AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE
In my last post, I presented a case study about Howard, the owner of a successful manufacturing company.
When Howard passed away without a suitable buy-sell clause to ensure an orderly transfer of his ownership interest, all of the business’s stakeholders were caught in the crossfire. These included the other shareholders, his wife and his children.
Today, I have another case study that ends on a more positive note. Why? Because these shareholders did it right at the outset.
Chris and Tom were equal partners and shareholders in an electrical contracting company. When they commenced operations, they instituted a shareholders agreement that included a clear and comprehensive buy/sell clause.
This clause stipulated that, should one shareholder, or his estate, want to sell or transfer their shares in the company, the other shareholder had the right of first refusal. This ensured that no shares would be sold to an unknown third party. It also ensured there would be a market for selling or transferring the shares.
The clause that leaves nothing to chance A key element of a sound buy/sell clause is a defined mechanism for determining how the purchase price of the business’s shares will be determined. In this instance, Chris and Tom had agreed to use the adjusted book value of the company, plus goodwill. Goodwill was defined as one year of the company’s average earnings before interest, taxes, depreciation and amortization (EBITDA).
In addition, the buy/sell clause stated that:
- The purchase price would be calculated by an independent valuation professional.
- The valuation report would be paid for by the company.
- The purchase price would be paid for with life insurance policies on the shareholders that listed the company as the beneficiary.
- In the event there was not enough insurance in place, the remaining balance of the purchase price would be paid in 60 equal instalments of principal and interest.
- To insure the partners remained adequately insured to cover the purchase price, a valuation of the company was performed every two years.
Put to the test Tragedy struck after Chris and Tom had been in business for over 20 years. Tom lost his son in an automobile accident.
The loss had a profound impact on Tom. His focus on, and performance in, the business deteriorated to the point where Chris was bringing in most of the contracts and managing most of the projects.
The partners agreed it was time for Tom to exit the business. Because they had a clear and understandable buy/sell clause, Chris was able to quickly buy Tom’s shares. The only point of contention was the value of some of the machinery and equipment, and they agreed to defer to a valuation by a professional appraiser.
A year after the buyout, Chris decided he didn’t want to be a business owner any longer. With the advice of a valuation expert, Chris spent the next two years marketing the business to potential buyers, and ultimately sold it to a general contractor that had decided to open an electrical contracting division. As part of the deal, Chris was hired as vice-president of that division.
Tom got the quick exit he needed, under fair and equitable terms. Chris, at 52 years old, was able to finance his retirement, budget for his kids’ post-secondary education, and land a new job with the general contractor that paid $200,000 a year.