The Role of Business Valuation in Funding Buy-Sell Agreements
Executive Summary
Business valuation is not a side exhibit in a buy-sell agreement; it is the pricing engine that determines how much liquidity the agreement must deliver, when that liquidity must arrive, who bears the funding burden, and whether the transfer will hold up under tax scrutiny, state-law enforcement, and owner-level negotiation. A buy-sell agreement works only when four elements are aligned at the same time: the triggering event, the valuation standard and process, the legal transfer mechanics, and the funding stack. If any one of those four is stale or vague, the agreement can produce either a cash shortfall, a tax surprise, or a dispute over whether the contract price reflects the interest’s real value.
After the Supreme Court’s June 2024 decision in Connelly v. United States, owners should not assume that corporate-owned life-insurance proceeds earmarked for a stock redemption are offset by the corporation’s redemption obligation for federal estate-tax valuation. In the fair-market-value redemption structure before the Court, the insurance proceeds were treated as a corporate asset, and the redemption obligation did not reduce the value of the decedent’s shares. Combined with Treasury regulations requiring consideration of nonoperating assets, including life-insurance proceeds payable to the company, that decision materially changes how many entity-redemption plans should be modeled and funded.
The highest-confidence drafting position today is straightforward: define the standard of value, premise of value, and level of value; specify the valuation date for each trigger; require a clear appraisal process rather than a vague “mutual agreement” fallback; coordinate insurance, reserves, and note financing to a valuation corridor instead of a single fixed number; and include a dispute mechanism that resolves disagreements quickly enough that the business can keep operating. Those recommendations are consistent with the business-valuation frameworks of the AICPA, the American Society of Appraisers, and the International Valuation Standards Council.
For most closely held businesses, the most defensible article-level conclusion is this: funding should follow valuation design, not the other way around. Owners should first decide what is being valued, on what standard, at what level, on what date, and by whom. Only then should they size life insurance, disability coverage, sinking-fund targets, lender capacity, and promissory-note backstops. Otherwise, the agreement is likely to be overfunded in quiet years and underfunded exactly when it is needed most.
Assumptions and scope
This article assumes a U.S. federal tax lens because the jurisdiction was not specified and the requested source priorities focus heavily on federal tax and valuation authorities. State corporate and LLC law varies, so this report uses Delaware as the illustrative state-law reference because its statutes expressly address transfer restrictions, LLC agreement governance, and trigger events specified in governing documents. The worked examples are hypothetical and educational, not legal, tax, or insurance advice.
Buy-Sell Agreements and Why Valuation Matters
A buy-sell agreement is a contract that governs the sale, offer to sell, purchase, or redemption of an ownership interest when a specified event occurs. In practice, the most common trigger events include death, disability, retirement, divorce, and other owner-exit events. For corporations, transfer restrictions can be imposed by charter, bylaws, or shareholder agreement; for LLCs, the operating agreement can specify events that cause transfers, dissolution, continuation, or redemption mechanics.
The business purpose is broader than succession alone. A well-built agreement preserves control, keeps equity away from unintended outsiders, creates liquidity for heirs or a departing owner, reduces the odds of litigation, and gives lenders, key employees, and counterparties a clearer continuity plan. For tax purposes, it can also influence whether an agreement’s price mechanism will be respected, but only if the arrangement satisfies the requirements of Internal Revenue Code section 2703 and the related regulations.
Valuation sits at the center of all of that. It answers five decisive questions: what exactly is being sold, what standard of value applies, what level of value applies, when the value is measured, and how differences in control, marketability, restrictions, debt, and nonoperating assets affect the final price. Funding is then layered on top of that answer. If valuation is unclear, every downstream funding choice becomes guesswork.
The logic is simplest when seen as a process: the trigger does not create value; it activates a valuation process that determines the transfer price; the funding stack then satisfies that price using insurance, reserves, borrowing, or seller financing. That is why valuation is the operational hinge between contract drafting and liquidity planning.
