Jerry Seinfeld had a bit on how peoples’ perspectives on menu prices are very different before and after a meal. When it comes to the purchase and sale of business ownership interests, this fundamental feature of human psychology can be worked around. Mercovus has authored several valuations for this purpose, and, inevitably, the seller thinks the value is too low and the buyer thinks the value is too high. It is important for business owners to reach an agreement “before the meal” rather than to try to determine a fair price when interests are no longer aligned.
A buy-sell agreement is a contract between the shareholders (who are typically also employees) of a business with the goal of determining how an owner’s interest in the business is treated in the event of their departure. Typical events that trigger a buy-sell agreement include the owner’s termination, resignation, retirement, disability, divorce, bankruptcy, or death. Without a buy-sell in place, the departing member’s equity might pass to a relative who knows nothing about the business. The buy-sell can mandate that a deceased owner’s interest be sold to the other owners or to the company. This purchase must be funded, and, in the event of an owner's untimely death, the company/remaining owners may not have the necessary cash on hand. Enter: Life insurance.
A life insurance policy can be used to fund the purchase of the ownership interest, providing cash to the deceased’s beneficiaries without placing additional strain on the business and remaining owners. To ensure adequate insurance coverage, it is helpful to have an idea of what the interest might be worth. Enter: Valuation. The value of an interest upon death can be calculated using a predetermined formula, value, or method (for example, stipulating the hiring of an Accredited Senior Appraiser). Having a valuation upon entering the agreement can help the owners determine how much coverage they need.
For a digestible cartoon on buy-sell agreements, watch this video from Ohio National.