A lot of Buy Sell Agreements use a common valuation method called the “fixed price” method. It’s the easiest valuation method because the owners pick a number out of thin air and agree on a fixed value. The agreed on number determines the buy out price after a triggering event. Most Buy Sell Agreements state that the owners will review and update the value every year, but in reality few companies ever update the value.
People like Chris Mercer and me who understand how Buy Sell Agreements work or more often than not don’t work in the real world do not like fixed price valuation methods. Here are the reasons I do not recommend people use the fixed price valuation method:
- Unless the value is determined by an experienced appraiser the owners have no clue as to what the actual value of their company is. They are just guessing the company’s value. Do you really want your loved ones to be paid an amount for the company after your death that is based on a guess by a group of nonappraisers? The fixed value method always means that somebody is going to pay too much or too little and somebody else is going to be paid too much or too little.
- Once the value is agreed to and the Buy Sell Agreement signed, the chances are slim that the owners will review and revalue the company annually or whenever the value of the company changes significantly. See Chris Mercer’s article called “Fixed Price Buy-Sell Agreement Poster Child” in which he discusses a great bad example case where the owners of a company never updated the fixed price and it resulted in two lawsuits that took over ten years to resolve. The failure to update the value means that even if the original value was in the ball park the actual value of the company years later won’t even be close to the company’s real value.
- The Buy Sell Agreement needs to have an alternate valuation method that applies after a period of time such as one year, but many Buy Sell Agreements (not mine) lack this feature.
Buy Sell Agreement expert Chris Mercer says this about fixed price valuation methods:
“In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease. However, if you have a fixed-price agreement, you must have the discipline to update the price periodically. And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.”
If your Buy Sell Agreement has a fixed price valuation method I urge you to follow my advice listed below:
1. The owners must revalue the company not less than once a year and more often if something causes the value to increase or decrease substantially. It is not sufficient that the language of the agreement requires revaluations at least once a year. One or more owners must insist that all the owners actually revalue the company.
2. Make sure the Buy Sell Agreement has language that says: (i) the fixed price is eliminated after a period of time (such as one year) unless the owners agree that the price remains good or agree to a new price, and (ii) if the owners do not update the fixed price within the specified period the document contains a workable alternate valuation method.
3. Use an alternate valuation method that requires an experienced appraiser to determine the value as of the valuation date specified in the Buy Sell Agreement.