I’ve already covered why buy-sell agreements are important to small business owners, and the triggers that invoke that contract. In order to construct a valid buy-sell agreement, however, a proper valuation must be placed on the business.
There are three basic valuation methods used to determine the value of each partner’s share and the purchase price of their interest. These aren’t the only three methods, but they’re some of the most common methods that we’ve come across.
Using the agreed value method, the members or shareholders set a specific price per share or membership unit when they first enter into the buy-sell agreement. That value can be adjusted annually or every few years, and amend the original agreement by attaching a signed certificate of value to the buy-sell agreement.
Some companies use this method because they believe that the members or shareholders are in the best position to judge the company’s value. This method is also the most common when life insurance is used to fund the buy-sell agreement.
Appraisal is a valuation method determined by an independent certified public account. Most of the time, the buy-sell agreement has a specific clause that dictates that a particular accountant in private practice or the company’s corporate accountant conduct the appraisal.
Usually a buy-sell agreement will also lay out any particulars including the appraisal method, or any adjustments to the earnings or assets of the firm. The most complicated versions of this agreement also spell out contingencies in case either party objects to the valuation.
Other businesses use a formula to calculate the value. Though there are many different formulas used to determine valuation, the members or shareholders would agree on one and incorporate its use in the buy-sell agreement.
Some common formulas include book value and liquidation value. Book value is the net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities. Liquidation value is the total worth of a company’s physical assets when it goes out of business or if it were to go out of business. Liquidation value is determined by the tangible assets the company owns, while intangible assets are not included.