The process below reflects that sequencing. It also shows why agreements fail when they start with a coverage amount rather than a valuation framework.
The valuation-to-funding sequence:
- Trigger event occurs — death, disability, retirement, divorce, deadlock, or other contractually specified event.
- Determine the valuation date — the contract should state which date applies for each trigger type.
- Apply the standard of value, premise of value, and level of value — fair market value or fair value, going concern or liquidation, controlling or noncontrolling interest.
- Select methods and complete the valuation — income, market, asset-based, or a weighted blend.
- Set the transfer price — adjusted for debt, nonoperating assets, and any contractually specified discounts or premiums.
- Apply the funding stack — insurance proceeds, sinking fund or reserves, third-party financing, and a promissory note backstop.
- Close the equity transfer — execute the assignment, update the cap table, and notify lenders and stakeholders.
- Handle post-closing tax, basis, and true-up steps — record basis adjustments, file required tax forms, and reconcile any interim payments to the final price.
In other words, the role of valuation in funding buy-sell agreements is not merely to “set a price.” It determines the amount that must be funded, the timing of the funds, the legal defensibility of the price, and the tax profile of the transaction. That is why stale fixed-price agreements so often fail in real life: value changes, but the insurance or reserve design does not.
Funding Structures and Valuation Alignment
The most common funding source for a death trigger is life insurance because it creates rapid liquidity when a transfer obligation arises. Consumer guidance from the National Association of Insurance Commissioners explains that life insurance is designed to pay named beneficiaries at death, including an organization when an insurable interest exists. Federal tax regulations generally exclude death proceeds from gross income under section 101(a)(1), although transfer-for-value rules and section 101(j) can limit that result in some structures. Premiums are generally not deductible where the taxpayer is directly or indirectly a beneficiary.
For disability triggers, insurance is structurally different. The same NAIC materials define disability income insurance as coverage that pays when an insured is disabled or unable to work because of illness, disease, or injury, often on a short-term or long-term basis. That means a disability buyout clause should not simply copy the carrier’s marketing language. It should define the trigger event contractually: for example, inability to perform material duties, required waiting period, medical certification standard, and whether the buyout is immediate, phased, or contingent on permanence.
Ordinary disability income coverage replaces income; it does not necessarily fund an equity buyout. A disability trigger should be matched to disability buy-out coverage, reserves, lender capacity, or seller-note mechanics.
The two principal structural forms are cross-purchase and entity purchase, with hybrid or wait-and-see structures sitting between them. In a cross-purchase, the remaining owners buy the departing owner’s interest directly. In an entity purchase, the company redeems the interest. In a hybrid structure, one party commonly has the first option and the other bears a mandatory fallback obligation if the option is not exercised. The arrangement in Connelly itself was hybrid in that the surviving brother had a first option and the corporation had a redemption obligation if he declined.
The practical difference for funding is profound. With entity purchase, corporate-owned life insurance is convenient and scales more easily as owner counts rise, but Connelly shows that corporate-owned death proceeds can also increase the company’s estate-tax value. With cross-purchase, the surviving owners usually obtain direct basis in the acquired interest under the general cost-basis rule, and the company’s value is not increased by a policy the company never owned. For partnerships and many LLCs taxed as partnerships, a section 754 election can also produce inside-basis adjustments when an ownership interest is transferred.
Not every trigger should be funded the same way. Death often fits life insurance. Disability may fit disability buyout coverage plus a note. Retirement rarely fits insurance and is often better matched to reserves, installment notes, or external financing capacity. Divorce, bankruptcy, termination, or deadlock events often need forced-transfer pricing rules with deferred payment mechanics because insurance is either unavailable or impractical. That is why the agreement should be drafted as a funding stack, not a single funding tool.
