Negotiating a buy-sell arrangement is complicated. As my wife, Kristine, pointed out to me yesterday, most people see how complicated it is and just chose not to do it. After all, it is the heady, early days of the partnership, so who wants to talk about a break up?
A great deal of the stress, I think, comes from the unknown. What are the options? Which options should be chosen? It is difficult for business partners to choose a buy-sell method when they don’t even know what their choices are.
Here, then, are a few of the most popular choices, demystified a little (I hope):
The Appraisal: A favorite of big firm lawyers, they use the appraisal for almost any buy-sell situation. Events that trigger a buyout are defined. They usually include death or disability of a partner, and may also include mechanisms for voting a partner out, retiring, and other events like the ones listed here. When a triggering event happens, the company hires a business appraiser. Often these are CPA’s that specialize in business valuation, but they might be some other form of financial analyst, business lawyer, economist, etc. The appraiser will get the financial documents needed to value the business, and will usually interview the partners to find out if there are any known events on the horizon. The appraiser then generates a fair market value (or a fair value) for the shares being sold.
The good thing about this kind of buy-sell arrangement is that it works no matter how many partners or what their shareholdings are. It is important to give the appraiser some guidance about the terms of purchase, and perhaps to specify mandatory discounts when the reason for the buyout is a “bad reason” (like a partner just quits, when the business agreement did not allow quitting or punishes quitting with a discount).
Cost is the biggest problem with this approach. These types of business valuations are expensive. A thorough one can cost $10,000 or more. If you use the three-appraiser variation (where the buyer chooses an appraiser, the seller chooses an appraiser, and the two appraisers choose a third appraiser) you can be in for some serious expense. Because of the cost, this option is really not appropriate for smaller businesses.
The Standoff: This is a favorite of my friend Robert Demes. In this type of buy-sell agreement, the partner who wants the separation, for whatever reason, names the terms of the deal: price, cash down, payments over time (term, interest rate and collateral) and any other deal points. The other partner then chooses to buy or sell at that price and under those terms.
This is a great way to get to a fair price without a lot of cost. It is useful only in limited situations, however.
It is difficult to use this process if there are more than 2 partners, or if the partners do not have an equal number of shares. It is difficult to use this process if the partners have significantly different wealth: the wealthier partner can simply choose terms the poorer partner cannot meet.
It is also useful only for events where both partners may want to or are able to continue the business. It doesn’t make a lot of sense when one partner has left the business due to death, disability, retirement, quit, etc.
The Escalating Bid: This is similar to the standoff, except that the partner who wants to buy the other one out proposes a price, and then the partner receiving the offer must either accept the price or counteroffer to buy the first partner out at a higher price. The rounds of raised offers go on until someone agrees to sell.
To make this buy-sell agreement work, the terms are usually set, as far as percentage down, interest rate, number of years to pay, and security. The only variable you are negotiating is the price.
This buy-sell agreement is essentially a variant of the standoff, and works well and doesn’t work well in the same situations and for the same reasons. The escalating bid is less of an all-or-nothing and more of a structured negotiation.
The Set Price: The set price is meant to be a fair and inexpensive way to have a very flexible buy-sell agreement that can work in all situations and no matter how many partners there are or what the percentage ownership is. With the set price, the partners set the price of each share of stock (or membership interest or partnership share) each year, usually at the company annual meeting. The share price prevails for the next year: if any event occurs that triggers a buy-out during the year, the company buys the shares at the set price. Like the escalating bid, the terms are also usually spelled out, and can include set discounts for minority shares or for certain triggering events (you might get the full price for disability, but not for quitting).
When this works, it can work well. The set price works best when the partners take advice from their accountant and attorney at the annual meeting and really take care to set a fair price.
This method has a lot of potential pitfalls, though. First, most partners eventually just forget to keep setting the price every year. This makes the buyout useless. Attorneys sometimes try to paper over this by making the last set price good until a new one is set, but that can be a disaster when it has been years and the last set price is grossly out of date. Second, this method often has partners setting a price when the sale event is on the horizon. Partners may have a good idea who will be the buyer and who will be the seller, and it may become difficult or impossible to set a fair price. Worse yet, one set of partners may be tempted to withhold critical information from the partner they think they will be buying out, in order to get agreement to an inadequate price. If discovered, this can lead to some nasty litigation.
The set price is a nice buy-sell method, buy I recommend you specify a back-up to resolve problems or take over if the price cannot be agreed on or you forget.
The Formula: This is a cross between the set price and the appraisal, and can work well. With the formula, the partners, hopefully with the help of an accountant or a business valuation professional, agree up front on the formula that will be used to calculate share value when a triggering event occurs. The formula can be complex or simple, and can change over time as the company matures. The formula can include all manner of situational discounts and other bells and whistles. When a triggering event occurs, the partners plug the company’s data into the formula and determine a share price. The company then buys the shares.
This works well if you have a good formula, so it is one of the more expensive up-front options because you pay to have the formula crafted on the front end, and get a relatively inexpensive buyout on the back end. The method only works as well as the formula, though, and as your company changes over the years, the formula may become dated and inaccurate – you are well served to have the creator revisit the formula from time to time.
These are a few of the most popular buy-sell options. There are many others, and unending variations on these. I may describe some others in a future post. In any case, getting this done before you have a buy-out event will save you a lot of time, money, heartache, and legal fees. The method you choose is only as good as the document it is described in, so pay the money to hire a competent business lawyer and get it drafted up properly.