14 Jul Your Buy-Sell Has a Valuation Formula. It’s Already Wrong.
A business owner died last year. His buy-sell agreement said the purchase price would be “three times trailing twelve-month net income.” The formula produced a value of $3.8 million.
His widow hired a business appraiser. The appraiser valued the company at $7.9 million. The difference was $4.1 million, and the estate’s attorney made sure everyone in the room understood that.
The surviving partner thought the buy-sell agreement settled the question. It did not. The estate argued the formula was unconscionable, that it was set years ago under different circumstances and no longer reflected the company’s actual value. The dispute took fourteen months to resolve.
This is not uncommon. If no one has their eyes on it, a buy-sell valuation can stop reflecting reality within a few years of being written.
The Three Approaches
Most buy-sell agreements use one of three approaches to set the purchase price.
A fixed agreed value. The partners agree the business is worth a certain amount and write that number into the agreement. They promise to update it annually. In practice, that doesn’t happen. The number goes stale. The business grows. The agreement still says the price from five years ago.
A formula. Book value. Revenue multiple. EBITDA multiple. These formulas feel objective, which is why lawyers and business owners like them. The problem is that a formula captures one dimension of value. A company with $4 million in EBITDA and three long-term government contracts is worth far more than a company with $5 million in EBITDA and no recurring revenue. The wrong formula treats them the same.
An appraisal at the time of the event. This produces the most accurate number. It also produces it at the worst possible time. One partner has just died or become disabled. The surviving partner needs to move fast. Instead, both sides hire appraisers, the appraisers disagree, and now you are negotiating valuation during a crisis. The process can take six months or more.
The Gap Gets Worse Every Year
Valuation problems are not static. They compound. A formula or fixed value that was 10% off three years ago might be 40% off today. Businesses grow. They add revenue streams. They build goodwill that no formula captures. They acquire assets that don’t show up on the balance sheet the way an appraiser would account for them.
Meanwhile, the insurance policies that fund the buyout are still set at the old number. So you have a double gap: the agreement understates the price, and the insurance doesn’t even cover the understated price. This is how funding gaps form, and they widen every year.
What the Right Approach Looks Like
There is no single correct valuation method for every business. But there is a correct process. It has three parts.
First, choose a primary method that fits your business. A formula works for some businesses if it’s the right formula and it’s reviewed regularly. An appraisal mechanism works for others, as long as the agreement pre-selects the appraiser or the method for choosing one so there’s no argument about it later.
Second, build in an annual review. Not a suggestion to review. A requirement. Some agreements tie the review to the annual insurance check. Others tie it to the company’s fiscal year-end. The mechanism matters less than the habit.
Third, coordinate the valuation with your insurance. When the value goes up, the coverage needs to go up. When it doesn’t, you have an agreement that promises more than it can deliver. Life insurance is the most common funding mechanism. If your business has grown since you last reviewed your policies, your buy-sell agreement is underfunded.
What a Stale Valuation Actually Costs
When a buy-sell agreement produces a number that one side considers unfair, the agreement doesn’t resolve the dispute. It becomes the dispute. The estate or the departing partner challenges the formula. The surviving partner insists the agreement is binding. Attorneys get involved. The business operates in uncertainty for months while the adults in the room argue about a number that should have been updated years ago.
The cost of keeping your valuation current is a few hours per year plus whatever your advisor charges for an update. The cost of letting it go stale is measured in legal fees, business disruption, and relationships that don’t recover.
Related Reading
Buy-Sell Agreements. The foundation: what a buy-sell agreement is, the three structures, and the five events that trigger it.
Buy-Sell Agreements and Life Insurance. How life insurance funds the buyout, and why the coverage must match the current valuation.
How to Arrange Insurance Funding of Your Buy-Sell Agreement. The mechanics of matching your insurance to your actual buyout obligation.
Need a Partnership Agreement. The operating rules every partnership needs before a triggering event forces the issue.
When Was the Last Time You Checked the Number in Your Buy-Sell Agreement?
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