Why multi-ownership companies need buy-sell agreements

Business ownerships with multiple owners rarely last a lifetime. Typically, when multiple owners start or buy a business, they are friends, or at the least, they are friendly. As time goes by however, friendships often deteriorate. In many smaller businesses there comes a time when a "trigger event" occurs that changes the relationship:

1. An owner may die.

2. An owner may retire.

3. An owner may be fired by the other owners.

4. An owner may quit.

5. An owner may become disabled and not able to work.

6. An owner may divorce.

Regardless of which "trigger event," it usually signifies that a change is about to take place and oftentimes that change is not pleasant. When it occurs the owners will often consult an attorney, whose first question is often, "What does your buy-sell agreement say?" The typical response is, "What buy-sell agreement!" And, at that point, many multipl-ownership businesses find themselves in deep legal trouble. It should come as no surprise that many, if not most, smaller multiple-ownership businesses do not have a buy-sell agreement in place.

Let's assume a business enterprise has four owners, each with a 25 percent interest. One owner wants out (a trigger event) and wants the other three owners to buy him out.

Is the departing owner entitled to receive 25 percent of 100 percent of the value of the business enterprise, or is the departing owner entitled to receive something other than 25 percent of 100 percent?

It all depends on what the buy-sell agreement says, provided there is one. Assuming there is one, it also depends on the standard of value provided for in the buy-sell agreement.

There are essentially two standards of value that could typically apply: fair value and fair market value.

Fair market value is defined as "The price that a hypothetical, willing buyer would pay, that a hypothetical, willing seller would accept, all parties being in possession of the facts, no party being compelled to act, and the business being offered on the open market for a reasonable period of time." The key elements are: "willing buyer, willing seller".

Here's a example of how fair market value works:

Owner No. 4 says to owners 1, 2 and 3, "I want out of here! Buy me out!" Owners 1, 2 and 3 tell him: "Go out into the world and try to sell your 25 percent interest. We will pay you whatever someone else is wiling to pay you." Owner No. 4 finds that no one will pay him 25 percent of the total enterprise value. Owner No. 4 returns to the other three owners and tells them that he has no buyers. The three owners then tell him they will pay him 25 percent of the total enterprise value less a discount for lack of control and a discount for lack of marketability or liquidity. Owner No. 4 is most dismayed at the news that the discounts could run from 15 percent to 60-70 percent. This owner often turns to the courts, only to find out what fair market value really means and that the situation probably meets the standard of fair market value; willing buyer, willing seller, despite the fact that all parties may not be agreed upon price.

Fair value, meanwhile, is defined as "a proportionate share of the whole."

Here is an example of how fair value works:

Owners No. 1, 2 and 3 want to get rid of owner No. 4 so they tell him: "We've decided to buy you out." Owner No. 4 says, "I don't want to be bought out, but if you insist, you can pay me 25 percent of the value of the total enterprise value." Owners 1, 2 and 3 say, "Your interest is subject to discount" and owner No. 4 replies, "You may be willing buyers but I'm not a willing seller, so the standard of fair market value does not apply. You can pay me 25 percent of the whole."

The next step is for the clients and attorneys to make some decisions.

Here are some factors that need to be considered for inclusion in a buy-sell agreement:

1. What constitutes a trigger event?

2. How would a divorce be handled, or do the owners want the divorced spouse as a co-owner?

3. How is a bankruptcy of an owner handled?

4. How will the value be established?

5. Who will select the appraiser? (one party, all parties, none of them?)

6. What will be the standard of value (fair value, fair market value)?

7. What approaches and methods should the appraiser use?

8. What will be the effective date of valuation?

9. What professional appraisal standards (not standards of value) should be utilized?

10.What qualifications will be established for the appraiser (MCBA, CBA, ASA, AM)?

11. How will the buy-out be funded (insurance, periodically)?

(This article is not intended to be a substitute for competent legal advice, tax advice, estate planning and other areas of shareholders', members' or partners' concern.)

Jerry F. Golanty is Nevada's only Master Certified Business Appraiser accredited in litigation support and owner of BizVal in Reno. He also serves as governor of the Institute of Business Appraisers. Contact him at 332-4881 or jerrygolanty@bizval.net.