Business Valuation Issues in Shareholder Disputes

October 2014       Download PDF      Print

Shareholder disputes often involve a minority owner who believes he has been mistreated or disagrees with decisions made by the controlling owner. Sometimes, such disagreements can be too significant to resolve peacefully and lead to costly and time-consuming litigation. This can be a major distraction for company leadership and therefore have a deteriorating effect on a business' value. Often, these disputes lead to a minority shareholder or business partner leaving the company.

Shareholder dispute claims are typically classified as either dissenting shareholder actions or minority oppression actions. Some of the most common events triggering shareholder disputes include:

  • Deceptive practices
  • Diversion of income
  • Involuntary dissolution of a business
  • Non-payment of distributions
  • Breach of contract

Business valuation experts often play an important role in resolving shareholder disputes by providing independent and unbiased opinions of value for the shares in question. For the most part, business appraisers use the same process and methodology for shareholder disputes as they use for other types of engagements. However, attorneys and their experts should be mindful of several aspects of business valuation that are unique to shareholder disputes.

Avoid Disputes with a Buy-Sell Agreement

Many shareholder disputes often could have been resolved before entering litigation had the owners drafted a buy-sell agreement. Valuation experts can play an instrumental role in helping owners and their attorneys draft provisions in buy-sell agreements that can be extremely valuable in resolving disputes and minimizing the likelihood of lengthy and expensive court battles.

Key provisions of buy-sell agreements may describe the situations in which a shareholder is allowed or required to buy out the shares of another shareholder and outline how the value of said shares should be determined. Establishing mechanisms to determine share value is particularly important, as arguments over pricing issues can prolong litigation. These mechanisms may come in the form of an agreed-upon-value, a valuation formula, or a set of guidelines for hiring a third-party valuation professional.

If the agreement calls for a third-party appraisal, it should also specify business valuation components, such as standard and premise of value, the valuation date, and the use of valuation discounts. Each of these components, when applied inconsistently, can have a significant impact on the resulting conclusion of value and having them clearly defined can minimize the likelihood of a dispute over share value. Even if a dispute does enter litigation, the terms of the buy-sell agreement could be upheld by the court. When parties do not have a buy-sell agreement with these valuation components specified, shareholder disputes can be dragged out due to the complex statutes and case law surrounding them, which are discussed in the sections below.

Standard of Value in Shareholder Disputes

Valuation professionals must identify and define the appropriate standard of value before proceeding with any appraisal. A standard of value is a set of hypothetical conditions under which the business will be valued. There are several generally accepted standards of value, including fair market value, fair value, and investment value. Choosing the right standard of value and applying it correctly is important as each standard can yield different opinions of value. This is often challenging in a litigation setting, as the correct standard varies depending upon the nature of the case and jurisdiction. Therefore, it is particularly important that attorneys communicate with their valuation experts to ensure they understand standard of value in the context of shareholder disputes in a particular state.

Every state has its own shareholder rights laws, often referred to as dissenting shareholder statutes or minority oppression statutes, which provide protections for minority shareholders. Many states have relied on the Model Business Corporation Act ("MBCA") as a foundation for establishing these statutes. Accordingly, a common remedy in dissent or oppression actions is to require the controlling shareholder to buy out the minority shareholder's interest at "fair value".

While the term "fair value" is widely used in these statutes, it is almost always vaguely defined. Most states have adopted definitions either identical or similar to the one set forth in the 1984 revised version of the MBCA, which reads:

"Fair value," with respect to dissenter's shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding the appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable." 1

As noted, some jurisdictions have removed some parts of the MBCA's fair value definition or, instead of using "fair value", have used "fair cash value", "value", or "fair market value". States may also require one standard of value in dissent cases and another in oppression cases. Because statutory fair value definitions are typically vague, and because it is similar to fair market value, there is often confusion surrounding how to correctly determine fair value. The blurred distinctions between fair market value and fair value can lead appraisers to make incorrect assumptions in their valuations. Some of the primary differences between these two standards of value are outlined below.

Differences Between Fair Market Value and Fair Value2
Fair Market Value Fair Value
1. Willing buyer 1. Not always a willing buyer
2. Willing seller 2. Not a willing seller
3. Neither under compulsion 3. Buyer not always compelled; seller under compulsion
4. Assumes a typical hypothetical buyer and seller 4. The impact of the proposed transaction not considered; the concepts of fairness to the seller a possible consideration
5. A price equitable to both 5. A concept of "fairness" to the seller, considering the inability to keep the stock
6. Assumes buyer and seller have equal knowledge 6. No such assumption
7. Assumes reasonable knowledge of both parties 7. No such assumption
8. Applicable to controlling interests or minority blocks 8. Applicable to minority blocks
9. Applies to all federal tax valuations 9. The most common value standard in state dissenting and oppressed shareholder statutes

One of the major differences between the two standards is that under fair market value, appraisers may apply valuation discounts, such as the discount for lack of control (DLOC) and discount for lack of marketability (DLOM), to obtain the value for minority interests. On the other hand, fair value often does not involve the application of valuation discounts. As with standard of value, the applicability of discounts may also vary from state to state.

