A buy-sell agreement is a contract set forth by the owner or owners of a business to describe how ownership changes may take place. Like a good insurance policy, one of these agreements can help protect a contractor and other owners of a construction company in difficult times (e.g., death, disability, retirement, termination, other compulsions to sell). The hope for all companies and their advisors is that the agreement is drafted, signed, and saved away—never to be used. However, more frequently than you might imagine, these key documents are absolutely vital for managing potentially turbulent situations among shareholders.
Contractors sign contracts all the time. That’s why the word is right in your occupational sobriquet: contractor. However, one contract that every construction business owner needs to sign is sometimes overlooked: a buy-sell agreement.
Laying the foundation
Ownership transitions can transpire under many different circumstances—some good, some not so good. In the context of a buy-sell, such circumstances are referred to as triggering events.
These can include a relatively happy occurrence such as a long-time construction company owner retiring to enjoy rest and recreation. Conversely, triggering events can also include an owner’s death, disability, or contentious departure.
As mentioned, the buy-sell will—in very specific detail—see to the orderly transfer of ownership and control following a triggering event. The agreement will also create a market for otherwise unmarketable ownership interests and generate the liquidity needed to pay estate taxes and other expenses.
Setting the Method of Calculation
The critical feature of a buy-sell agreement is a well-crafted, carefully worded valuation provision. This language will set the purchase price for a departing owner’s shares and, ideally, prevent future conflicts and even litigation over share value. After all, the events that precipitate the need for the use of this specific agreement are usually quite stressful – so, pre-planning these events in advance will save heart ache and the mental calorie burn down the road.
Within the actual document, various approaches can determine value at the time of a triggering event. In some cases, the agreement will stipulate that an independent valuation expert must opine on valuation of the company. In other cases, the agreement will specifically state the formula for how the business will be valued (e.g., the company is worth 4x trailing twelve month EBITDA less indebtedness plus existing cash). The particular method you choose, or how you formulate it, won’t necessarily be superior to others; however, if you choose the latter of the two examples, then the buy-sell agreement should be revisited occasionally to see if an amendment is merited. Also worth noting is the choice to deploy an optional method as well—in other words, you don’t necessarily have to pick just one method for your agreement. Qualifiers such as either and or can be placed in the clause to provide flexibility.
Note about Fair Market Value
Buy-sell agreement valuation clauses don’t necessarily have to stipulate a true fair market valuation at the time of a triggering event. In many cases, owners are aware that the specific predetermined method (see above) could generate less actual proceeds than are realized in the sale in an arm’s length transaction to a third party. Primarily, this is acceptable because business owners are usually seeking a rational or acceptable solution to an otherwise controversial issue; having all owners agree (in advance while emotions are “in-check”) on a solution and leaving the company on solid footing afterward are important considerations.
Note about Protecting the Business
After reading this article, you might be concerned about the potential financial obligation that a buy-sell agreement could create for your business. As is usually the case, readily available insurance products can protect you and your business against the risks associated with certain triggering events (usually death, but can be more expansive). Many policies are designed or customized to directly piggy-back on buy-sell agreements. Involving your advisors and appropriate insurance providers in the conversation as the agreement nears completion is a wise decision—just to make sure you have a good idea of costs and challenges you might encounter with various ways the agreement can be drafted.
Making it rock solid
Even if you already have a buy-sell in place, be sure to review it from time to time as the circumstances surrounding your construction business change. Also, don’t go it alone or have a limited team approach on this matter: involve your financial/M&A advisor, attorney, and a qualified valuation expert to ensure your agreement is rock solid.