How Do You Value a Business for Buy-Sell Purposes?

Owners of closely held businesses should have a buy-sell agreement if there are multiple owners. The buy-sell agreement, often incorporated in a Shareholders Agreement for corporations, Operating Agreements for limited liability companies, and Partnership Agreements for partnerships, should plan for the continuity of the business upon such events as:

– Death or disability of an owner
– Divorce of an owner
– Termination of employment of an owner
– Bankruptcy of an owner
– Owner’s attempt to transfer ownership to third parties

The goal of many owners of closely held businesses is often to keep it closely held and to maintain come control over who the co-owners are. Thus, when an event occurs in which one owner will be required to transfer his or her ownership interest, the remaining owners may desire to purchase the ownership interest from the departing owner.

If the remaining owners desire to purchase the interests of the departing owner, how do they determine the purchase price? The owners can always agree as to the determination of the price, regardless of what a document provides. A good buy-sell agreement will provide for the method for determining the price where there is no agreement at the time of the purchase. There are various methods that may be used, such as:

  • Agreement of the owners, documented quarter-annually, semi-annually or other period of time
  • Book value, or some multiple
  • Multiple of gross revenues
  • Multiple of earnings (EBITDA)
  • Some other, customized formula
  • Third party appraisal

If the owners are family members such as parents and descendants, then the buy-sell agreement should provide for a price that is intended to be “fair market value”, so that the departing owners are not deemed by the IRS to have made a gift for tax purposes. You should carefully consider which approach is the “fairest” for the owners.

An agreement of the owners can be an acceptable method if made regularly and the owners are generally the same ages and in the same health. Otherwise the younger or healthier owners may desire an artificially low price.

The book value approach is easy to calculate. However, in a service business, there may not be many assets on the books and therefore the value may be artificially low. Also, it does not take into account goodwill or other intangible assets and ignores the fair market value of the assets, which could be higher.

A multiple of revenues is also an easier method. Owners may want to consider the historic revenues and the projected revenues. Should there be a weighted average?

A multiple of earnings may at first glance seem easy. The problem is that closely held businesses often pay higher benefits to its owners and these may often be in lieu of dividends, Thus, the earnings may not truly reflect the value of the business. Often, the owners may need to make certain adjustments and exclude some expenses to the owners.

Finally, often the most “fair” way to value a business may be to hire the services of a professional business valuation expert. This may also be the most expensive way to value the business, but should result in a more educated way of determining value.

Valuing a business for buy-sell purposes is not an easy task. It plays an important part in the buy-sell process among the owners of a closely held business. If you would like help in structuring and documenting your buy-sell agreement, please contact Morris R. Saunders.