Buy Sell Agreements Example Slides


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Buy Sell Agreements Example Slides

  1. 1. You’ll Never Think About Buy-Sell Agreements the Same Way Again Z. Christopher Mercer, ASA, CFA Mercer Capital
  2. 2. Three Questions to Ask Your Clients <ul><li>Do you have a buy-sell agreement? </li></ul><ul><ul><li>If so, what type of agreement is it? </li></ul></ul><ul><li>Do you know what your buy-sell agreement says? </li></ul><ul><ul><li>There are six defining elements that must be in every process agreement if you want the valuation process and, therefore, the agreement, to work </li></ul></ul><ul><li>How is your buy-sell agreement funded? </li></ul><ul><ul><li>How life insurance proceeds are treated can make a big difference in the valuation of the company </li></ul></ul>1 2 3
  3. 3. 1 Do You Have a Buy-Sell Agreement?
  4. 4. The “Wayne” Story <ul><li>Company successful over next decade, Value grows to $5.0 million </li></ul>1964 1974 <ul><li>Wayne’s Dad makes investment in start-up in 1964 </li></ul><ul><ul><li>$250,000 for 25% </li></ul></ul><ul><ul><li>Buy-sell agreement fixes price at $1.0 million ($250,000 for 25%) </li></ul></ul><ul><li>Wayne’s Dad dies in 1974 </li></ul><ul><ul><li>Buy-sell agreement was never updated </li></ul></ul><ul><ul><li>Company paid $250 thousand for the 25% interest </li></ul></ul>Human Fallout
  5. 5. What Is a Buy-Sell Agreement? Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself They establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner
  6. 6. Buy-Sell Agreements Require agreement at a point in time Relate to transactions that will or may occur at future points in time Define the conditions that “trigger” the buy-sell provisions Determine the price(s) at which the specified future transactions will occur
  7. 7. How Do Buy-Sell Agreements Get Created? <ul><li>Something happens </li></ul><ul><ul><li>Have a company </li></ul></ul><ul><ul><li>Do a deal </li></ul></ul><ul><ul><li>Invest in a company </li></ul></ul>Attorney says “You have to have a buy-sell agreement!”
  8. 8. How Do Buy-Sell Agreements Get Created? <ul><li>Owners, shareholders, and investors often resist </li></ul>Exercise in future thinking Focused on adverse possible future events No one wants to think about dying Procrastination is the name of the game (or avoidance!) Brings up uncomfortable differences Age Capital Participation Insurability
  9. 9. How Do Buy-Sell Agreements Get Created? <ul><li>Attorney finally drafts something </li></ul><ul><ul><li>Little or no review by shareholders </li></ul></ul><ul><ul><li>Maybe it gets signed </li></ul></ul><ul><ul><li>Into the drawer (or lockbox or file), until… </li></ul></ul>
  10. 10. Potential “Trigger Events” <ul><li>Q Quits </li></ul><ul><li>F is Fired </li></ul><ul><li>R Retires </li></ul><ul><li>D Disabled </li></ul><ul><li>D Death </li></ul><ul><li>D Divorce </li></ul><ul><li>B Bankruptcy </li></ul><ul><li>Others? </li></ul>
  11. 11. Get Agreement. Now.
  12. 12. <ul><li>Based on how price is determined </li></ul><ul><ul><li>Fixed price agreements </li></ul></ul><ul><ul><li>Formula agreements </li></ul></ul><ul><ul><li>Shotgun agreements </li></ul></ul><ul><ul><li>Process agreements </li></ul></ul>Types of Buy-Sell Agreements Valuation Processes
  13. 13. 1. Fixed Price Agreements <ul><li>Advantages </li></ul><ul><ul><li>Easy to understand, easy to negotiate – the first time only! </li></ul></ul><ul><ul><li>Inexpensive </li></ul></ul><ul><ul><ul><li>Easy for attorneys to draft </li></ul></ul></ul><ul><ul><ul><li>No appraisers required </li></ul></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Fixed prices are seldom updated, even over periods of many years. Inequities are almost certainly a result of out-of-date fixed price agreements </li></ul></ul><ul><ul><li>Easy to set an initial price, but may be difficult to reset as time passes and interests diverge </li></ul></ul><ul><ul><li>The longer period of time between updates to fixed price agreements, the greater the potential for a divergence of the interests of the various parties </li></ul></ul><ul><ul><li>Betting that the other guy(s) will die first! </li></ul></ul>
  14. 14. Fixed Price Agreements are often out of date when inked! If your client has one, update it now!