A practical comparison is below.
| Structure | Who buys the interest | Typical cash source | Valuation advantage | Main valuation risk |
|---|---|---|---|---|
| Cross-purchase | Remaining owners | Owner-owned life insurance, owner capital, notes | Buyers usually get direct cost basis; avoids company-owned death-proceeds issue | Becomes complex as owner count rises; can be uneven if ownership percentages change |
| Entity purchase | Company redeems | Corporate-owned life insurance, reserves, borrowing | Easier administration with many owners | After Connelly, company-owned insurance may increase value without offsetting redemption liability for estate-tax valuation |
| Hybrid or wait-and-see | First option to owners, fallback to company or vice versa | Split insurance design, reserves, notes | Flexible at the time of actual trigger | Ambiguity if priorities, deadlines, and appraisal mechanics are not explicit |
| Sinking fund or reserve model | Owners or entity depending on structure | Operating cash set aside over time | Useful for retirement or scheduled exits | Chronic underfunding if value grows faster than reserves |
| Loan or installment note | Owners or entity depending on structure | Bank line, seller note, internal installment | Good shortfall backstop | Debt capacity may contract exactly when the trigger occurs |
| Disability buyout design | Owners or entity depending on structure | Disability coverage plus note/reserves | Makes a hard-to-fund trigger more manageable | Long elimination periods and uncertain claim timing can cause interim cash mismatches |
The table above synthesizes the legal mechanics reflected in Connelly, general tax rules on insurance proceeds and basis, partnership basis-adjustment rules, and common buy-sell continuity planning practice.
A strong agreement therefore sizes funding by reference to a valuation range, not merely a single estimated value. The simplest formula is:
Required liquidity = expected transfer price + transaction costs + tax friction + working-capital buffer − existing reserves − committed lender proceeds.
That formula is not statutory language; it is a planning model. But it captures the commercial reality that buy-sell funding sufficiency depends on more than the nominal purchase price.
Valuation Methods, Discounts, and Trigger Design
The first drafting step is to specify the valuation assignment itself. ASA standards require the appraiser to identify the type of entity, the business interest under consideration, the applicable standard of value, the premise of value, the level of value, and the valuation date. AICPA guidance likewise warns that buy-sell terms can affect scope, standard and level of value, discounts, and methodology. That means an agreement that says only “fair value as determined by an appraiser” is often incomplete.
The standard of value, premise of value, and level of value
The standard of value answers whose economics govern the pricing task. The most common buy-sell standard is fair market value, but some agreements use fair value, investment value, or a contract-specific definition. The premise of value asks whether the company is valued as a going concern, orderly liquidation, forced liquidation, or another premise. The level of value asks whether the result is a controlling interest, marketable minority interest, or nonmarketable minority interest. Each of those choices changes the funding need, sometimes materially.
Market approach
The market approach compares the subject company or interest with market evidence from comparable businesses. ASA states that the market approach determines a value indication by using methods that compare the subject to similar businesses or interests that have been sold. ASA’s statement on the Guideline Public Company Method adds that publicly traded comparables can provide objective, empirical data for valuation ratios when adequate and relevant information exists. IVS likewise describes both the comparable-transactions method and the guideline publicly traded comparable method, and emphasizes that adjustments are often required for differences in profitability, growth, marketability, control, geography, and legal form.
For funding triggers, the market approach is especially useful when the agreement wants a real-market benchmark that can be refreshed quickly and explained to non-specialist stakeholders. It is strongest where there are credible comparable companies or recent transaction data. It is weakest when the business is too unique, too small, or too owner-dependent for comparables to be meaningfully adjusted.
Income approach and discounted cash flow
ASA defines the income approach as a method through which anticipated benefits are converted into value. IVS explains that under the income approach, future cash flows are converted into a present value, and that all methods under the income approach are variations of discounted cash flow. IVS’s DCF framework specifically calls for decisions about cash-flow type, explicit forecast period, cash-flow forecasts, terminal value, and discount rate.
For buy-sell funding, the income approach is often the most decision-useful method where the company is private, the actual economics depend on expected future performance, and comparables are weak. It is also the method most likely to magnify disputes if the forecast assumptions are not governed by contract. An agreement should therefore say whether management forecasts are presumed reliable, whether normalized earnings are used, whether owner compensation is adjusted, and whether nonrecurring items are included or excluded. Otherwise, the parties can end up litigating the forecast rather than the transfer.
