With formula buy-sell agreements, it is my recommendation to review the multiples in the agreement and determine if they reflect current reality.  Additionally, you will need to determine what earnings to apply to the multiple.  As in the previous example, let’s say the formula in the buy-sell agreement is value = 3.0x EBITDA.   If the agreement is silent as to how EBITDA is determined, then disagreement and/or misapplication can apply. 

In a valuation context, there can be several valid adjustments to EBITDA such as: non-recurring income and expenses, income and expenses related to non-operating assets, lease payments to a related party and adjustments to owner compensation (among others).  Any adjustments should be specifically included and identified in the buy-sell agreement formula to avoid uncertainty in the formula calculation.  Keep in mind, any adjustments to EBITDA can create swings in the company value. 

Further, it is important to identify the appropriate timing of the earning stream. For example, does the agreement specify that the last twelve months of EBITDA should apply? Last calendar year? Last fiscal year? Three-year average EBITDA? Five-year average? Each of these can alter the value depending on company characteristics. The point is that none of these are technically wrong, but if not defined, the formula is subject to differing interpretations.

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 This can lead to owner tensions similar to an outdated set/fixed price agreement.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.