If a dispute between shareholders cannot be resolved, the only thing to be done — other than dissolution or appointing a receiver — is to have a shareholder buy out, so the corporation survives unencumbered by a troublesome shareholder. Troublesome is a misnomer, for usually the one bought out was oppressed in some way by the other shareholder(s), brings a complaint to redress his or her grievances, at which point the other shareholder or shareholders elect to pay him or her off to exit the corporation.
If criminal law involves bad people on their best behavior and divorce law involves good people on their worst behavior, shareholder disputes are somewhere in between. Disputes have erupted between brothers in a family corporation, high school pals, and partners of more than 20 years. Often each knows the others’ dirty laundry. A buyout proceeding functions like a divorce except that the only custody issue involves the corporation. The shares of one shareholder are bought by the other so they can go their separate ways.
The buying shareholder wants a low price and a selling shareholder wants a high price. Usually high hopes preceded the bad times. Bad times refers to the relationship. The relationship can go bad because of either financial failure or success. Failure can engender finger-pointing and scapegoating. Success can engender greed. Either can be fatal to the relationship. At the time of high hopes, often no provision was made in a shareholder agreement for a future buyout or disagreements. Many business people fail to consider and plan for the consequences of failure or success.
Into this emotional maelstrom, the courts want to save the business and fairly treat the departing shareholder. Valuation standards and approaches are key. Valuation is different in a shareholder dispute case. In tax cases, the valuation incentive is often to diminish value to decrease taxes owed. In acquisitions, the fair market value standard assumes arms length bargaining between a willing buyer and a willing seller, neither under duress.
In the market (thus, in a fair market valuation), buying less than a majority of shares usually causes a minority shareholder discount to be applied. If a company’s value is $100, buying 49 percent of the shares is worth less than $49 because of the inability to control the corporation. The majority shareholder could decide to increase salaries at the expense of dividends, for example, diminishing the investment return for the minority shareholder. Liquidity discounts are often applied to shares of corporations that are not publicly traded.
In shareholder disputes, while jurisdictions differ, the most common standard to determine the price of the buyout is “fair value,” not “fair market value.” The fair value is different from the fair market value and often — depending on the jurisdiction — precludes, either as a matter of fact or law, minority discounts or liquidity discounts that apply only to minority shares, even while applying “current and customary” valuation methods as would be used in a similar transaction not arising out of a shareholder dispute. With respect to other valuation issues, such as how to treat non-recurrent expenses or income, excessive salaries, compensation disguised as expense reimbursements, and fraud, the difference between fair value and fair market value is irrelevant.
Another key issue is setting the valuation date. In many cases, the corporate acts that led to the dispute had a significant effect on the value of a business, and therefore on the value of the shares held by the shareholder who seeks a buy-out. While various state statutes and case law can create a few wrinkles in determining the valuation date, most jurisdictions agree that the proper date is the day before the shareholder meeting where the offending corporate act took place. In cases of shareholder oppression, where the dispute is caused more by chronic disagreement or misconduct rather than any one act, the date the complaint is filed or the date a buyout is elected in a pleading is usually chosen as the valuation date. To the extent that wrongful acts affected the fair value, the court can adjust the buyout price.
Valuation opinions must be tied to the valuation date, meaning that retrospective appraisals are necessary. As counter-intuitive as it may seem, events that have occurred after the buyout date that were unforeseeable at the buyout date often — under valuation standards — cannot be considered. The knowledge that each party had as of the time of the valuation date will be taken into account when setting the valuation, however.
Expert testimony is key, but many lawyers unfamiliar with valuation standards in shareholder disputes can get misled by their expert into claiming minority and other discounts appropriate to a fair market valuation but inappropriate in a shareholder buyout in which fair value is the standard. Moreover, it is useful for the lawyer to understand the complex world of valuation credentials. As it stands, there are four major governing bodies that award certification (American Society of Appraisers (ASA), Institute of Business Appraisers (IBA), American Institute of Certified Public Accountants (AICPA), and the National Association of Certified Valuation Experts (NACVA)), each with its own set of requirements. For the most part, the requirements are similar, but they are not identical. For example, an AM from the American Society of Appraisers requires two years of full-time appraisal experience, while a CVA or AVA from the NACVA does not require any on-the-job experience to obtain. In addition, some of these governing bodies offer more than one level of certification, as the ASA awards both the AM but also the more prestigious Accredited Senior Appraiser (ASA) status to its more experienced members.
I once had an expert say that the Institute of Business Appraisers was not a credible source of business valuation standards, then say the Institute’s standards didn’t conflict with anyone else’s, but then admit he didn’t know for sure because he wasn’t a member. Understanding the subtleties and nuances of the certification process can help ensure that the right valuation expert is found for a case, as well as preventing any surprises down the line, such as the opposing party challenging the expertise of your chosen expert. Old fashioned investigation of an expert is also required. I once found a reviewing court opinion criticizing an opposing expert for an “inflated, if not bloated” analysis in another case. It was no surprise that our trial judge declined to rely on his opinions.
Valuation can be an enormously complicated subject, even without the added drama that a shareholder dispute brings to the table. Understanding the basics of the process is only the beginning, as each jurisdiction offers its own twist on valuation, and the specific facts of the case may make things even more complex. In the end, having experienced counsel is essential to this part of the process, and can make all the difference in making sure that a shareholder’s shares are valued fairly for all parties in a case.