When an owner terminates his or her interest in a company, it often is a stressful event, such as death, disability, dispute, etc. The termination will typically cause the departing owner to receive compensation for his/her interest in the company. A well drafted buy-sell agreement with a formula clause covering various types of terminations can significantly reduce the stress of the transaction to purchase the interest of the departing owner.
Typical formulas will be similar to formulas used in the valuation of the entity, such as EBIDTA (earnings before interest, depreciation, taxes and amortization); cash flow; book value adjusted for certain items, etc. Whatever the formula used, it must be easily calculated and stand up to the scrutiny of an independent appraisal when required. Such an independent appraisal will be required upon death of the owner for estate tax purposes, or if disputed by the surviving owners.
Formulas should be tested periodically to make sure they are reasonably close to fair market value. We recommend that companies engage a certified business appraiser every 2-6 years depending on the volatility of the business and general market conditions.
-Eugene Fleishman, CPA, Principal