With Minnesota’s Revised Uniform Limited Liability Company Act going into effect later this year, it is a perfect time to review your current LLC’s operating and member control agreements, or to start planning if you are going to form an LLC under the new law. Many different topics are addressed in an operating agreement (which will now encompass what used to be member control agreements). One of the most important sections is the buy-sell agreement. The buy-sell agreement sets a plan for how members will be able to buy and sell their rights in the company, triggering events for when a company or other members will have the option or be forced to buy back rights, and how to set a price when a potential sale may take place.
Each company will have different views on how to deal with voluntary or forced sales, and whether the company, other members, or third parties should be the purchasers. Regardless of how each LLC decides to handle different triggering events, every transaction will need to have a price. Triggering events will almost always include very difficult situations like death, disability, and divorce, so it is important to make the process run smoothly and avoid additional stress for the parties. The three main valuation strategies for buy-sell agreements are discussed in more detail in the sections below.
Fixed Price Agreements
Fixed price agreements are the easiest and cheapest option for valuing a purchase, but this does cause sacrifices in other areas. This valuation technique works exactly as it sounds — members set the price of a share, which needs to be updated periodically. If you choose this method, be sure that your members and board (if applicable) are actively involved in the oversight of the company and will be able to update the price periodically; this method could drastically over- or under-estimate a reasonable price if it is not updated. The biggest problem with this method is that the price does not take current conditions into consideration, and it may be very outdated. However, an added benefit of this method is that the periodic price update can be used to evaluate the performance of managers. Having the members set a price on shares is effectively periodically valuing the company. Changes in the total value of the company are a great benchmark for judging managers’ past performance. By using this price as an evaluation tool, you can cut down on the time required to prepare evaluation metrics, and more accurately see the impact of managers across the entire company rather than one aspect of the company at a time. As a whole, fixed price agreements are cheap and easy but they often lead to the least accurate price for a transaction.
Formula agreements, like fixed price agreements, may not reflect the market reality when the transaction is taking place. Formula agreements will often be written with each share having the value of a fixed percentage of revenue, EBITDA, or a similar metric. Formula agreements more accurately represent the current state of the LLC, but may end up relying on metrics from the previous year that are substantially different from the current year. To combat this issue if you choose to use a formula agreement, it is often more prudent to use averages of your benchmark value — whether revenue, EBITDA, or another factor indicative of your LLC’s performance — spread over multiple years. This will help to paint an accurate picture of the company’s value and will mitigate the impact of unforeseeable spikes or drops in the market. Although company metrics may seem to speak for themselves, any metric used in a formula should be defined in explicit detail. It is best to remove any ambiguity when first writing the buy-sell agreement to avoid problems in what may be a very difficult and complex transaction. Formula agreements provide more accuracy than fixed price agreements, but still risk setting an inaccurate price by possibly ignoring the current condition of the company.
Process agreements are the most accurate in terms of setting a realistic value, but they can also be the most time consuming and expensive. Under a process agreement, the company will typically hire appraisers to value the shares at the time of sale. It is important to note that this is the only method that sets a price based on the current market rather than a past determination. There are many ways to use appraisers in valuing a sale — just make sure to clearly define the process in your agreement, and give a definitive role to each appraiser that may be involved.
Each of the above pricing strategies has good and bad aspects. The right choice will depend on your business, and where your priorities fall in a transaction.
If you are considering updating or creating a buy-sell agreement, you should work with an attorney to structure your contract to meet your needs and expectations. This article was sponsored by Vlodaver Law Offices, LLC, an experienced business solutions and transactions law firm in the Twin Cities. If you would like a free legal consultation, contact us.