To ensure a smooth ownership and management transition from one generation to the next, all closely held construction companies should have a succession plan. And a key component of that plan needs to be a buy-sell agreement.
A buy-sell agreement provides for the orderly transfer of ownership and control when an owner dies, becomes disabled or leaves the business. It also creates a market for otherwise unmarketable ownership interests, providing a departing owner’s family with a fair price and the liquidity needed to pay estate taxes and other expenses.
To work effectively, a buy-sell agreement must have a carefully designed valuation provision, which sets the purchase price for a departing owner’s shares. If the agreement undervalues or overvalues the company’s shares, it can result in unpleasant surprises, disputes or even litigation.
Consider your options
Most buy-sell agreements use one (or a combination) of the following approaches to set the price:
- Negotiation between the parties,
- Valuation by one or more independent professional appraisers (either at regular intervals or after a “triggering event,” such as the death, disability or departure of an owner), or
- A valuation formula tied to book value, earnings or other factors.
To avoid ambiguity, the agreement should spell out the agreed-upon valuation criteria. Is the price based on fair market value, fair value, investment value or some other standard? Is it based on the value of a controlling interest or a minority interest? What valuation date should be used?
Engage an appraiser
Negotiation can be a cost-effective way to arrive at a price that’s fair to all concerned — so long as the parties can reach an agreement. If they can’t, litigation may be inevitable. One potential solution is to provide for a negotiated price but, if the parties are unable to agree within a certain amount of time, then bring in an independent appraiser.
Independent appraisals near the date of a triggering event generally produce the most accurate results. A professional appraiser will scrutinize your company, taking into account the special characteristics that distinguish it from other businesses in the industry and drive its value. The disadvantage of this approach, however, is that it can be costly.
To avoid this expense, many companies develop valuation formulas and incorporate them into their buy-sell agreements. Formulas are inexpensive and easy to use, but they’re also risky. Why? Because they become obsolete soon after the buy-sell agreement is signed. Book value, for example, may approximate fair market value at the time a company is established, but it quickly becomes out of date as the company generates earnings and builds goodwill.
Case in point: Two business partners had a buy-sell agreement that set the price at net book value plus $50,000. When one partner died, the surviving partner was able to acquire the deceased partner’s interest from his estate for just under $200,000 — even though its fair market value had grown to more than $11 million.
Some companies use formulas based on earnings multiples, but they also can be unreliable. A multiple of earnings may approximate a company’s value at the time an agreement is signed, but it won’t necessarily reflect the company’s value over time.
Review your agreement
It’s a good idea to review your buy-sell agreement periodically to ensure its valuation provisions reflect your construction company’s current circumstances. This is particularly important if your agreement uses a valuation formula that’s more than a year or two old.