  15. 15. 2. Formula Agreements <ul><li>Examples </li></ul><ul><ul><li>Multiple of EBITDA – (5 x EBITDA) </li></ul></ul><ul><ul><ul><li>Less debt? </li></ul></ul></ul><ul><ul><li>Book Value </li></ul></ul><ul><ul><ul><li>“ Shareholders’ equity per the audited financial statements at the end of the fiscal year immediately preceding the valuation date.” </li></ul></ul></ul>State a single formula to be applied to balance sheet and/or income statement metrics
  16. 16. 2. Formula Agreements <ul><li>Advantages </li></ul><ul><ul><li>Easy to understand, easy to negotiate – the first time only! </li></ul></ul><ul><ul><li>Inexpensive </li></ul></ul><ul><ul><ul><li>Easy for attorneys to draft </li></ul></ul></ul><ul><ul><ul><li>No appraisers required </li></ul></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>No formula selected at a point in time provides reasonable and realistic valuations over time </li></ul></ul><ul><ul><li>Changes occur in companies, industries, local, regional, national and world economies, some or all of which can impact the “true value” of an enterprise relative to any set formula </li></ul></ul><ul><ul><li>Formulas, if not specified carefully, can be misinterpreted – or are subject to multiple interpretations </li></ul></ul>
  17. 17. <ul><li>If your client has a formula agreement, have someone calculate the formula result as if there were a trigger event now, and then deal with any issues that arise </li></ul>
  18. 18. 3. Shotgun Agreements <ul><li>Concept is that the initial offering side (which will that be?) virtually has to name a “reasonable” price, i.e., one at which he would be willing to buy or sell </li></ul><ul><li>Assumes both parties have equal financial capacities and knowledge about the business and its prospects to engage in either a buy or a sell transaction </li></ul>One side makes an offer Other side has a choice to sell at that price <ul><ul><li>In the alternative, if other side decides not to sell, may have the right to buy (no obligation) </li></ul></ul>
  19. 19. 3. Shotgun Agreements <ul><li>Advantages </li></ul><ul><ul><li>Pressure on offering party to establish a “fair” price </li></ul></ul><ul><li>Disadvantages </li></ul><ul><ul><li>Parties seldom have equal financial capacities and may have different knowledge about the business </li></ul></ul><ul><ul><li>Minority shareholders may be at a disadvantage </li></ul></ul><ul><ul><ul><li>Easier for a 90% shareholder to acquire 10% than vice-versa </li></ul></ul></ul><ul><ul><ul><li>Smaller shareholder, unable to swing the big deal, may have to offer lower price than “fair” in order to insure capability to either buy or sell, and therefore, receive a lower price on sale </li></ul></ul></ul>
  20. 20. 4. Process Buy-Sell Agreements <ul><li>A buy-sell agreement provides a valuation process employing one or more appraisers </li></ul><ul><li>Value is determined by the appraisers in a manner defined in the buy-sell agreement </li></ul><ul><li>Two types of process buy-sell agreements: </li></ul>Multiple Appraiser Single Appraiser
  21. 21. 4. Process Buy-Sell Agreements <ul><li>Your client’s buy-sell agreement should be </li></ul>Predictable Understandable <ul><ul><li>Likely to achieve reasonable resolutions </li></ul></ul><ul><ul><li>Helpful in the wealth management process </li></ul></ul>
  22. 22. 4. Process Buy-Sell Agreements <ul><li>Recommendation </li></ul><ul><li>Good for clients’ businesses </li></ul><ul><li>Excuses, excuses, excuses…No excuses, really </li></ul>Single Appraiser Select Now, Value Now Value Regularly
  23. 23. Recommendation Single Appraiser Agreement Select Now, Value Now
  24. 24. Single Appraiser Agreement Select Now & Value Now <ul><li>Advantages </li></ul><ul><li>Selected appraiser viewed as independent </li></ul><ul><li>Appraiser’s valuation process is seen by all parties at the outset </li></ul><ul><li>Appraiser’s conclusion is known at outset and has established a baseline price for the agreement </li></ul><ul><li>Because process is observed at the outset, all parties know what will happen when trigger event occurs </li></ul><ul><li>Because the appraiser must interpret the “words on the pages” in conducting the initial appraisal, any issues regarding lack of clarity of valuation-defining terms will be resolved </li></ul><ul><li>Selected appraiser must maintain independence with respect to process and render future valuations consistent with terms of agreement and with prior reports </li></ul>
  25. 25. Single Appraiser Agreement Select Now & Value Now <ul><li>Advantages (Continued) </li></ul><ul><li>Subsequent appraisals, either annually or at trigger events, should be less time-consuming and expensive than other alternatives </li></ul><ul><li>Parties should gain confidence in the process </li></ul><ul><li>Parties will always know the current value for the buy-sell agreement (helpful for planning all-around) </li></ul><ul><li>Appraisers’ knowledge of the company and its industry will grow over time, enhancing confidence for all parties with the process </li></ul><ul><li>Creates a means of maintaining pricing for other transactions, thereby enhancing “the market” for a company’s shares </li></ul>
  26. 26. 2 Do You Know What Your Buy-Sell Agreement Says?
