It is true that a formula approach to determining the value of shares under a buy-sell agreement can be easy to calculate, understand and communicate. What is often missing from a formula, however, is a good approximation of the actual value of a business. This can happen when several years pass and a value that was once reasonable by formula calculation is obsolete due to changes in industries, the general economic climate, the markets served, and the company itself. When a triggering event occurs (termination of employment, retirement or death), shareholder interests become disjointed and friction can and will arise, especially if the outgoing shareholder (or his estate) believes that the value set for his stake in the capital is too low and inherently unfair. The agreement must not be an instrument for the transfer of property to the family members of the deceased for less than complete and reasonable consideration. So a buy-sell agreement fulfills this test, which has its roots on Reg. 20.2031-2(h) and a large number of cases, two requirements must be met. The agreement must constitute a trade agreement in good faith. This test is not very difficult to pass.

Reasons deemed valid include, for example, (1) maintaining current management policies, (2) maintaining exclusive control of the family, and (3) retaining key employees. When assessing a business interest under a purchase and sale agreement, the use of book value or fair value is not always the best option. Because of the inherent unfairness of a book value purchase and the additional cost, time and complexity associated with a fair value purchase, some entrepreneurs rely on a formula approach that aims to approximate fair value without formal measurement. The problem of lack of economic justification: a formula may simply not reflect legitimate economic justification. In other words, the economic measure used in each formula should generally serve as an approximation of distributable cash flows. Distributable cash flows can be defined as cash flows that can be distributed to owners without affecting the operational viability of the business. Distributable cash flows can be measured discreetly by adjusting the expected enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) for non-cash expenses and corresponding tax consequences, working capital requirements and capital expenditures. Formulas typically use approximations for distributable cash flows, such as EBITDA and net income. To the extent that a formula does not reflect future distributable cash flows, it is unlikely to provide an accurate valuation. When a cross-purchase contract is used, homeowners purchase life insurance policies for the lives of others. By using an entity purchase agreement, the company establishes policies for the lives of its owners, designating the company as the beneficiary of the policies. The cross-purchase contract is used more often in practice.

The Court of Appeal agreed with the Tax Court`s conclusion that the Corporation`s contracts of purchase and sale were testamentary substitutes, having regard to the facts and circumstances of the formation and terms of those contracts. Another aspect of the present case concerned the examination of the appropriateness of the consideration. The Finance Court concluded, and the Court of Appeal accepted, that the formulas of the agreements in question were not comparable to what persons with adverse interests acting on market terms would accept and that they did not have a reasonable relationship to fair value. Agreed value. Shareholders who follow an agreed value approach commit to determining an initial value per agreement and then updating the value, preferably once a year. The use of an agreed value may be suitable for any type of company, provided that shareholders are somewhat sophisticated or at least have competent professional advisors to assist them in the annual valuation. I sometimes recommend that clients hire a qualified business appraiser to determine the initial valuation and provide clues on how to update the value each year. I also specify in detail in the buy-sell agreement which factors shareholders can take into account each year. In Lauder`s estate, however, the tax court provided insight into the application of this test. The Tax Court concluded that a contract of purchase or sale was merely an instrument for reducing inheritance tax if (1) testamentary considerations influenced the parties involved and (2) the formula of the agreement did not reflect full and reasonable consideration because it did not set a fair price for the interest […].