Asset-based approach
ASA’s asset-based standard states that the approach is appropriate in the circumstances specified by the standard, and IVS continues to recognize cost and asset-based approaches as one of the principal families of valuation methods. In buy-sell contexts, the asset-based approach is commonly most informative for holding companies, real-estate-heavy businesses, investment entities, distressed businesses, or situations where net asset value is a binding floor. For many operating companies, it is better as a corroborative check than as the sole pricing method.
Guideline public comparables and guideline transactions
Both ASA and IVS treat guideline public company data and guideline transaction data as core market-approach methods. IVS states that comparable transactions should ideally be arm’s-length, recent, reliable, and sufficiently similar, and that actual transactions generally provide better evidence than intended or announced transactions. It also explains that publicly traded comparables provide readily available market metrics and public filing information, but only where the subject is sufficiently similar to support meaningful comparison.
These methods matter to funding because they help determine whether the buy-sell price should track a market multiple, a transaction multiple, or a weighted blend. If the agreement references “EBITDA multiple” without saying whether the multiple is derived from public companies, private transactions, or internal historical transactions, the funding mechanism can become unpredictable.
Discounts, premiums, minority interests, and option pricing
ASA’s discount-and-premium standard requires that the base value to which a discount or premium is applied be clearly defined and that the appraiser explain why the adjustment applies and how it was derived. IVS elaborates that a DLOM is appropriate when the comparables have superior marketability to the subject asset and notes that DLOM may be quantified using option-pricing models, restricted-stock studies, or pre-IPO studies. The same IVS material explains that control premiums and discounts for lack of control are used to reflect differences in decision-making power and that public-company methods may require a control premium when valuing a controlling interest, while transaction methods may require a DLOC when the comparable transactions represent controlling-interest deals but the subject is a minority interest.
The IRS DLOM Job Aid, while explicitly nonprecedential, is still useful as a cautionary document because it underscores that marketability discounts are fact-intensive and often controversial in estate and gift contexts. For buy-sell agreements, the practical drafting implication is not to force a discount or premium by implication. State it. If the parties intend a pro rata enterprise value with no minority or marketability discount, say that. If they intend fair market value of the actual interest, say that instead. Ambiguity is expensive.
Timing and trigger design
A trigger event does not answer the harder timing question: as of what date is value measured? That question should be customized by event type.
| Trigger | Common valuation date choice | Why it matters |
|---|---|---|
| Death | Federal estate-tax value is generally measured at date of death, subject to any valid alternate valuation-date election; the contract may separately specify date of death, month-end, or another administrative pricing date for the buy-sell price | Avoids conflating the contract purchase price with the federal estate-tax valuation |
| Disability | End of elimination period, date of permanent disability certification, or staged dates | Avoids buying out temporary disability too early |
| Retirement | Date of retirement notice, last day of service, or scheduled closing date | Helps coordinate note and tax planning |
| Divorce | Date of court order, final decree, or transfer notice | Avoids mismatch with domestic-relations timing |
| Bankruptcy | Filing date, adjudication date, or forced-transfer notice | Limits value manipulation during distress |
| Termination for cause or voluntary resignation | Effective separation date or notice date | Prevents post-exit windfalls or punitive underpricing |
The point is not that one answer is universally correct. The point is that the agreement should not leave the answer open. AICPA’s buy-sell guidance emphasizes that agreement terms affect methodology and discounts, and common trigger-event discussions from AICPA-related succession planning sources show that death, disability, retirement, divorce, and similar events are regularly addressed in buy-sell language.
A fixed-price certificate can still have value, but only if it is refreshed regularly and paired with a fallback appraisal procedure. The facts in Connelly illustrate the danger of drifting away from an outside-appraisal process just when the agreement is invoked.
