Formula Buy-Sell Agreements

If you are dealing with a formula buy-sell agreement there are a few key considerations to keep in mind.  Generally speaking, the formula often does not take into account current multiples.  If the agreement called for a 3.0x EBITDA multiple but currently similarly situated companies are transacting at 5.0x EBITDA, then there are obvious incongruities with current fair market value. 

For example, based on general valuation theory: value equals earnings times a multiple. So if EBITDA is $500,000 and the EBITDA multiple is 3.0x the implied value is $1,500,000. If current multiples are 5.0x then the implied value is $2,500,000 - or a $1,000,000 difference. This can lead to owner tensions similar to an outdated set/fixed price agreement. 

Some other important considerations to keep in mind: what EBITDA will you apply (think time frame)? Are any adjustments to EBITDA applicable?

Additionally, numerous formula buy-sell agreements use book value. However, after the passage of time, book value becomes somewhat irrelevant in determining the true value of the business.  The assets on the balance sheet can be fully depreciated and long-term assets/investments are not shown at current fair market values.  Book value can be a useful tool at the outset and is understandable, but as time passes things will change with the business, the industry and economy over time.  If your business has been a profitable venture and you are using book value as the formula, then it makes sense to discuss possible changes to the buy-sell agreement with your partners.