September 15, 2017

Are You Gambling with your Buy-Sell Agreement?

Buy-sell agreements are almost always triggered unexpectedly (after all, who expects to die, to be fired or to become disabled?) and into an emotionally-charged environment. Now, imagine opening your buy-sell […]

Buy-sell agreements are almost always triggered unexpectedly (after all, who expects to die, to be fired or to become disabled?) and into an emotionally-charged environment. Now, imagine opening your buy-sell agreement after a triggering event, probably for the first time since you prepared it with your fellow owners (often in simpler times where optimism and naiveté were prevalent) and quickly realizing that the approach to value that it prescribes will result in one or more of the shareholders – perhaps the buyer, perhaps the seller – getting the proverbial “shaft”.

Our experience would suggest that this scenario is not uncommon. In fact, buy-sell agreements that do not adequately address the issue of valuation have been referred to as “ticking time bombs” that could destroy shareholder value, family legacies, long-time friendships or entire companies once triggered…

Value Determination

Buy-sell agreements generally form part of a shareholders or partnership agreement and govern how ownership of a privately-held entity will change hands if and when something significant happens to one or more of the current owners of the business. Buy-sell agreements are supposed to provide:

  • A market for the shares in the event an owner dies or otherwise has to leave the company (i.e. a triggering event).
  • The price and terms for the shares.
  • A means for the buyout to be financed.

As there is no active market to readily establish the price of a privately-held company, some form of a valuation is an underlying requirement of buy-sell agreements, and usually fall under one of three pricing mechanisms:

  • Fixed price – the owners agree on a price and include it in the buy-sell agreement.
  • Formula price – the owners agree on a formula to calculate price. The formula may be “book value”, or a multiple of historic, current or future revenue, EBITDA or free cash flow. However, due to changes in the company or the industry, both the fixed price and the formula price approaches can become dated and result in unreasonable values in the current environment.
  • Valuation process – the owners agree that if the buy-sell agreement is triggered, one (or more) business valuators will be retained to determine the price. However, none of the owners have any idea what will happen once the valuator is engaged.

Recommended Valuation Process 

Our recommended mechanism for determining value within a buy-sell agreement is as follows:

  • The owners agree on a qualified business valuator (preferably someone with a Chartered Business Valuator designation).
  • This business valuator defines the valuation engagement as specified in the buy-sell agreement and receives agreement from the owners on any other “silent” issues that may impact the valuation process.
  • The business valuator provides an initial draft valuation of the business.
  • After receiving input from all of the owners, the initial valuation is finalized.
  • The same valuator then provides a valuation update on a regular basis (generally on an annual basis or else every other year).

We recommend that this process be implemented now, well in advance of any potential

triggering event, as:

  • There will be an understanding (and acceptance) of the valuation process developed over time, as well as tracking of current prices (which can also facilitate estate planning and/or life insurance funding for the owners).
  • Unanticipated problems with the valuation process defined in the buy-sell agreement will be identified and fixed prior to any triggering event.

And while this process will result in the business incurring additional expenses and time commitments throughout the life of the buy-sell agreement, the information and peace of mind that result are a prudent investment for all of the business owners.

The Survey

Catalyst recently conducted a confidential survey whereby we asked a sample of local lawyers a series of questions to draw upon their experiences in implementing, administering or litigating buy-sell agreements, specifically regarding the valuation-aspects. Approximately thirty participated, and their responses have been compiled at the end of this report.


Whether or not it is acknowledged, a buy-sell agreement forms part of any business owner’s future plans, and if it fails to operate properly when triggered, the results can be disastrous. In fact, if the valuation mechanism in your current buy-sell agreement is outdated or ineffective, each owner is essentially betting that the flawed-value will favor them upon a triggering event – and gambling with one of your most valuable assets is not a strategy we would recommend!

Survey Results

Question 1
How many times are you asked to draft, review, or act upon the buy-sell provisions of a shareholders or partnership agreement in a typical year?
  • 0-5:  20.83%
  • 6-10:  29.17%
  • 11-20:  33.33%
  • 21 or more:  16.67%
Question 2: 
When drafting a buy-sell agreement, which method do you generally recommend to clients for purchase price determination?
  • A pre-determined fixed price:  12.5%
  • A valuation based upon a formula included in the agreement:  25.0%
  • A valuation performed by a valuation expert upon the triggering event:  41.67%
  • Other:  20.83%
Question 3:
When a pre-determined fixed price is used, how often do you suggest it be reviewed and/or adjusted?
  • Annually:  66.67%
  • Every 2 years:  12.5%
  • Every 3 years:  8.33%
  • Other:  12.5%
Question 4:  
When a pricing formula is included in the agreement, which method do you most frequently recommend to clients?
  • A multiple of the book value of the company:  8.33%
  • A multiple of average EBITDA or net earnings over a multi-year period:  25.0%
  • A multiple of EBITDA or net earnings from the prior year:  8.33%
  • An average of more than one of the above methods:  20.83%
  • Other:  37.5%
Question 5:  
When the agreement calls for a valuation to be performed, what definition of value do you most frequently recommend to clients?
  • Fair market value:  87.50%
  • Fair value:  8.33%
  • Book value:  4.17%
Question 6:  
When the agreement calls for a valuation to be performed, who do you most frequently recommended your clients see to complete the valuation?
  • An accountant (whether the company’s or a third party):  29.17%
  • A valuation professional (i.e. a Chartered Business Valuator):  58.33%
  • No specific recommendation, other than an independent and/or outside party:  4.17%
  • Other:  8.33%
Question 7:  
Which of the following additional provisions do you generally recommend clients consider including in the valuation section of the agreement? (Choose all that apply)
  • The valuation should allow for any discounts for lack of control (i.e.minority interest discount):  39.13%
  • The valuation should allow for any discounts for lack of marketability:  30.43%
  • The valuation should allow for any key person discounts:  21.74%
  • The valuation should not consider any of the above discounts:  30.43%
  • The valuation should include any goodwill and intangible asset value:  47.83%
  • The valuation should not include the proceeds of any life insurance policies:  43.48%
  • The valuation should consider any latent tax liabilities that might exist on appreciated assets:  43.48%
  • Other:  8.70%
Question 8:  
When the valuation has been completed according to the agreement, how is the payment of the purchase price generally structured?
  • All cash:  16.67%
  • A combination of cash and a promissory note:  70.83%
  • Other:  12.5%
Question 9:  
If the purchase price includes a promissory note or other form of deferred consideration, how is the interest rate defined?
  • Non-interest bearing:  4.35%
  • A fixed rate, based upon the current prime rate (i.e. prime + X %):  52.17%
  • A pre-determined fixed rate:  13.04%
  • A floating rate based upon prime rates:  21.74%
  • Other:  8.70%
Question 10:  
When drafting the valuation section of an agreement, do you consult with valuation experts?
  • Occasionally:  79.17%
  • Never:  20.83%
Question 10A:  
If the purchase price includes a promissory note, what do you generally recommend for a repayment period?
  • 1-3 years:  65.22%
  • 4-7 years:  13.04%
  • 8-10 years:  4.35%
  • Other:  17.39%
Question 10B: 
If the purchase price includes a promissory note, is security provided?
  • Yes:  62.50%
  • No:  12.50%
  • Other:  25.0%