Now’s the time to revisit your buy-sell agreement

If you own an interest in a closely held business, it’s a good idea to review your buy-sell agreement, particularly its valuation provisions. The economic crisis has been tough on everyone, and many business owners have seen the value of their shares decline. If a buy-sell agreement’s terms don’t reflect current conditions, your interest may be priced too high.

A buy-sell agreement that overvalues your interest can result in higher estate taxes and hurt the business or its surviving owners.

Buy-sell benefits

Buy-sell agreements permit or require the company or the surviving owners to buy back the interest of an owner who dies, becomes disabled or otherwise leaves the business. Their benefits include:

• Restricting ownership to family members, management or some other select group,
  
  
• Creating a market for otherwise unmarketable shares,
  
  
• Providing an owner’s family with cash to pay estate taxes and other expenses, and
  
  
• Establishing the value of the interest for gift and estate tax purposes (if certain requirements are met).

A buy-sell agreement’s valuation provision specifies the price — or, more likely, the method for determining the price — that will be paid for a departing owner’s interest. The most effective valuation method is to conduct regular, independent appraisals of the business interests. This helps ensure that the price is fair and that it accurately reflects the value of the business at the time the interest is transferred.

Valuation formulas: Handle with care

Some companies set the buy-sell price using a formula — such as book value or a multiple of earnings or cash flow. Well-designed formulas can provide an effective low-cost alternative to periodic appraisals, but they also present some risks.

For a family business, for example, to use a formula to establish an interest’s value for gift and estate tax purposes, you must prove that the buy-sell agreement is a bona fide business arrangement and that its terms are comparable to similar arrangements entered into by unrelated parties. Failure to meet IRS requirements can lead to a determination that the interest was undervalued, resulting in additional taxes, interest and penalties.

During good economic times, formulas based on book value often underestimate business value because they don’t reflect current fair market value, and they fail to consider earnings or goodwill. But even formulas based on earnings or cash-flow multiples are risky. Why? Because multiples are derived from industry averages that may not fully reflect the characteristics of the business being valued.

In today’s volatile economic times, valuation formulas may be even more dangerous. The values of some businesses have dropped below their book values. And earnings or cash flow may no longer be reliable indicators of fair market value. What may have in the past been an appropriate formula may no longer be relevant. For instance, perhaps 10 years ago six times earnings before interest and taxes (EBIT) was a good indicator of value for companies in a particular industry. But if four or five times EBIT is more accurate today, the formula should be adjusted.

Evaluate your agreement

To determine whether your buy-sell agreement is still doing its job, evaluate its valuation provision to ensure that it yields a fair price. If your agreement uses a formula, consider switching to periodic appraisals. But if you continue to use a formula, review it to be sure it reflects current conditions in your industry and in the economy as a whole. •