Why is a Machinery and Equipment Appraisal Required for a Buy Sell Agreement?

What is a Buy Sell Agreement?

A buy sell agreement is the equivalent of a personal will but for a business.  It will define triggering events that will allow or require partners to buy out one another.  Some of the common triggering events include death, incapacitation, retirement, succession, or a partner's desire to leave the company. The agreement will usually define who can buy out the partner and at what cost.  In addition, it may define the methods used for valuing the company at the time of execution.  The goal of the buy sell agreement is to document the intentions of the shareholders prior to the situations occurring so that the parties are fairly compensated.  Buy sell agreements can be funded through insurance policies or other mechanisms to help assure that adequate funds are available to complete a transaction when a triggering event occurs.  It is recommended that a buy sell agreement is constructed by an attorney with experience in creating such documents due to its importance.

Methods of Valuation Used for Determining Business Purchase / Sale Amount

There are three main approaches to valuing a business:

  1. Market Approach
  2. Income Approach
  3. Asset Approach

Business valuation conclusions often look at all three approaches and then the business appraiser includes or excludes various methods for specific reasons or may do a weighted average of multiple calculation methods.

The Market Approach looks at comparable transactions that have been completed for businesses with similar characteristics such as industry, size, and location.  When a data set of enough transactions of a similar business can be compiled, then this method is used to look at percentage of revenue or multiples of earnings of the data set in comparison to the subject company.

The Income Approach looks at business valuation from a return on investment perspective. Calculations of earnings streams, possibly both past and future, are viewed and factors are applied based on the appraiser's assumptions of economic, industry, and risk rates.

The Asset Approach looks at the business assets to calculate a value.  Machinery, equipment, inventory and other assets are appraised and a value is calculated.  Especially in today's economy, this valuation method is extremely important for businesses that have been only marginally profitable since the value of the business may be driven by the tangible assets versus having much, if any, goodwill value.

The Importance of the Machinery and Equipment Appraisal

A machinery and equipment appraisal is a necessity to make sure that the Asset Approach should be the driving value factor or excluded from the value factors of a business valuation.  Excluding the Asset Approach Method arbitrarily creates a business valuation report that could be refuted in court by an opposing attorney in a situation where a buy sell agreement is contested.  Buy sell agreements are constructed with good intentions, however, when partners or surviving family members feel that they have been unjustly compensated for their share of the business, it can become a litigious situation.  Making sure that a certified machinery and equipment appraisal is completed removes uncertainty from a business valuation conclusion.