Shareholder disputes involving valuation issues often arise upon the execution of “triggering events” such as the death, retirement, or disablement of a shareholder.1 Too often, shareholders’ agreements, although designed to mitigate or avoid disputes, contain faulty, incomplete, or contradictory language concerning valuation, which serves to create or to aggravate controversies.2 The likelihood of a shareholder dispute can be eliminated or mitigated through the careful consideration of valuation provisions in shareholders’ agreements related to six basic questions: who, what, when, where, why, and how?
Who Perceives Value?
In business valuation theory, the question “who perceives value” addresses the concept of the standard of value.3 Classically, four standards of value exist: Intrinsic Value, Fair Market Value, Investment Value, and Fair Value. Intrinsic Value refers to a positive estimate of what value should be despite certain market based indications. For example, a stock analyst’s assessment of a company’s shares as a “buy” or a “sell” relative to the current market price reflects such a standard. As the standard of Intrinsic Value constitutes a positive versus a normative concept in relation to market-based indications, it typically applies to public companies and is rarely involved in shareholder disputes. The standard of Fair Market Value, defined as follows, finds widespread application in tax matters:
. . . the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.4
A key aspect of this definition is the “hypothetical” nature of both the buyer and seller. By hypothetical, specific attributes such as tax bases, motivations, investment acumen, and financial wherewithal typically cannot be assumed.5 Accordingly, the hypothetical buyer/seller represents an amorphous amalgamation of the universe of potential investors. In contrast, Investment Value refers to value by a specific buyer. In the context of shareholder disputes, consideration of an equity interest’s value in the hands of the company (frequently the eventual buyer in a shareholder dispute) or by a specific shareholder (e.g., a controlling shareholder) constitutes an aspect of Investment Value. Fair Value, frequently the standard of value under state law concerning shareholder disputes, is described by the Model Business Corporation Act (“MBCA”) (as amended in 2005) as follows:
. . . the value of the corporation’s shares determined: immediately before the effectuation of the corporate action to which the shareholder objects; using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal; and without discounting for lack of marketability or minority status except, if appropriate . . .6
Since this definition, unlike the standards of Fair Market Value and Investment Value, does not stipulate as to the nature of the buyer and seller, Fair Value tends to reflect a modified form of both/either Fair Market Value and/or Investment Value. In these situations, issues such as the applicability of discounts for lack of control and lack of marketability, as well as premiums for certain corporate tax structures (e.g., S corporation premiums) should be specifically addressed. If a shareholders’ agreement requires a third-party valuation by a professional, the question of “who” may also concern the person or firm hired to perform any valuation potentially required by a third-party professional. In answering this question of “who,” specific individuals, firms, or professional designations may be cited. However, in so doing, flexibility should be incorporated or the named individual/organization should be frequently updated to reflect changes in the employment status or health of the individual, the nature of the company, or relevant professional standards.
What Is Being Valued?
Many shareholders’ agreements fail to answer what interest is the subject of the valuation. Intuitively, since a shareholders’ agreement governs shareholders, and thus by extension their equity interests, it suggests the respective shareholders’ equity interests need to be valued. Frequently, however, shareholders’ agreements use language such as “the value of the Company.” Such a statement may not reflect equity value, but rather enterprise value (the total capitalization of a company, which includes both equity and debt). Complicating matters further may be the existence of a complex capital structure involving convertible debt, mezzanine debt, preferred stock, etc. A shareholders’ agreement should incorporate specific language as to the interest to be valued.
When Is Value Being Determined?
Many shareholders’ agreements fail to address when value should be assessed. Timing is critical to value as it determines that information and events were known or knowable as of the valuation date. The aforementioned MBCA specifically notes value as of the point in time “immediately before the effectuation of the corporate action.” However, this language does not specifically address the consideration of the effect of the corporate action if known as of the valuation date. That is, if the corporate action itself was known and likely (but not effected) as of the valuation date, how should its impact upon value be assessed? Similar to corporate actions, triggering events such as the death of a key employee/shareholder may generate real and significant financial repercussions. Should the anticipated loss of sales due to the death of a key employee/shareholder be considered as known or knowable in determining value?
The known or knowable concept involves both the existence of a fact as well as knowledge about it. The latter concept begs the question: knowledge by whom? Typically the known or knowable concept is applied to that of a hypothetical buyer in the interest to be valued. But, should price multiples derived from public companies be applied to financial metrics (e.g., EBITDA) published subsequent to the valuation? What about financial information concerning the company being valued published months after the valuation date? An argument may be made that information external to the company may be treated differently from information internal to the company (since a hypothetical buyer could ask the seller for financial data and representations, which may approximate the information latter prepared). However, many analysts treat such information by the same criterion.
