Buy-sell ageements Tieking time bombs or reasonable resolutions?

By Z. Christopher Mercer

DUY-SELL asreements are some -fDor the least incierstood, yet most important corporate documents in your corporate files. Nearly every business of any size with more than one shareholder has-or should havea buy-sell agreement.

These agreements establish the mechanism for the purchase (and corresponding sale) of equity interests upon the occurrence ofcertain "trigger events." Trigger events can be remembered by an acronym, QFRDD: Quits, Fired, Retires, Disabled, Dies.

If you think about it, these events are called "trigger events" because someone almost certainly has a gun to his or her head, whether your firm or a shareholder, when they happen.

They come in three types: crosspurchase agreements, entity-purchase agreements, and hybrid agreements. Cross purchase agreements call for individual shareholders to carry life insurance on the lives of other shareholders. This may not be feasible if your company has substantial economic value or workable if there are many shareholders. And they don't help in other circumstances.

Entity-purchase agreements call for your company to purchase shares when a shareholder leaves as result of any of the trigger events. Hybrid agreements provide for the company to pass purchase rights to shareholders under certain circumstances. Most buy-sell agreements that we see are entity purchase agreements.

So dust off your agreement. What kind of agreement is it? Look at it from business and valuation perspectives. You may want help from a competent business appraiser and your lawyer. There are four ways your agreement can determine value when trigger events happen.

Fixed price. The shareholders can agree on a fixed price. The only problem is that. if vou are like most busi- nesses, you will never update the agreement and the value mechanism will become woefully out-of-date.

Formula. The shareholders can agree on a formula. The only problem is there is no formula that will provide reasonable results over time given the changing nature of your markets, your industry, and your company.

Shotgun. Sounds fair, because if you name the price, I get to decide whether I'll buy or sell. The only problem is that this doesn't work with more than two shareholders, and it may not work if someone's spouse has that shotgun placed at his or her head!

Appraisal process. Many buy-sell agreements provide for an appraisal process to determine value when trigger events occur. There are multiple appraiser processes and single appraiser processes. Some owners think that they have a pricing mechanism with a right offirst refusal. The only problem is that there is no requirement to either buy or to sell. So there is no assurance of a transaction when trigger events occur. Rights of first refusal are often used in conjunction with buy-sell agreements in order to insure that remaining shareholders get to choose who they will be in business with.

All pricing mechanisms other than appraisal processes have a common characteristic. The parties to the agreements are betting that the other party will die, retire or otherwise leave first. And, you know, one of them will be right. But that will not likely be good for the other. if the price is unreasonably set by an out-of-date fixed price, a faulty formula, or otherwise.

So let's examine appraisal processes. Many agreements call for one side to retain one appraiser and for the other side to retain another. Usually, both appraisers provide valuations. If they are within ljVo or so of each other, the average is the concluded price and the process is over. If not,

- Part 1

the first two appraisers generally select a third appraiser, whose job it is to reconcile the disparities. The third appraiser's conclusion will either be averaged with one or both of the first two conclusions, or it may even be determinative of value.

The bottom line is that you won't know, until a trigger event occurs, how this process will play out-nor will you have any idea what the value will be. And that's not good business.

We have recommended a single appraiser process for companies for many years. All parties to a buy-sell agreement agree on a single appraiser at the time the deal is signed. The appraiser then provides an appraisal based on the kind of value you've agreed upon. If there are any problems with the definitions of value or other aspects of the process, they will be uncovered and can be fixed. The appraisal becomes the initial value for pu{poses of the agreement.

The selected appraiser then provides a reappraisal every year (or two for smaller companies) to update the buy-sell price. The parties then have current valuation information for personal and corporate planning purposes. The appraiser may have to provide an appraisal following a trigger event. depending on how long it has been since the last appraisal. Everyone knows what will happen and is knowledgeable about value and the process all along. Now, that's good business.

To find out why the time and expense of working on an agreement and providing for a regular appraisal is cost-effective, even for not-so-large businesses, see Part 2 in a future issue.

- Z. Christopher Mercer, ASA, CFA, is founder and c.e.o. of Mercer Capital, a national business valuation and investment banking firm, and author o/ Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? Reach him at ( 800) 769-0967 or www.mercercapital.com.

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fF YOU think firing a long-term Iemployee is difficult. try firing one who is a family member. As daunting as the task may be, sometimes it's necessary.

Any major firing threatens to disrupt a business, creating fear and anxiety, and shifting alliances among employees. But the disconcerting and disruptive ripples from firing a family member may spread throughout the family as well. Handling this difficult matter the right way can limit emotional damage to the family and business and, with good communication and a few procedural tips, it can also ultimately strengthen them.

Preventiorl is always the best strategy. Because most terminations have long roots, it's advisable to know as early as possible whether a family member is developing into a healthy plant or troublesome weed. The cultivating of prospective family members should begin before they enter the business. Avoid promising any future position. Constantly reinforce the value that performance, not family status, always determines a person's position in the company. No one is owed any company positioneven after they're in it. If termination becomes necessary, the ordeal will be easier for everyone if these values have been firmly established.

Regular and honest performance reviews are essential. Although people disagree about their automatic use, 360" reviews-reviews that solicit input from both subordinates and superiors-are an excellent tool for family business members. Not only do 360' reviews help ensure the objectivity that is so difficult to achieve when reviewing family members, but if termination eventually becomes' necessary, they provide important backup that can help defuse emotional reactions.

Unfortunately, even the most conscientious prevention strategies can