Drafting a Buy-Sell Agreement

One of the most important features of the buy-sell agreement is the mechanism for determining the purchase price of the ownership interest. In many cases it may be advisable to use the services of a certified public accountant or a professional business appraiser. A good starting point would be a professional appraisal. If all the owners agree upon the method used by the appraiser in determining the value of the business, the same method could be used for purposes of determining the purchase price in the buy-sell agreement.

Fixed price method.

One of the simplest methods is to use a fixed price, redetermined periodically by the owners. For example, the owners could agree to meet each year after the financial statements for the entity have been prepared to discuss adjusting the purchase price for purposes of the agreement. If this method is used, consideration should be given to using some other method to determine the price if the fixed price has not been redetermined within a specified period. It may be to the advantage of a younger or healthier owner to refuse to agree to an upward adjustment of the purchase price when the other owner or owners are older or in bad health. By requiring an automatic adjustment if the price is not readjusted by agreement, the older or less healthy owners are protected. For example, the buy-sell agreement may be drafted to provide that if the owners fail to agree to a new purchase price after a certain period of time, such as two years, and one of the owners dies, the last purchase price determined will be adjusted upward or downward based on the increase or decrease in either the book value of the business or the average earnings of the business over the period of time from the last redetermination of the purchase price to the occurrence of that owner’s death.

Book value and adjusted book value.

The book value of the business may be used to set the purchase price, although in most cases the book value will not reflect the real value of the business. The book value uses the historic cost of assets less depreciation, which in many closely held businesses is determined under the same depreciation method used for tax purposes. However, an adjusted book value may be more appropriate because it can take into account the following factors:

1. Any assets not appearing on the balance sheet, such as goodwill and work in progress;
2. Any accrued income or expenses not appearing on a balance sheet prepared under the cash or hybrid method of accounting;
3. Any contingent liabilities;
4. The appraised value of certain assets such as real estate and large machinery;
5. The market value of securities of other companies held as investments that are listed on a recognized exchange;
6. The loss of the deceased owner’s services to the business; and
7. Insurance proceeds.

There are three ways to account for life insurance proceeds. First, the cash value of the policy on the deceased owner’s life before his or her death, which should be reflected in the balance sheet, can be used in place of the proceeds. Second, the excess of premiums paid by the entity over the cash value before death can be added to the book value. Third, the proceeds can be substituted for the cash value of the policy.

More information about the book An Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business

Related CLE

Buy-Sell Agreements for LLCs and S Corporations brings more insight to the topic of buy-sell agreements from the perspective of majority and minority owners of S corporations and LLCs. This 90-minute program (which is available as an audio CD package or on preloaded Apple® iPod nanos) comes with a sample shareholder agreement and LLC operating agreement that are reviewed in-depth by our expert faculty. This program, combined with An Estate Planner’s Guide to Buy-Sell Agreements for the Closely Held Business, gives you the comprehensive and up-to-date information you need on buy-sell agreements to better serve your business clients.

Faculty: James P. Dalle Pazze, Ronald A. Levitt, Thomas J. Nichols

Section of Taxation and the ABA Center for Continuing Legal Education

Back to May 2007 Inside Practice Index

Previous Issues of Inside Practice