Drafting, Tax, Legal, Governance, and Dispute Resolution
The tax-law anchor is section 2703. The statute and regulations generally disregard an option, agreement, or restriction for transfer-tax valuation unless the arrangement is a bona fide business arrangement, is not a device to transfer property to family members for less than full and adequate consideration, and is comparable to similar arm’s-length arrangements. The regulations also explain that “general business practice” is not proven by isolated comparables and that one recognized valuation method may be acceptable even if more than one method is common in the business. In short, the agreement must be commercially real, not merely tax-motivated, and its valuation mechanism must look like something independent parties could actually have negotiated.
Treasury’s estate-tax valuation regulations also matter directly to funding. For stock without reliable market quotations, the regulation points to the company’s net worth, prospective earning power, dividend-paying capacity, and other relevant factors, and expressly requires consideration of nonoperating assets, including life-insurance proceeds payable to or for the benefit of the company. The same regulation recognizes that an option or contract price may be disregarded unless the arrangement is a bona fide business arrangement and not a device to transfer shares below adequate consideration, with section 2703 providing special rules for post-1990 arrangements.
That framework helps explain why Connelly landed where it did. The Court emphasized that a redemption obligation at fair market value does not offset life-insurance proceeds because a fair-market-value redemption does not change the economic position of the shareholders. In practical planning terms, that means entity-purchase agreements funded with corporate-owned policies should be re-modeled for estate-tax exposure, especially where the agreement is intended to redeem the interest of a shareholder whose estate may be taxable.
For income-tax purposes, life-insurance death proceeds are generally excluded from gross income when paid by reason of death. However, the exclusion can be limited by the transfer-for-value rule and by the employer-owned life-insurance rules in section 101(j). Section 264 generally disallows deductions for premiums where the taxpayer is directly or indirectly a beneficiary under the policy. For business-owned policies, the section 101(j) notice-and-consent rules, applicable exceptions, and Form 8925 reporting should be checked before assuming the proceeds will be fully income-tax-free.
Entity choice can change the post-closing economics. IRS practice-unit materials state that tax-exempt income, including life-insurance proceeds, can increase S-corporation shareholder stock basis. Depending on timing and allocation rules, some redemption structures may create favorable stock-basis results, but those outcomes are fact-specific and should be reviewed by tax counsel rather than assumed. For partnerships and LLCs taxed as partnerships, a valid section 754 election, or limited mandatory adjustment rules in certain cases, can produce inside-basis adjustments under sections 734(b) and 743(b) after qualifying transfers or distributions. For surviving owners, that may make a cross-purchase-style result economically more attractive than a redemption, even before Connelly is considered.
State law determines whether the transfer mechanics will be enforceable. Delaware corporate law expressly permits written transfer restrictions, including forced offers, mandatory purchases, consent rights, and automatic transfer provisions, and presumes restrictions adopted to preserve tax advantages to be for a reasonable purpose. Delaware LLC law is even more contract-focused: it gives strong effect to the LLC agreement, permits events specified in the agreement to control dissolution or continuation, and expressly provides that death, retirement, resignation, expulsion, or bankruptcy of a member does not dissolve the LLC unless the agreement says otherwise. That is a powerful reminder that funding logic belongs inside the governing documents, not in a disconnected side letter.
Governance should be drafted with the same care as valuation and tax. AICPA valuation standards distinguish between a full valuation engagement and a calculation engagement. The former culminates in a conclusion of value; the latter is a limited-scope engagement resulting in a calculated value. A calculation engagement is not inherently improper; AICPA materials recognize both valuation engagements and calculation engagements. For a binding buy-sell trigger involving tax, estate, lender, or dispute risk, however, a full valuation engagement is usually more defensible because it allows the valuation analyst to select appropriate approaches and methods and express a conclusion of value.
