Reviewing Buy-Sell Agreements

While the Buffalo metropolitan area has not felt the dramatic economic downturn that the majority of the nation has felt, the impact on the value of businesses during these economic cycles can be subject to a wide swings in either direction.  This can be the result of national AND local economic conditions, the outlook for the particular industry within which the company operates, the availability of working capital, and the local labor force, just to name a few factors.  Even for businesses that are flourishing and growing, the perceived value of a company can fluctuate because less liquidity, less financing, and less demand translates into lower values.

Any market condition presents a good opportunity to discuss with business owners the importance of reviewing their buy-sell agreements and, particularly, the selected value or the formula they use in that agreement to measure the worth of a business under various exit transactions.  Whether selling a business interest internally to other remaining shareholders or externally to third party buyers, they should consider having their businesses valued, review their buy-sell plan, and adjust their exit strategies at least bi-annually.  Failure to do so could mean delayed retirement, unfulfilled estate plans and an inability to transfer true/real value at a market price.

There are 3 key steps in conducting a buy-sell review: 1) Review the language in the agreement 2) Value the business 3) Review the plan’s funding.

Review the Language in the Agreement

· Does the agreement include a provision for disability?  Is the definition the same as the disability insurance funding?

· Is a business valuation required or is there simply a set value which may be too low or too high?

· Does the agreement take into account the recent changes in the estate & gift tax laws?

· Does the agreement coordinate with the planned funding?

Valuing the Business

The single most neglected area in a buy-sell agreement is the valuation of the business.  It is neglected because many owners assume the business is worth whatever is on the balance sheet.  

There can be very different perceived values, depending upon the type of event or exit transaction for measuring the value of the business; i.e., divorce, sale to insiders, sale third parties, disaster losses, contractual damages, and estate and gift purposes, to name a few.  The third party buyer could be an investment buyer, or, a strategic buyer, in which case, the values are likely different, as are the measurements involved.

There are three main methods that can be used to value a business: 1) the income approach where the value of the business can be found in the earnings of the company; 2) the asset approach where the value is in the company’s assets and not necessarily its earnings; and 3) the market approach where the value is determined based on other relevant market transactions that have recently taken place.  Your business valuation expert will determine the appropriate method based on  company specific criteria such as the type of business, purpose of valuation, etc.

Things you should look for in the business valuation:

· Make sure the valuation analyst took into consideration not just the national and state economy but also our local economy.  Buffalo’s economy is very different from that of Niagara Falls, New York City or even Rochester.  This difference could have a significant impact on value.

· How has the analyst accounted for recent earnings that were negatively impacted due to the recession?  Has an analysis of projected future cash flows been considered?

· What is the industry outlook for the company?  How has the analyst accounted for projections that show strong future results or perhaps a slower than average recovery?  Even if the company has strong earnings now, they may not be representative of future results.

We are seeing lower business values now compared to 3-4 years ago.  Lack of traditional sources of financing, increasing costs of doing business, decline in lender risk tolerance. 

These economy-driven changes in value can cause less than optimal outcomes such as: 1) overpaying for your partner’s ownership interest or 2) not being able to purchase the interest because of reduced credit lines and overall lack of financing.

Review Funding

Funding for the exit plan may come in different forms, but it is important to determine the sources in advance and put them in the agreement.  Then they must be updated as external and internal conditions change over time. For example, funding can come from earnings and be paid out over a period of years, or can come from bank financing, or pre-funded in the form of life insurance.

A business valuation is essential to the exit planning process.  Without an accurate idea of the company’s true value, the exit plan is more theory than real fair market value.  Likewise, without an adequate funding strategy, a buy-sell agreement is only an expensive piece of paper.

cmealey@songinvaluation.com or (716) 630-0600 x 208