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Lost Profit Damage Claims
Valuable Buy-Sell Agreements
Two partners in their mid-40s happily operated a medical practice that provided well for both of their families. But when one died unexpectedly, the remaining owner was challenged to not only maintain the practice alone, but also endure a costly, painful litigation with the surviving spouse whose unrealistic financial expectations were based on an overstated evaluation of the surviving physician's earnings, not the value of the practice itself.
While nothing could have protected the owner or spouse in this case from the grief of losing their partner, a comprehensive buy-sell agreement may have prevented the financial fallout.
"Absent an appropriately drafted buy-sell agreement," says Mark Medwig, senior consultant for Gleason & Associates, "the determination of value is often contentious, costly and time-consuming."
A buy-sell agreement that clearly defines how a company is to be valued is essential for every privately held firm with multiple owners or shareholders who will one day want or need to sell an ownership interest due to retirement, death, a disability, divorce or dispute. This is particularly true when one or more of the shareholders also work in the business.
According to Medwig, who recently assisted a family-owned business in a dispute with a sibling who had been fired, the ideal buy-sell document considers every possible scenario, leaving little for interpretation. Because the agreement between the shareholders stipulated buy-out provisions upon death, not termination, both sides of the family incurred significant costs before settling the issue.
"While most owners and their legal advisors understand the importance of buy-sell agreements," Medwig notes, "often insufficient attention is paid to their valuation provisions." An unambiguous buy-sell agreement should cover these details:
Valuation date. Since timing can dramatically alter a company's worth, buy-sell agreements should stipulate when value should be determined - for example, the date of a shareholder's death, on Jan. 1 of the year of death, or another pre-set date.
Standard of value and price-setting mechanisms. While "fair market value" is a common valuation standard, buy-sell agreements should specify how fair market value will be determined. By an appraisal or the average of multiple appraisals, for example? By a formula, such as five times the previous year's earnings or five times the average earnings over the previous three years? Pre-tax or after tax earnings, with or without depreciation? Earnings with or without adjustments to shareholder compensation and benefits?
Proportional value. According to Medwig, buy-sell agreements frequently neglect to consider premiums or discounts for controlling and non-controlling interests. "An agreement should indicate whether a 25 percent non-controlling interest in a company will be valued at the same level or proportion as majority shares," he says.
Funding and terms of payment. Buy-sell agreements should also stipulate how and when an owner or an owner's heirs will be paid - for example, in a lump sum within a certain time period of the shareholder's retirement or death, or over a pre-determined timeframe on a specified payment and interest schedule.
Financial data used to determine value. What records will be used to assess the company's value - internal books and records, audited financial statements, tax returns, independent analyses, financial projections? If projections are to be used, who will be responsible for determining key assumptions?
In addition to defining each valuation parameter, a buy-sell agreement should be revisited annually to make sure its provisions make sense as business conditions change. "We encourage clients to engage us to review the valuation provisions of a buy-sell agreement when they're drafting or updating the document," Medwig explains, "while there's still time to insert a degree of specificity that can prevent litigious disagreements in the future."
Excerpted from Briefly Speaking, a complimentary newsletter published by Gleason & Associates.
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