Disputes should be preplanned too. The American Arbitration Association publishes a standard commercial arbitration clause and explains that, absent a mutual neutral selection, it can use a rank-and-strike process to appoint neutrals. For a buy-sell agreement, that matters because the dispute often is not whether a transfer must occur, but how quickly an appraiser or arbitrator can resolve the purchase price so the business can keep functioning. A good clause should therefore separate three issues: emergency operational relief, appraisal mechanics, and final dispute resolution.
The most useful drafting checklist for advisors is therefore not a list of trigger events alone. It is a coordinated matrix of: governing document location, transfer restriction validity, valuation standard, valuation date by event, specific methods allowed or weighted, discount and premium treatment, treatment of insurance proceeds, required documentation, funding waterfall, note terms, basis and tax review, and dispute pathway. If any of those boxes are blank, the funding plan is almost certainly weaker than it looks.
Worked Examples and Sample Clauses
The examples below are purely hypothetical. They are intended to show how valuation outcomes can make the same insurance design look either sufficient or dangerously thin.
Worked example showing entity-purchase shortfall risk after Connelly
Assume a corporation has an operating value of $10,000,000 before the death of Owner A. The corporation owns a $4,000,000 policy on Owner A. Owner A owns 60% of the company. The agreement says the company must redeem at fair market value as of the date of death.
| Item | Amount |
|---|---|
| Pre-death operating value | $10,000,000 |
| Corporate-owned death benefit | $4,000,000 |
| Estate-tax valuation base if proceeds are included | $14,000,000 |
| Owner A percentage | 60% |
| Indicated redemption price | $8,400,000 |
| Insurance available | $4,000,000 |
| Immediate funding shortfall | $4,400,000 |
This is the Connelly problem in simple form. If the agreement or insurance design assumed the corporate policy would fund most of the redemption, but the valuation base increases because the company owns the death proceeds, the purchase obligation can outrun the actual cash by millions. The usual repair mechanisms are reserves, a committed line, or a promissory note. The better repair is ex ante: redesign the structure or coverage assumptions before the claim occurs.
Worked example showing cross-purchase sufficiency and buyer basis
Now assume the same $10,000,000 operating value, but Owner A owns 40% of the company and the surviving owner or owners own a $4,000,000 policy on Owner A personally.
| Item | Amount |
|---|---|
| Operating enterprise value | $10,000,000 |
| Owner A percentage | 40% |
| Purchase price | $4,000,000 |
| Death benefit paid to surviving owner(s) | $4,000,000 |
| Immediate funding shortfall | $0 |
| Purchaser’s tax basis in acquired interest under cost basis concept | $4,000,000 |
Under the general cost-basis rule, the buyer takes basis equal to cost. If the business is organized as a partnership or LLC taxed as a partnership, a section 754 election may also allow inside-basis adjustments that improve post-closing tax economics. That does not make cross-purchase universally better, but it does explain why valuation professionals and estate planners often revisit structure after Connelly.
Worked example showing disability funding sufficiency under different valuation outcomes
Assume a 30% owner of a services firm becomes permanently disabled under the agreement after a 12-month elimination period. The buyout price is based on normalized EBITDA multiplied by a market multiple, minus debt.
| Assumption | Scenario A | Scenario B |
|---|---|---|
| Normalized EBITDA | $1,800,000 | $1,500,000 |
| Selected multiple | 4.5x | 4.2x |
| Enterprise value | $8,100,000 | $6,300,000 |
| Debt | $(1,200,000) | $(900,000) |
| Equity value | $6,900,000 | $5,400,000 |
| Disabled owner percentage | 30% | 30% |
| Buyout price | $2,070,000 | $1,620,000 |
| Disability policy proceeds | $1,200,000 | $1,200,000 |
| Sinking fund | $500,000 | $500,000 |
| Note required | $370,000 | $0 |
The takeaway is not that disability insurance is weak. It is that disability triggers usually need at least one secondary funding source because valuation can move materially during the elimination period, and the final purchase date may not line up with policy timing. The contract should therefore specify whether the note is mandatory if policy proceeds are short and whether there is any true-up if the final value changes after an interim payment.
