Can You Predict The Future?
Why a buy-sell agreement or partnership agreement is important to your business.
At the inception of a business, there is a sense of enthusiasm and optimism about the potential of the company. The partners’ aspirations for the newly created company are closely aligned as they embark on their journey together. Accordingly, because the partners are getting along so well when the company is newly established, it is important to prepare a partnership agreement or buy sell agreement during the honeymoon phase of the business.
Over the years, as the business changes, disputes inevitably occur between partners over things like: the compensation of the partners, the direction of the company, continuing the business or the value of the company. Things such as divorce or death of a partner can cause major disruptions to a business as well. To avoid disruptions to the business and to avert substantial costs that are associated with such disruptions, it is important to have in place a buy-sell agreement between the partners and shareholders of the company.
Partner or Shareholder Buyout
A well written buy-sell agreement will cover situations such as the death or divorce of a partner as well as a circumstance when a partner or shareholder leaves the business. A properly prepared buy sell agreement will describe the obligations of both the departing shareholders and the remaining shareholders. The buy-sell agreement will specify the terms of the buyout as well as how the buyout price is calculated and the buyout process. The terms of the buy-sell agreement must be structured in a cost-effective manner to allow the business to continue and to allow the leaving shareholders to be paid their agreed buyout amount, keeping in mind that the business must continue to grow.
In almost all instances, setting a specific buyout price three, five or ten years in the future is impossible. A business is unable to accurately predict its future value. In addition, getting leaving shareholders and partners to agree on a price with those shareholders and partners remaining in the business is impractical. Accordingly, it is essential to create a formula or process for which a valuation of the business is to be determined. Although there are many ways to create this formula or process to determine the value of a business, the following are a few common methods:
Annual Fixed Price. The shareholders or partners of a business annually determine the price per share of the business.
Book Value. The business partners set a price based on the net value of the business’s assets minus its liabilities as shown on its balance sheet.
Capitalization of earnings. This valuation method measures a company’s value based on its past profits.
Appraisal. Although a business appraisal may provide the most accurate valuation of the company, business appraisals are costly and the evaluation may be dependent on the appraiser. Appraiser will establish the company's value.