Valuations in Shareholder Disputes

by | May 10, 2024 | Taxes

Shareholder disputes are common occurrences in today’s complex business world. These disputes can often be divisive, long-lasting and expensive. They can arise in almost any privately owned business, sometimes without warning.

Here are come common types of lawsuits minority shareholders may file against controlling shareholders:

Dissenters Rights Actions

State law may give corporate shareholders the right to receive cash payment for the “fair value” of their shares, if they don’t consent to a major corporate transaction. This may provide shareholders with an easy way out of the business if they don’t want to be a part of a merger or an acquisition, for example.

Shareholder dissent suits are related to specific actions, such as involuntarily being cashed out in a merger, sale of material assets of the business, recapitalization, or other major changes to the business.

Shareholder Oppression Actions

Oppression actions occur when minority shareholders of closely held corporations assert that they’ve been treated unfairly or prejudicially by those in control and seek dissolution of the company or a buyout of their shares. Oppression remedies are available to shareholders when they establish that the majority has excluded them from their proper share of the benefits accruing from the enterprise.

Standard of Value

Minority shareholders in dissenters’ rights or oppression actions may be entitled to receive the “fair value” of their shares, rather than fair market value. Courts in many states have interpreted this standard of value to equate with an interest’s pro rata share of the company’s entire value on a controlling basis. In other words, no adjustments are allowed to be made to the company’s cash flows or preliminary estimate of value for the interest’s relative lack of control or marketability. In most jurisdictions, fair value also generally excludes any appreciation in value that results from the action to which the minority shareholder dissents.

However, laws and interpretations vary from state to state and may depend on the specifics of the case at hand. So, attorneys and valuators should always discuss the appropriate standard of value, including whether to make adjustments for control and marketability, early in the valuation process.

Shareholder Agreements: Friend or Foe?

Corporate shareholders may enter into contractual agreements to help minimize disputes, specify owners’ rights and restrictions, and outline methods for resolving disputes and redeeming ownership interests.

But these agreements can also cause disputes, if they’re unclear and the parties interpret their provisions differently. These disputes most often arise around the value of the interest being redeemed.

There are a number of ways in which an agreement can set a price, including:

  • A formula built into the agreement (for example, five times the last five years’ average earnings before interest, taxes, depreciation and amortization),
  • Annual (or periodic) setting of the value by the board,
  • Fixed amount of buy-out (for example, $100 for a multi-physician practice buy-in and buy-out),
  • Book value, or
  • Fair market value to be determined by credentialed valuation professionals.

Fixed formulas or valuations based on book value often cause disputes, especially if the company hasn’t followed the agreement for previous buyouts or if the amount was decided arbitrarily many years earlier. Even when the parties use valuation experts, conflicts may arise if the valuators don’t agree on the value of the business interest.

Disputes can often be minimized by proper planning up front. Usually, this consists of a comprehensive, professional shareholder agreement. Here are three key points to keep in mind:

1. The agreement should be written by an attorney. While that sounds simple, some smaller companies may attempt to write their own agreements using canned software or an old agreement as a template. When disputes arise, this can be a recipe for disaster.

2. It’s prudent to have the draft agreement reviewed by a team of people. This team typically includes the company’s top managers (if the entity is a party to the agreement), as well as the company’s accounting and tax professionals. A valuation expert can help ensure you’ve covered all the value-related bases, including defining the appropriate standard of value and outlining a timeline for appraising and redeeming an exiting shareholder’s interest.

3. Periodically brainstorm with advisors to determine potential areas of dispute in the agreement. A shareholder agreement can be a valuable tool in heading off litigation in the future. But, it’s also a living document that may need to be revised as market conditions, company operations and shareholders’ personal lives change over time.

Cover Your Assets

Proactive planning while relations between owners are amicable can go a long way toward protecting your investment from the unexpected. Contact your legal and financial advisors for more information. They can help draft and update shareholder agreements to avoid future disagreements between your company’s owners.