Worked example showing retirement underfunding from stale fixed-price design
Assume a retirement trigger for a 35% owner.
| Item | Stale fixed-price design | Updated appraisal design |
|---|---|---|
| Last certificate of value | $7,000,000 | — |
| Current appraised equity value | — | $9,000,000 |
| Retiring owner percentage | 35% | 35% |
| Purchase price | $2,450,000 | $3,150,000 |
| Existing sinking fund | $2,500,000 | $2,500,000 |
| Surplus or shortfall | $50,000 surplus | $650,000 shortfall |
This is the classic “agreement looks funded until it is used” problem. A fixed certificate that is not refreshed can make the funding plan appear adequate while the real transfer price has moved far away. Retirement is especially exposed because it is often the trigger least likely to be insured and most likely to be funded with reserves or debt.
Sample clauses linking valuation to funding
The clauses below are educational models only. They should be rewritten by local counsel for the governing entity, tax classification, and insurance design. They reflect the core themes found in section 2703, Delaware entity law, AAA dispute mechanisms, and AICPA/ASA valuation standards.
Sample clause for standard of value and level of value
For each Trigger Event, the Purchase Price shall equal the Fair Market Value of the
Subject Interest as of the Valuation Date, determined on a going-concern premise.
Unless this Agreement expressly states otherwise, the appraisal shall value the
actual interest being transferred and shall apply only those discounts or premiums
that are consistent with the stated standard of value, premise of value, level of
value, and facts of the Subject Interest. No additional formula discount or premium
shall apply by implication.
Why it works: it states the standard, premise, and level of value clearly while letting the appraiser apply only those discounts or premiums that are appropriate to the actual interest being transferred.
Sample clause for annual certificate with appraisal fallback
Within 90 days after the end of each fiscal year, the Owners shall attempt in good
faith to execute a written Certificate of Equity Value for the Company. If no current
Certificate of Equity Value exists on the Valuation Date, or if the Trigger Event
occurs more than 12 months after the effective date of the last certificate, the
Purchase Price shall be determined by an independent valuation engagement performed
in accordance with the valuation provisions of this Agreement.
Why it works: it preserves administrative simplicity but blocks stale-price drift. If an agreement requires periodic valuation updates, failing to update the value can create additional tax-risk analysis under the section 2703 regulations — the safer drafting approach is to require an appraisal fallback when the last agreed value is stale.
Sample clause for appraiser selection and deadlock
The Company and the Transferring Owner or the Owner's legal representative shall each
select one independent credentialed business valuation professional within 10 business
days after written notice of a valuation determination. The two selected professionals
shall jointly determine the fair market value of the Subject Interest. If they do not
agree within 20 business days, they shall appoint a third independent credentialed
business valuation professional, whose determination shall be final and binding absent
manifest error.
Why it works: it gives a deadline, competence standard, and final tie-breaker.
Sample clause for funding waterfall
The Purchase Price shall be funded first from insurance proceeds specifically maintained
for the applicable Trigger Event, second from any designated buy-sell reserve account,
third from available third-party financing, and fourth from a promissory note payable
over not more than 60 months at the Prime Rate plus 2.00%, with prepayment permitted
at any time without penalty.
Why it works: it turns “we intend to fund this somehow” into a closing sequence. Interest rate, security, default, subordination, usury, and lender-consent provisions should still be reviewed under applicable state law and existing credit documents.
Sample clause for disability specificity
"Permanent Disability" means the inability of an Owner, as certified by two independent
physicians acceptable to the non-disabled Owners, to perform the material duties of
such Owner's customary role in the Business for a continuous period of 12 months, with
no reasonable expectation of return to full-time active service within the succeeding
6 months.
Why it works: it avoids overreliance on policy wording alone.
Sample clause for arbitration of residual disputes
Any controversy arising out of or relating to the interpretation or enforcement of
this Agreement, other than the arithmetic implementation of a final appraisal
determination, shall be settled by arbitration administered by the American Arbitration
Association under its Commercial Arbitration Rules, and judgment on the award may be
entered in any court having jurisdiction.
