Some of the primary reasons that the services of a business valuator are required involve changes related to shareholders. In some cases, a successful business may add one or more shareholders to strengthen its core operations or reward performance. In others, a mutually agreed-upon exit of a shareholder may lead to an orderly buy-out. Perhaps a breach has occurred, and a shareholder is being dismissed. Or perhaps the majority shareholders are oppressing the minority.
These are just a sample of the scenarios that can occur that commonly require an independent business valuation to resolve.
When a valuation is required, the first step is usually to review the Shareholders Agreement, if one exists. A well-prepared Shareholders Agreement will dictate, among other things, the key considerations of valuations, such as:
a) The valuation date, which is usually based on the occurrence of a specific event.
b) The definition of value to be used and whether or not a minority discount should apply. For instance, the generally-accepted definition of Fair Market Value (“FMV”) typically used by valuators would apply a discount to a minority shareholding, so this is a very important distinction. Unless otherwise stipulated, the FMV of the shares of a minority shareholder (i.e. 50% or less ownership, all other things being equal), would be subject to a discount for a lack of marketability and control that would make each minority share worth less than the same shares held in a majority position.
c) How the calculation of value is to be performed, which can include the following:
i) Valuation by Formula wherein the calculation to arrive at the required value may be specified in the agreement (e.g. 3x EBITDA). This can make the process less costly and more efficient, but it may lead to further issues if the specified formula is stale-dated or subject to manipulation (upward or downward).
ii) Periodic Valuation where a valuation is performed regularly over a specific period (e.g. every 2 years), in order to be relied-upon to mitigate disputes should there occur in between valuation dates.
iii) Independent Valuation by a qualified valuator.
When the circumstances are relatively amicable (i.e. mutual agreement to add a shareholder, or facilitate an exit), then the process of valuation is rather simple. If a valuator is required, they can be engaged on behalf of both sides to prepare an independent valuation, and provide a report that is binding, or that is used as a starting point for negotiations between shareholders (i.e. the buy-in or buy-out price).
Shareholder Disputes and Joint Retention
In the case of a dispute, a valuator may still be jointly retained by both sides, but there is increased risk of disagreement between the parties involved with respect to key information. Consider a case where a relationship breakdown has occurred, and a minority shareholder is expected to exit. The parties (the existing shareholder(s) and the exiting shareholder) may disagree on several issues, including, but not limited to, the following:
i) The roles, responsibilities and contribution to the business of each shareholder (i.e. are they active or passive?), and their corresponding market compensation (i.e. the cost of a replacement employee).
ii) The actual compensation, including perquisites and benefits (e.g. health plans, vehicle allowance, etc.) of each shareholder or related parties (i.e. family members).
iii) The existence of personal or discretionary expenses and other normalizing adjustments that could impact the normalized income that a valuator would use to calculate the value.
iv) Whether or not the business has commercial goodwill (i.e. whether the business has any value that could be transferred to a purchaser).
v) The applicability of a minority discount.
vi) The budgeted or forecasted operations of the business. In this case, the exiting shareholder may believe, rightly or wrongly, that the company’s future prospects are better than historical results, which would equate to a higher value, while the existing shareholders may disagree.
From a valuator’s perspective in a joint retainer scenario, open and impartial communication is necessary, in order to ensure information provided by each party is considered in producing the valuation report.
Shareholder Disputes – Oppression Claims
In the case of oppression, where it is alleged that actions of the majority shareholders may have unfairly harmed minority shareholders, a different valuator would likely be retained by each side. Similar issues to those above would be relevant, however, where oppression is present, the courts have considered Fair Value (i.e. FMV without consideration of a minority discount) to be the most applicable and equitable value definition. Furthermore, there may be additional consideration for specific transactions, if those are determined to unfairly benefit the majority shareholder.
If your business has multiple shareholders, but does not have a shareholder’s agreement in place, you should consider discussing the matter with your corporate counsel. Even if the relationship amongst shareholders is strong, a breakdown is always a potential issue, and it is typically beneficial to take proactive measures, rather than reacting after the fact.