Many buy-sell agreements incorporate valuation formulas to establish the purchase price because they're relatively simple and they enable the parties to determine the buyout value of their shares at any time.
Common formulas are based on multiples of earnings (e.g., pre-tax, post-tax, operating income), book value (total assets less total liabilities), adjusted book value (fair market value of assets less fair market value of liabilities), or some combination of earnings and book value.
Unfortunately, valuation formulas rarely result in a true fair market value at the time of a triggering event under the buy-sell agreement. The value of a business depends on a number of factors not readily reflected in a formula, such as growth, state of the economy, or competition in the industry. To avoid potential unfairness to the buyer or the seller, consider a provision requiring that fair market value as of the time of the triggering event be determined by a qualified business valuation specialist.
If a valuation formula must be used, be sure to spell out the parties' intentions carefully. Pay particular attention to the definition of key terms, such as fair market value, which may have different meanings to financial professionals than to nonprofessionals. And be sure that the methods of calculating earnings, book value, and other factors are clearly defined. To the extent possible, design the formula to remain fair as the business changes over time and provide examples that value the company as of the agreement date.
Should Value Depend on the Nature of a Triggering Event?
A price based on a pro-rata share of the value of the enterprise as a whole may be fair in the event of a shareholder's death or disability. But when an owner leaves voluntarily, perhaps to compete with the company, a different valuation approach may be appropriate. For example, the price might reflect a "penalty," such as extended payment terms, a reduced down payment, or a minority interest discount.
