Why Do You Need A Buy/Sell Agreement?
Most business partnerships start with the best intentions, but not every partnership ends that way. That’s why buy-sell agreements are so important. A buy-sell agreement is a contract between business partners that dictates who can buy a departing partner’s share of the business and establishes a fair price for the partner’s stake. The agreement also describes how to determine a company’s value if all the owners decide to sell.
A typical buy-sell agreement covers a potential sale or buyback situation when a partner leaves a business. The agreement may specify to whom a departing partner can sell (usually they must sell to someone else in the business), and it also sets a fair price for their share of the business. This protects the remaining partners by guaranteeing that the departing partner will sell their share to a suitable owner, and it protects departing partners by assuring them a fair price for their shares of the business.
It’s not easy to determine a fair price in advance. A company’s owners must agree on a price that, years from now, will represent their firm’s true value. This is obviously a calculated risk: You cannot know today if your business will prosper in the years ahead or struggle to make a profit. Still, picking a fair price or a formula for setting the buyout price is essential.
There are five common ways to determine a buyout price
The partners simply agree on a price for the business and put that number in the buy-sell agreement.
The partners set a price based on the net value of the company’s assets minus its liabilities as shown on its most recent year-end balance sheet.
Multiple of book value
If a small business has been up and running for several years, its real value is probably greater than its book value. The multiple-of-book-value method takes into account intangible assets that add to a company’s worth such as patents, copyrights, brand names and trade names.
Capitalization of earnings.
This method measures a company’s value based on its past profits. This works well for established companies with a solid financial history.
A buy-sell agreement can stipulate that, at the time of a buyout, a professional business appraiser will establish the company’s value.