  27. 27. The Six Defining Elements of Process Buy-Sell Agreements Standard of Value Qualifications of Appraisers Level of Value Appraisal Standards The “as of” date Funding Mechanism
  28. 28. <ul><li>Normally fair market value </li></ul><ul><ul><li>Willing buyer, willing seller….but buyers of what? </li></ul></ul><ul><li>Fair value </li></ul><ul><ul><li>Defined under state law </li></ul></ul><ul><ul><li>A defined term, of sorts, under accounting rules </li></ul></ul><ul><li>Investment value </li></ul><ul><ul><li>From the perspective of whom? </li></ul></ul><ul><li>“ The Value,” “Going Concern Value,” and on and on and on… </li></ul>Defining Element #1 –Standard of Value
  29. 29. Defining Element #2 – Level of Value <ul><li>Which level? </li></ul><ul><ul><li>In other words, the value of what? </li></ul></ul><ul><li>Should be specific </li></ul><ul><ul><li>Refer to specific language and specific page in book (preferably mine!) </li></ul></ul>
  30. 30. Defining Element #2 – Level of Value
  31. 31. Defining Element #2 – Level of Value Price we hope to get if we sell the company together Price the rest of us can reasonably pay if we have to buy out someone else “ Fair market value of the (minority) interest”
  32. 32. Defining Element #2 – Level of Value $100 Per Share $60 Per Share $140 Per Share
  33. 33. Defining Element #3 – The “As Of” Date <ul><li>Defines the situation at the Company, </li></ul>Within the Industry National Economy Pricing from Guideline Cos. Comparable Transactions
  34. 34. Defining Element #4 – Qualifications <ul><li>Qualifications of appraisers </li></ul>Education Credentials Experience in appraisal Size of the firm Continuing education Valuation Training Nature of firm’s business Industry experience Reputation Compliance w/Prof. Standards
  35. 35. Defining Element #5 – Appraisal Standards to be Followed The Institute of Business Appraisers Business Valuation Standards and Rules of Professional Conduct ASA Business Valuation Standards Principals of Appraisal Practice and Code of Ethics of the ASA Uniform Standards of Professional Appraisal Practice Professional Standards of NACVA Other professional standards? Specify
  36. 36. Defining Element #6 – Funding Mechanism <ul><li>Who buys? </li></ul><ul><ul><li>Other shareholders </li></ul></ul><ul><ul><li>Company </li></ul></ul><ul><ul><li>Other shareholders and/or company </li></ul></ul><ul><li>Life insurance </li></ul><ul><li>Adequacy of funding </li></ul><ul><li>Nature of mechanism </li></ul><ul><ul><li>Cash (is there a sinking fund?) </li></ul></ul><ul><ul><li>Notes </li></ul></ul><ul><ul><ul><li>Down payment </li></ul></ul></ul><ul><ul><ul><li>Terms </li></ul></ul></ul><ul><ul><ul><li>Interest rate </li></ul></ul></ul><ul><ul><ul><li>Security </li></ul></ul></ul>What does your buy-sell agreement say about the treatment of life insurance proceeds in the event of the death of a shareholder subject to it?
  37. 37. 30 Questions Handout
  38. 38. Questions to Consider <ul><li>Is there a reasonable probability that the agreement will operate to effectuate a reasonable transaction when trigger events occur? </li></ul><ul><li>Are all shareholders who should be subject to the agreement parties to it? </li></ul><ul><li>Do the shareholders who are parties to the agreement understand how the agreement will operate to determine prices and terms for future transactions? </li></ul><ul><li>Has the agreement been reviewed by legal counsel to ensure compliance with applicable laws and statutes? </li></ul>
  39. 39. Questions to Consider <ul><li>Are the six defining elements of value as outlined in this presentation clearly specified? </li></ul><ul><li>Will the pricing mechanism provide a reasonable value if and when trigger events occur in the future? </li></ul><ul><li>Is the funding mechanism in place and workable? </li></ul><ul><li>How do you resolve differences? </li></ul>
  40. 40. Questions to Consider Nature, Size & Ownership of Equity Parties to consider in discussions about the buy-sell agreement? Groups of shareholders and relative ownership maintenance? Active vs. passive shareholders? Restrictions under loan agreement? Multiple classes of ownership? Age of shareholders? State law considerations? ROFRs?
