(October 2008) A written agreement is an essential tool when negotiating the purchase of a book of business. While some advisors in this predicament do have a buy-sell agreement, many plan only for success and not other potential outcomes, including failure.
Here are some issues to keep in mind when drafting such an agreement.
Payment terms are generally negotiated ahead of time and can have the most positive impact. While many agreements have a repurchase mechanism following the death or disability of a partner, other issues go unanswered. For instance, what if the business fails? What happens if the buyer and seller have a fallout, or if one of them decides to leave the arrangement?
In the latter case, include a repurchase liability clause. Repurchase liability describes the financial burden placed on a business when payments are made to a departing shareholder. It must provide for a fair term to the withdrawing shareholder in light of the business’s ongoing capital needs and the needs of the remaining shareholders and their families.
The specific terms of the purchase will depend in large part on the size of the interest being acquired and the cash flow being generated by the business.
Let’s look at an example. Practice A is worth $1 million and generates revenues of $500,000. It is owned by two partners who merged their practices three years ago. Sally, the senior partner, is retiring, and owns 70% of the practice. Accordingly, she expects a payment of $700,000.
Jim, the junior partner, agrees with this valuation but is faced with a quandary. Since forming the partnership three years ago, the practice has generated, on average, $275,000 in cash flow (after expenses), which was paid as either compensation or distributions to the two owners.
Of course, Sally took $192,500 of this amount (70%), and Jim received an annual compensation of $87,500.
Here is the first of many challenges. In five years, Jim will likely not have the cash needed to pay $700,000 in one payment and will not be capable of borrowing the funds needed to make a cash payment — especially in today’s credit cycle. Unless the buy-sell agreement stipulates the payment terms, Sally and Jim will have to negotiate the terms separately.
What if the relationship between Sally and Jim has soured? This is not uncommon. Because of the deterioration in the relationship, Sally could stick to a mandatory cash repurchase or use Jim’s inability to pay as a reason to blow up the partnership. Whether she’s successful or not could end up being determined by a court. But either way, this is not what Sally and Jim had in mind when they consummated their commitment to each other.
You can avoid this scenario by stipulating the payment terms in advance. In my experience, payment terms will cover a five-, seven- or 10-year period. Assuming Jim is satisfied with the same income, the practice has $192,500 to be used to repurchase Sally’s interest as retiring shareholder. This could be theoretically completed in 3.65 years ignoring interest, but in reality, with interest payments included, the minimum terms would be five years. At 7% interest, this would equate to an annual payment of $159,555.
Obviously, these payment terms leave little for Jim and illustrate the tension between the parties in a buy-sell agreement. This example, although extreme and simplified, shows why the minimum term for most well-written agreements is five years.
Standard of value
Payment terms are not the only pitfalls in a buy-sell agreement. We often see buy-sell agreements that fail to accurately define the standard of value.
Value is a key legal concept, and agreements that do not stipulate the standard to be applied can face protracted disputes when partnerships fail. If you base your value on one standard (fair market value, for example), discounts are applicable to minority interests in the stock.
But under the standard of fair value, the discounts are not necessarily applicable. Good buy-sell agreements will stipulate whether these discounts should be applied. It is possible, too, that the discounts are applied under certain triggering events, and not under others. If the agreement is silent on discounts, jurisdictional law prevails, and this may not be what the parties had in mind.
When buy-sell arrangements fail, an ensuing lawsuit will be primarily focused on the non-financial facts and circumstances of the case. Was a partner pulling his or her weight, or was the partner forced out by a culture that excluded his or her ability to perform? This is where a buy-sell agreement needs to be airtight.
That means avoiding ambiguous words such as value, asset and profit. Does profit mean “pretax profit” or “profit before payments to owners”? We’ve seen cases where the parties insisted that profit was meant to be synonymous with revenue.
A buy-sell agreement is not a safety blanket that removes all risk, but you will at least avoid some common mistakes. Consult not only a lawyer to draft the agreement but also a business valuator who can offer expertise on buying and selling a book.
Owen Dahl, CFA, LIFA, is a principal at Moss Adams in Seattle. He is the co-author of How to Value, Buy or Sell a Financial Advisory Practice: A Manual on Mergers, Acquisitions and Transition Planning (Bloomberg Press). email@example.com