FAIR PRICE FOR MINORITY SHAREHOLDERS
An employee holding a minority interest in the company often encounters the challenge of securing fair value for the shares if his/her employment is terminated.This article discusses key points that counsel should address when representing a minority shareholder and the benefits of retaining an experienced business valuation expert (BVE).
Buying Out a Minority Shareholder
Recently, a minority shareholder was terminated and the employer demanded that he sell back his shares.The shareholder held a 25% stock interest in one company (Demo Co.) and a 33% interest in a related leasing company (Lease Co.).Demo Co. had a shareholders agreement with a buy-sell provision that only triggered on the death of a shareholder.The repurchase price was to be the shares book value plus 25%.The agreement did not provide for an appraisal method for determining fair market value, and was silent on a buyout in the event of a termination of employment.Previously, the company had used book value without a premium as the basis for repurchasing another minority shareholders shares upon employment termination.For Lease Co., the shareholders had an agreement containing buyout rights upon death, withdrawal, resignation or retirement with the repurchase price set at book value plus 15%.
The minority shareholder asked us to advise him on his rights and their demand to buy back his shares. The result, described below, generated for the minority shareholder almost 25% more than the companys book value for his Demo Co. shares and nearly 50% above the companys initial repurchase offer for all of his shares.
Legal Counsel and Business Valuation Expert as Teammates
The first step was to retain an experienced business valuation expert.By working as a team, counsel and the business valuation expert (be) can most effectively determine whether the agreed upon method for valuing the shares as presented in the shareholders agreement or, in our situation where there was no agreed upon valuation method, reflects fair market value. Typically negotiations will occur over whether discounts for lack of marketability and minority interests should be applied in reducing the fair market value.
Then, we needed to determine whether a trigger event had actually occurred under the buy-sell agreement.Close attention always needs to be given in the shareholders agreement to potential trigger events such as death, disability, employee termination, or resignation; otherwise a withdrawing shareholder may retain his or her shares.Certainly where the employee contests the grounds for the termination, counsel may need to take more assertive action to seek remedies for the employee.In situations where the employee and the company desire a mutual termination of their relationship, again the grounds for the termination are important in effecting a fair buy-out price.
Another question is the companys source of funding for the purchase price, and its ability to satisfy the purchase price based on the proposed payment terms.Upon termination, other than upon death or disability, insurance is not available for funding the buyout; therefore, the companys operations, assets and the ability to liquidate those assets need to be closely scrutinized.
The due diligence for valuation purposes is paramount for maximizing the purchase price to be paid.The BVE needs to employ practical experience and deep operational and financial knowledge to review the companys financial statements, and to interview senior management.The BVE often can find items on the companys books that are incongruent with highly conservative projections made by senior management that impact future payments to the outgoing shareholder.In our situation, the BVE was able to glean from senior management off balance sheet assets and income that routinely occurred for projects.Closer scrutiny of the companys business practices and off balance sheet value by the BVE enabled us to maximize the return for our client.
Buy-Sell Agreements
Buy-sell agreements are particularly important for closely held businesses because there is no ready market for selling an ownership interest.Without a buy-sell agreement, the party that wants to sell is at a bargaining disadvantage, as is the group that desires to buy out a nonperforming shareholder.The purpose of a buy-sell agreement is to restrict the shareholders ability to transfer his/her ownership interest.Since disputes and disagreements inevitably arise among shareholders, an owner should be able to exit without forcing the remaining owners into an uncomfortable business relationship with new owners, possibly competitors.
Drafted properly, a buy-sell agreement keeps the corporate shares in the hands of those active in the business and fixes the value of those shares upon trigger events.If the buy-sell agreement is combined with a mandatory purchase option agreement, it can provide a ready market for closely held ownership interests when shareholders die or withdraw from the business.The buy-sell agreement also can establish a value for the equity and can provide for contingencies such as disability, divorce, insolvency or incapacity.The buy-sell agreement should specify the method for determining the purchase price.Common methods include a fixed price per share, an appraisal by an independent BVE to establish the fair market value or a formula such as an earnings multiplier or a percentage of book value.Buy-sell agreements are intended to avoid litigation by which the owners prepare for unusual but foreseeable events that have an impact on the businesses.They can become detrimental if the shareholders do not fix an appropriate price or update the agreed price or do not fix an appropriate valuation method.
Even with careful drafting for the repurchase of the shares, the buy-sell agreement may not be enforceable if the company does not satisfy the retained earnings test or balance sheet test under California law.A back-up mandatory purchase or purchase option held by the other shareholders to purchase the shares, can provide another source of funds.
Joel Weinstein advises companies on mergers and acquisitions, recapitalizations, management buyouts, equity and debt financing and private and public offerings. He can be reached at (310) 286-1700 or by email at jweinstein@rutterhobbs.com.