Valuation Discounts in Shareholder Disputes

Whether valuation discounts should be applied in a fair value context is often subject to contentious debate in shareholder disputes. As already noted, the majority of states use the fair value definition set forth in the 1984 revised MBCA; however, the definition was revised again in 1999 to read:

"Fair value," with respect to dissenter's shares, means the value of shares immediately before the effectuation of the corporate action to which the dissenter 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, for amendments to the certificate of incorporation pursuant to section 13.02." 3

The primary difference between the 1984 definition and the 1999 version is that the latter addresses the inapplicability of valuation discounts. Few states have integrated this update into their statutes, but the new definition has been referenced in several shareholder dispute cases as support for the exclusion of valuation discounts. While there is currently no clear consensus among states on whether fair value calculations should include the application of discounts, the trend appears to be moving towards excluding them.

Some jurisdictions may reject the use of discounts altogether, while others may allow for the application of one discount, such as the DLOM, but not for the DLOC. Some states rely on the discretion of the court to decide on the applicability of discounts based on the unique circumstances of each case. In jurisdictions where statutes provide no direction on this topic, parties often turn to precedential case law.

Delaware case law is often cited in these situations, and one shareholder dispute case that provides some guidance on the applicability of discounts is Cavalier Oil Corp. v. Harnett. In Cavalier Oil, the Delaware Supreme Court held the following:

"Discounting individual share holdings injects into the appraisal process speculation on the various factors which may dictate the marketability of minority shareholdings. More important, to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority of shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result." 4

The decision in the case above, and the primary argument against applying discounts, is based on the concept of fairness to the seller. The underlying logic is that by applying a discount, the controlling shareholders would be paying less than the pro-rata value for the minority shareholder's shares, and would therefore be unjustly rewarded.

The New Jersey Supreme Court made two rulings on the same day that illustrate how some states apply discounts on a case-by-case basis to ensure all shareholders are treated fairly. In one ruling, Balsamides v. Protameen Chemicals, Inc., one shareholder was ordered to sell his interest to his partner, who was the oppressed shareholder. The court allowed for a 35% DLOM because the oppressed shareholder would incur the effects of diminished value if he ultimately sold the business due to the lack of marketability of privately held companies. In the other case, Lawson Mardon Wheaton, Inc. v. Smith, the court ruled against the DLOM, stating that dissenting shareholders should not be penalized for exercising their statutory rights.5

Given how the complex rules associated with the application of discounts can vary from state-to-state, attorneys and their appraisers should have a firm understanding of the statutes and case law surrounding the subject in their particular jurisdiction.

Valuation Date & Timing Issues

It is important to note that business valuations are an estimate of value at a particular point in time. Many dissenting shareholder statutes provide that fair value should be determined as of the day before the meeting of shareholders at which the proposed action was dissented from. Similarly, many minority oppression statutes state that fair value should be determined as of the date of the commencement of the oppressing action.

The concept of whether any elements of information unknown at the time of the dissenting or oppressing action should be considered in fair value calculations is another issue that arises in shareholder disputes. Rules on this topic may vary between jurisdictions and depend on the type of dispute.

For example, in New Jersey's dissenting shareholder statutes, the dissenting shareholder cannot receive credit for any appreciation in value, nor can they be penalized for any loss in value, that comes from the action in question. The New Jersey statute that applies in oppression cases states that value can be adjusted "plus or minus any adjustments deemed equitable by the court".6 In comparison, Delaware courts have allowed for the consideration of elements of future knowledge in fair value calculations in dissenting shareholder cases.

Communicate the Rules

There are other valuation subtleties to consider in shareholder disputes besides standard of value, discounts, and timing factors. The laws surrounding these issues should be considered equally before any valuation engagement begins. While experienced valuation experts may understand some of the rules within some jurisdictions, many of them will rely on the advice of the attorney. Therefore, it's important the attorneys assess their valuation expert's understanding of these issues and clearly define them, as it can ultimately have a significant impact on value and the court's decision.

[1] Model Business Corporation Act § 13.01(3)(ABA 1984).
[2] Trugman, Gary R. Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses.
[3] Model Business Corporation Act § 13.01(4)(ABA 1999).
[4] Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989).
[5] Ibid.
[6] N.J.S.A. Section 14A:12-7(8)