Preface: Buy-Sell agreements are vital to multiple owner businesses. This blog is a guideline to understanding pricing option methodologies for buy-sell agreements.
Pricing Options for Buy-Sell Agreements
Typically, there are three methodology options for purposes of pricing a business for a buy-sell agreement, i) fixed pricing, ii) formula pricing iii) valuation pricing. Often business owners underemphasize the importance of a buy-sell agreement when multiple owners are involved in a business. Buy-sell agreements are like fire coverage. You don’t want to spark them, but if they are required, you are thankful for the contributions towards an appropriate buy-sell agreement plan. The problem often is that many business owners lack the awareness of the importance of a well-developed buy-sell agreement until after it’s required. If you’re reading this, you are now foreadvised.
Beyond overemphasizing why you need an effective buy-sell agreement, e.g. a sale of ownership for reasons sometimes unanticipated or unplanned, to prepare or update your buy-sell agreement you need understand buy-sell agreement characteristics, e.g. the pricing methodology options.
Fixed Pricing: A fixed pricing agreement for a buy-sell agreement, sets a specific value to your business, e.g. $2,000,000 or say maybe $9,000,000. If you own 20%, your value is 20% of that fixed price. Simply easy. Here is the problem with a fixed price agreement. If your business is growing at 10% or say 20% on a compounded rate, the value of the business asset should be appreciating too. After only say two years of development, your fixed price would be below fair market value, out of date, and someone would lose value if a sale transpired. Be fair to others, and be fair to yourself. You don’t know who will need the buy-sell agreement first; but every successful business will either later or sooner, need a buy-sell agreement. Fixed pricing options are often not the most advisable, unless the fixed price is updated each year. The fixed price should be set with a realistic methodology.
Formula Pricing: Formula pricing is a methodology that applies a specifically defined valuation metric to the businesses value. The formula can be a multiple of net income averages, pre-tax income averages, EBITDA multiples. Often formulas are a capitalization of a defined earnings approach, or maybe a formula of book value. Formula pricing is easy to negotiate when the buy-sell agreement is sparked, and a business value required. Disadvantages of the formula methodology are that sometimes the formula doesn’t result in a realistic valuation, e.g. asset intensive businesses. Often for a formula pricing option to work, the formula must be a weighted combination. This is an approach of attempting a business valuation, often without qualified oversight. If your business asset is material to your net worth, let’s talk about valuation pricing.
Valuation pricing. Worth the valuation pricing option, you define the buy-sell agreement value to be based upon the valuation guided appraisal from a single appraiser, or advised multiple appraiser averages. The disadvantage of the valuation pricing, is that the methodology used, often similar to the formula pricing, typically depends on the side the appraiser is working. If you don’t tell the appraiser what formula to use, they will decide for you. And, the appraiser can often adjust value variable significantly based upon the interest or party they represent. This is why multiple appraiser values are often advised for material asset businesses, i.e. one appraiser for the seller, one appraiser for the purchaser, and average the two valuations. Valuators can apply minority discounts, or marketability discounts so you will get a realistic value, but that may differ from what one party considers fair market value. The “as” date will often be a significant variable in value setting, e.g. December 31st, or say June 30th.
Summary: Typically, there are three methodology options for purposes of pricing a business for a buy-sell agreement, i) fixed pricing, ii) formula pricing iii) valuation pricing. The pricing methodology is only one of multiple features in a buy-sell agreement. Maybe you can determine and agree on fair market value with one of the three pricing methodologies, but how is that value funded? We will discuss funding buy-sell agreements in a following blog.