This situation was recently addressed in Estate of Gallagher v. Commissioner, which involved a July 5, 2004, valuation date:
We agree . . . that the June 2004 financial information should be used in valuing decedent’s units. Petitioner argues that the June information was not publicly available as of the valuation date, preventing a willing buyer and seller from relying upon it in determining fair market value. That is not to say, however, that our hypothetical actors could not make inquiries of . . . [the Company] or of the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of-June conditions. Moreover, we understand . . that the June 2004 financial information accurately depicts the market conditions on the valuation date, not that a willing buyer and seller would have relied upon the data.7
A shareholders’ agreement should specify, relative to triggering events, when value should be determined and whether or not it should consider the impact, if known or knowable, of the triggering event.
Where Is the Governing Legal Jurisdiction?
The legal jurisdiction specified within a shareholders’ agreement may govern the standard of value either in its operation (e.g., if it defaults to state law) or if the shareholders’ agreement is superseded by legal action. Some states allow for the application of discounts for lack of control and lack of marketability, but the majority of such states prohibit such discounts.8 Even if state law generally forbids discounts, case law should be consulted. For example, in Illinois, “fair value” is defined as “the proportionate interest of the shareholder in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability” (emphasis added).9 Case law may define such “extraordinary circumstances” or other situations that may warrant the application of discounts. Given the magnitude of the discounts that may or may not be applicable, consideration should be given in determining the legal jurisdiction governing shareholders’ agreements.
Why Is Value Being Determined?
Classically, triggering events include the cessation of a shareholder’s employment by the company due to termination, resignation, disablement, death, or retirement, or the termination of ownership through death, or due to other specified events such as changes in the shareholder’s legal status resulting from a bankruptcy or a divorce. Additional scenarios may also be addressed. For instance, minority interest shareholders may fear being “frozen out” of corporate decision-making. A key concern and frequent area of controversy of corporate actions concerns dividend policy. A minority interest shareholder, concerned about a potential excess build up of investments or working capital in lieu of dividends, may be allowed a put option to sell his or her interest to the company if triggered by certain liquidity ratios or levels of non-operating assets.
How Is Value Being Determined?10
Shareholders’ agreements typically require one of three mechanisms to determine value:
Agreed-upon values require shareholders to state an agreed-upon value at periodic intervals
Put/call processes ensure determinations of value by conveying duality upon purchase offers. That is, one party’s offer to buy shares, if rejected, allows the declining party to purchase the equity interest of the shareholder making the initial offer at the offered price per share
Third-party valuations employ an expert or experts to perform a valuation in accordance with the guidelines of the shareholders’ agreements
Each mechanism possesses unique advantages and disadvantages that should be carefully considered in tandem with the facts and circumstances of the company and its shareholders.
In addition, the issue of the highest and best use of the company should be considered. That is, should the company be valued as a going concern or, if found to be relatively higher, in liquidation? Should this determination vary with in the valuation of a controlling versus that of a non-controlling interest? Depending on the definition answering the question of “who perceives value,” this concept should be specifically addressed.
Conclusion
Too often, during or subsequent to shareholder disputes, parties ask such rhetorical questions as how did this happen, why me, and when will this end? The potential time and cost of dealing with such situations pales in comparison to the expense of properly addressing, in drafting or amending shareholders’ agreements, the questions of who, what, when, where, why, and how as they relate to value.
1 In general, triggering events include the cessation of a shareholder’s employment by the company due to termination, resignation, disablement, death or retirement, or the termination of ownership through death, or due to other specified events such as changes in the shareholder’s legal status due to bankruptcy or divorce.
2 For purposes of this article, no distinction is made between the legal entity involved (e.g., partnership, corporation, etc.) and therefore the name of its corresponding agreement. Similarly, no distinction is made between shareholders’ agreements, buy/sell agreements, or any other agreements by existing shareholders governing the terms and conditions under which equity interests may transact. For all such situations, the term “shareholders’ agreements” has been utilized.
3 The article Shareholder Disputes: What is the Appropriate Standard of Value? by Brian R. Potter addresses this concept and appeared in the Fall 2010 SRR Journal. The article can be viewed at www.srr.com.
4 Rev. Rul. 59-60.
5 The phrases “investment acumen” and “financial wherewithal” in this context refer to differences between the hypothetical buyer and seller and do not indicate an absolute level possessed by either party. Under the fair market value standard, both the buyer and seller are assumed to possess all reasonable knowledge of relevant facts and have the financial means to affect a transaction.
6 Model Business Corporation Act § 13.01(4) (ABA 2005).
7 Estate of Gallagher v. Commissioner, TC Memo 2011-148
8 See, e.g., Pueblo Bancorporation v. Lindoe Inc., 63 P.3d 353, 364 67 (Colo. 2003) (surveying the states’ approaches to “fair value”).
9 805 ILCS 5/12.56 (e)
10 Additional information on the benefits and detriments of various methods in shareholders’ agreements to determine value can be found in the article Valuation Formulas in Shareholders’ Agreements by Christopher P. Casey and Aaron M. Stumpf which appeared in the Fall 2010 issue of this publication and can be viewed at www.srr.com.
