A buy-sell agreement (or "buy-sell" for short) is a formal legal
contract among a business's owners that sets terms for transferring ownership
interests. It gives owners, or the business itself, the right or responsibility
to buy an exiting owner's interest following a triggering event. Such events
may include an owner's death, divorce, disability, retirement, voluntary
departure for another reason, or loss of a required professional license or
certification.
Buy-sells are critical risk management tools for construction
businesses with multiple owners. And the agreement's valuation provision is
especially important because it sets the purchase price for a departing owner's
interest. If your business has a buy-sell, make sure you understand this
provision and review it regularly to ensure it still makes sense.
Negotiating a price
Valuation provisions can take various forms. For example, you
and your fellow owners may simply agree to negotiate a buyout price whenever
one of you leaves the business. This approach is cost-effective and lets you
consider recent events when determining a fair price for your business
interests.
The risk is that, when a triggering event occurs, you'll be
unable to reach a consensus or negotiate in good faith — and end up in court.
This is especially common if an owner dies and the deceased's family ends up
doing the negotiating.
One way to mitigate the risk is to set a negotiated price in the
buy-sell and bring in an independent valuation professional only if you no
longer agree on that price following a triggering event and can't negotiate
another one within a certain time frame. But that's the thing about negotiated
prices: They often become outdated over time and settling on another one can be
difficult.
Applying a formula
Some buy-sells state a valuation formula in the agreement's
language that's often tied to book value, earnings or other financial
benchmarks. This approach offers simplicity and predictability. However, it's
also quite risky.
Book value, for example, may provide a convenient starting point
for establishing value. But it often differs from fair market value and may
significantly undervalue established construction businesses with strong
earnings, customer relationships, backlogs or other intangible assets.
On a similar note, formulas based on earnings multiples may or
may not reliably indicate value, depending on your construction business's
circumstances at the time of valuation. One potential solution is to revisit
the formula annually and adjust it to produce a price the parties view as fair.
But this is easier said than done and can be easily overlooked when you're busy
bidding on and completing projects.
Engaging a valuation professional
Some buy-sells call for periodic valuations (for example, once
every year or two) and use the resulting price for any ownership interests
transferred between that valuation date and the next one. Other agreements
require the parties to engage a valuation analyst only when a triggering event
occurs.
Under either approach, engage a qualified valuation professional
to provide an objective estimate of your business's value. And be sure to
provide unambiguous guidelines for this individual. For instance, your buy-sell
should define the valuation date. Some agreements set the valuation date as the
triggering event. Others set it as the last day of an accounting period (say,
the end of the most recent fiscal year or quarter).
The valuation date you choose can significantly affect the
buyout price — particularly if the triggering event itself affects the
business's value. Using a period-end date may simplify the analysis by tying
the valuation to an established reporting date. However, it can also produce a
value that doesn't reflect significant developments between that date and the
triggering event. Your agreement should clearly establish which date applies
and how intervening events will be handled.
In addition, the valuation provision should spell out:
- The valuation standard (such as fair market value, fair
value or investment value),
- The premise of value (for example, going concern or
liquidation value), and
- Whether the interest being valued is controlling or
noncontrolling.
Because different valuation standards can yield different
results, the agreement should clearly identify which one applies. You might
want to address valuation discounts for lack of control or marketability, too.
When applicable, these discounts can become a significant and contentious
issue, so ironing out the details before a triggering event happens can help
streamline buyouts. The agreement should make clear whether and under what
circumstances such discounts apply.
Making the necessary adjustments
For construction businesses, factors such as backlog,
work-in-progress, equipment and bonding capacity can significantly influence
value, making a well-defined valuation provision especially important. Review
your buy-sell regularly — perhaps as part of an annual leadership meeting — and
adjust it as needed. We can help you gather all the relevant information and
ensure the agreement remains aligned with your business's current financial
performance and strategic goals.
