the Buy-Sell Agreement than the value as finally determined by the IRS. Even at the current maximum estate tax rate of 40%, a substantial understatement in value under the Buy-Sell Agreement could leave the deceased owner’s estate without the necessary liquidity to satisfy the resulting estate tax liability.