If, emulating Jack Nicholson and Morgan Freeman, you hope to climb the Pyramids and hit the tables in Monte Carlo when you retire from the business you’ve spent years building, read on. A properly drafted buy-sell agreement can give you the comfort that you can sell your interest in your company to you partners for a fair price.
Some buy-sell agreements include a formula to calculate the buy-out figure. For example: “Three times the company’s average net income over the prior three years”.
This approach is cheap to implement, seemingly easy to calculate, and will lead to consistent results if the company has a history of the same levels of performance year after year. But when the calculation is triggered, who knows whether the company will be looking at significant growth or is about to tank? In these cases, the only thing you know for certain about the formula is that it’s going to give someone a windfall - and that someone may not be you!
You should also bear in mind that measures such as net income can be managed to produce either a high or low value, depending on the personal interests of whoever is doing the managing.
An alternative approach is for the buysell agreement to include provisions for a full valuation of the business upon the triggering event. While this may be more expensive and involves some discussion about selecting a qualified valuator acceptable to all parties, it does allow the financial condition of the company at the triggering event to be taken fully into account.
However, valuators need some guidance in determining the value. First, tell us what “standard of value” to use. Normally “fair market value” is the appropriate formulation. This has a fairly precise meaning to a valuator, being the price at which the shares being valued would change hands between a willing buyer and willing seller, neither or which is under any compulsion to buy or sell and both of which possess knowledge of all relevant facts. Other terms such as “net book value” or “adjusted net asset value” may not give a valuator enough guidance and will inevitably give rise to disputes.
Beware: the fair market value standard implies that a valuator should take into account a discount from the company’s value for lack of marketability and lack of control - in the care of a minority interest, for example. If you don’t intend these factors to be taken into account, spell it out in the agreement.
We also need to know a specific valuation date. Only facts “known or knowable” as of that date can be taken into account in the valuation. If the agreement states that the valuation shall be as of the date of retirement or death, then any unforeseeable events that affect the company after that date are generally irrelevant. However, things that are foreseeable do affect value. So, if a major rainmaker for the firm dies or retires, the future cash flows of the company are likely to be affected and this will, in turn, affect the value of the company on a fair market value basis.
If you don’t have a buy-sell agreement, then get one. If you already have one, now is the time to review it and figure out what the financial consequences would be if the agreement was triggered tomorrow.
And if, having retired and now spending some of your buy-sell proceeds you meet Jack halfway up a Pyramid, say “Hi” from me.