  41. 41. Potential “Trigger Events” <ul><li>Q Quits </li></ul><ul><li>F is Fired </li></ul><ul><li>R Retires </li></ul><ul><li>D Disabled </li></ul><ul><li>D Death </li></ul><ul><li>D Divorce </li></ul><ul><li>B Bankruptcy </li></ul><ul><li>Others? </li></ul>
  42. 42. Questions to Consider Financial Statements / Corporate Information <ul><li>Financial statements to be used </li></ul><ul><li>Information “known” or “reasonably knowable” as of the valuation date </li></ul>Most recent fiscal year Trailing 12 months at most recent quarter-end OR
  43. 43. Questions to Consider Process Timetables <ul><li>When is appraisal due from appraiser? </li></ul><ul><li>Access of parties to talk to appraiser </li></ul><ul><li>What happens to valuation date in the event of avoidable or unavoidable delays? </li></ul><ul><li>Is owner of interest still a shareholder? </li></ul><ul><li>Is appraisal conclusion binding? </li></ul>No change Interest beyond _ days Reset the date Vote? Distributions? Dispute resolution process Will a draft be supplied to all interested parties?
  44. 44. Questions to Consider Who Bears the Cost of the Appraisal(s)? <ul><li>Cost of appraisal process </li></ul>Both sides bear own expenses? Company pays for process? Fairness to minority shareholders?
  45. 45. 3 How is your Buy-Sell Agreement Funded?
  46. 46. Funding the Buy-Sell Agreement <ul><li>Most buy-sell agreements with companies of significant size and ownership greater than 2-3 are corporate purchase agreements </li></ul><ul><li>Life insurance typically purchased by company </li></ul><ul><li>Key question: Is life insurance intended – </li></ul><ul><li>It makes a big difference! </li></ul><ul><ul><li>As a funding vehicle (to be used to acquire stock of deceased shareholder)? </li></ul></ul>As a corporate asset (to be included in value before determining price to be paid to deceased shareholder)? OR
  47. 47. True Story: Life Insurance What happens now? Dead
  48. 48. Funding Mechanism What about Life Insurance Treatment for Valuation Purposes?
  49. 49. Funding Mechanism What about Life Insurance Treatment for Valuation Purposes?
  50. 50. The “Catfish” Story 1978 1987 <ul><li>1978 </li></ul><ul><li>5 guys purchased catfish processing company </li></ul><ul><ul><li>Paid $2.0 million, with $500 of equity (pro rata, 20% each) </li></ul></ul><ul><ul><li>Buy-sell agreement entered into </li></ul></ul><ul><ul><li>4 of 5 worked in company </li></ul></ul><ul><li>1987 </li></ul><ul><li>One of partner/shareholders dies </li></ul><ul><ul><li>Company is debt-free and is worth $5.0 million </li></ul></ul><ul><ul><li>Buy-sell agreement says appraiser will determine “the fair market value of the interest” owned by the deceased (i.e., a 20% minority interest) </li></ul></ul><ul><ul><li>Acquisition period documents were clear that intentions of parties were that value be determined as pro rata value of company </li></ul></ul>Appraiser made all parties aware of conflict between documents. Valued on enterprise and minority interest basis. Parties ultimately agreed on price very close to enterprise value
  51. 51. Defining Elements per BSA Fair market value “ the value of the interest” Specified Mercer Capital named ASA/USPAP through credentials of appraisers Agreement silent – no life insurance <ul><li>Standard of Value </li></ul><ul><li>Level of Value </li></ul><ul><li>The “as of” date </li></ul><ul><li>Appraiser Qualifications </li></ul><ul><li>Appraiser Standards </li></ul><ul><li>Funding </li></ul>Section 12.4 Defining Elements
  52. 52. <ul><li>Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? </li></ul>The Buy-Sell Audit Checklist
  53. 53. Questions? <ul><li>Z. Christopher Mercer, ASA, CFA </li></ul><ul><ul><li>901.685.2120 </li></ul></ul><ul><ul><li>[email_address] </li></ul></ul><ul><ul><li> </li></ul></ul><ul><li>Mercer Capital </li></ul><ul><ul><li>5860 Ridgeway Center Parkway, Suite 400 Memphis, Tennessee 38120 </li></ul></ul>