Why it works: it follows the AAA model language while carving appraisal arithmetic away from full merits litigation.
Frequently Asked Questions
What is the single biggest reason buy-sell funding fails? Usually it is not the absence of insurance. It is the absence of a current valuation framework. A stale fixed price, an undefined standard of value, or an omitted discount policy can make the agreement look fully funded until the trigger actually occurs.
Does Connelly make entity-redemption agreements unusable? No. It makes them harder to model correctly. The decision means company-owned life-insurance proceeds can increase company value for estate-tax valuation without an offsetting reduction for the redemption obligation, so entity-redemption plans need refreshed valuation and tax analysis rather than automatic abandonment.
Should a buy-sell agreement use fair market value or fair value? There is no universal answer. What matters is defining the term precisely and pairing it with a premise and level of value. AICPA expressly warns that buy-sell terms can create unintended standards and discount outcomes if left loose, and ASA standards require the standard and level of value to be identified.
Should discounts for lack of control or marketability apply? Only if the agreement says they do, or if the chosen standard of value and actual interest being valued make them appropriate. ASA requires the base value and rationale for each discount or premium to be defined, and IVS explains when DLOM, control premiums, and DLOC are typically applied.
How often should the valuation be updated? At least annually, and more often after major changes in earnings, debt, acquisitions, owner mix, or litigation risk. That is a best-practice recommendation grounded in the standards’ emphasis on valuation date, scope, and current facts rather than a statutory interval requirement.
Can insurance be the sole funding source? Sometimes for death triggers in well-sized plans, yes; but for disability, retirement, and valuation-growth scenarios, insurance alone is frequently insufficient. Most robust agreements therefore combine insurance with reserves, debt capacity, or installment notes.
Is a calculation engagement good enough for a trigger event? Often not. AICPA distinguishes between a calculation engagement and a valuation engagement, and a trigger event that forces an actual transfer usually benefits from the fuller process and better documentation of a valuation engagement.
Why do LLC operating agreements need special attention? Because LLC law is highly contract-driven. Delaware’s LLC Act allows events specified in the operating agreement to control dissolution and continuation, and it generally prevents death, retirement, resignation, expulsion, or bankruptcy from causing dissolution unless the agreement says otherwise. The buy-sell mechanism must therefore be harmonized with the operating agreement.
Can disputes over valuation be arbitrated instead of litigated? Yes. AAA publishes model arbitration language and commercial procedures. Parties can also use appraisal clauses for price determination and reserve arbitration for interpretation and enforcement disputes.
What is the right advisor checklist before signing a buy-sell agreement? Confirm the trigger events, standard of value, premise, level of value, valuation date, methods allowed, discount rules, treatment of insurance proceeds, funding waterfall, note terms, tax review, governing-document consistency, and dispute path. If any of those items are uncertain, the agreement is not truly finished.
Key Sources
- Treasury regulations on valuation of stocks and bonds (26 CFR 20.2031-2) and property subject to restrictive arrangements (26 CFR 25.2703-1)
- Connelly v. United States, No. 23-146 (U.S. Supreme Court, 2024)
- Internal Revenue Code sections 264, 101(a)(1), 101(j), and 754
- Internal Revenue Manual business valuation guidelines and IRS practice unit on S corporation stock basis and life-insurance proceeds
- AICPA Statement on Standards for Valuation Services, VS Section 100, and AICPA buy-sell agreement guidance
- ASA Business Valuation Standards (income, market, asset-based approaches; discounts and premiums)
- International Valuation Standards Council (IVS) guidance on valuation approaches, DCF, comparables, and discounts
- Delaware General Corporation Law section 202 and Delaware LLC Act sections 18-1101 and 18-801
- American Arbitration Association Commercial Arbitration Rules and standard clause
- National Association of Insurance Commissioners consumer guidance on life and disability income insurance