To ensure a smooth ownership and management transition from one generation to the next, all architecture and engineering firms should have a succession plan. And a key component of your transition plan needs to be a buy-sell agreement.

A buy-sell agreement provides for the orderly transfer of firm ownership and control when an owner dies, becomes disabled or leaves the business. The buy-sell agreement should clearly identify how shares will be valued, who will value them and how the purchase of shares will proceed. It should also define the triggering events that require the continuing owners to buy shares from the departing owner, such as death, permanent disability or retirement, as well as the circumstances that require an owner to sell, such as loss of license or discreditable acts.

If an agreement is not in place or does not work, it can result in unpleasant surprises, disputes or even litigation.

For example, A/E firms established as C Corporations are considered qualified personal service corporations (PSC), giving them the unique ability to use the cash basis of accounting for tax purposes. The tax law requires that 95% of the company stock be owned by an employee or retired employee and does not count a former employee who is not retired as a qualified owner. If a shareholder departs, the firm is in danger of losing its PSC status and becoming an accrual basis taxpayer who must pay taxes on previously deferred accounts receivables. This can be avoided with a buy-sell agreement in place that requires the sale of an employee’s shares immediately upon departure from the firm.

The buy-sell agreement also creates a market for otherwise unmarketable ownership interests, providing a departing owner’s family with a fair price and the liquidity needed to pay estate taxes and other expenses. To work effectively, a buy-sell agreement must have a carefully designed valuation provision, which sets the purchase price for a departing owner’s shares.

Most buy-sell agreements use one (or a combination) of the following approaches to set the price:

• Negotiation between the parties
• Valuation by one or more independent professional appraisers (either at regular intervals or after a “triggering event,” such as the death, disability or departure of an owner)
• A valuation formula tied to book value, earnings or other factors

To avoid ambiguity, the agreement should spell out the agreed-upon valuation criteria, such as the valuation date to be used and whether the price is based on fair market value, fair value, investment value or some other standard.

Negotiation can be a cost-effective way to arrive at a price that’s fair to all concerned — so long as the parties can reach an agreement. If they can’t, litigation may be inevitable. One potential solution is to provide for a negotiated price but, if the parties are unable to agree within a certain amount of time, then bring in a qualified professional with valuation expertise in the AEC field, such as an Accredited Senior Appraiser (ASA) or a Certified Business Appraiser (CVA).

Business valuations near the date of a triggering event generally produce the most accurate results. A business valuation professional who is experienced in the A/E field will produce the most accurate value, taking into account all of the economic variables that exist at the time of the sale and the characteristics that distinguish it from other businesses in the built environment.

While attaining an accurate business valuation can be costly, the alternative is using a valuation formula that becomes obsolete soon after the buy-sell agreement is signed. Book value, for example, may approximate fair market value at the time a company is established, but it quickly becomes out of date as the company generates earnings and builds goodwill.

Case in point: Two business partners had a buy-sell agreement that set the price at net book value plus $50,000. When one partner died, the surviving partner was able to acquire the deceased partner’s interest from his estate for just under $200,000 — even though its fair market value had grown to more than $11 million.

Some companies use formulas based on earnings multiples, but they also can be unreliable. A multiple of earnings may approximate a company’s value at the time an agreement is signed, but it won’t necessarily reflect the company’s value over time.

It’s a good idea to review your buy-sell agreement periodically to ensure its valuation provisions reflect your A/E firm’s current circumstances. This is particularly important if your agreement uses a valuation formula that’s more than a year or two old.