July 29, 2016
Why your Partnership needs a Buy/Sell Agreement
Partnership Buy/Sell Agreements, contrary to what their name suggests, are not concerned with the immediate purchase or sale of business entities. Rather, they are contracts between all interest-holders (owners) within a privately-held company that govern the future transfer of ownership for a business. In short, they dictate how the ownership interests of a partner are handled in the event of his or her departure, death, or divorce. As every company must, at some point or another, deal with changes within its organizational structure, Partnership Buy/Sell Agreements provide for an orderly procedure at these key times.
Why do I need a Buy/Sell Agreement?
While not expressly required by law or regulatory bodies, Buy/Sell Agreements should be a part of most privately-held businesses for several reasons. For example, in states where the departure of a partner can cause the dissolution of the business, these agreements protect the business as a going concern. Even in states where no such laws exist, a Buy/Sell Agreement prevents disputes among the remaining partners over the value and rights to the departing partner’s ownership interest. In addition, the death or divorce of a partner can lead to difficulty allocating the partner’s assets among his or her family members and other recipients. Without a Buy/Sell Agreement in place, partnerships are at risk of expensive legal battles and possibly unwelcome new partners.
How is a Buy/Sell Agreement Done?
While Buy/Sell Agreements may vary greatly in their terms, conditions, and structure, the foundation of any Buy/Sell agreement is laying the groundwork on “rules of the game” and establishing the value of the ownership interest in question. While approaches vary in establishing value, the two most common methodologies are Book Value and Fair Market Value.
Book Value – the more objective of the two, with the base value taken straight from the company’s financial statements. While simplistic on a high level, its nature as a product of accounting exposes it to various complexities, such as inventory recognition, accruals/deferrals, and zero or negative book values. The base value taken from the financials must almost always be adjusted to account for these and other complexities. However, Book Value is often not expected to directly relate to the underlying or actual economic value of an entity.
Fair Market Value – Fair Market Value reflects the price at which a buyer and seller would agree to exchange, absent any external pressures. The fair market value is typically observed to be higher than book value, and is found by most often either by applying valuation metrics observed among comparable companies or through the discounting of future expected cash flows back to their present value. This methodology comes with its own set of complexities, including uncertain assumptions and discount rates dependent on circumstances that are subject to change.
Should I do it myself or get an advisor?
The decision between forming a Buy/Sell Agreement internally or with help from a legal advisor and an independent appraiser is ultimately left to the owners of a business, with costs and benefits for each option. The primary (and possibly the only) advantage of internal formation is avoiding the expense of advisors. However, the advantages of legal counsel and an independent appraiser are many, and focus on qualitative and long-term benefits that an in-house valuation cannot provide. They include the following:
Experience having seen many similar situations and knowledge of how to avoid pitfalls (legal)
Relatively low cost from language largely already prepared (legal)
Advice for how and when to modify the agreement as situations evolve (legal)
Unbiased opinion on Fair Market Value (financial advisor)
Accounting Expertise in determining correct Book Value (financial advisor)
Stronger legal weight in court than internal opinion (legal and financial advisor)
Preferential treatment by the IRS in tax decisions (financial advisor)
Provides accepted basis for Merger or Acquisition analysis (financial advisor)