Valuation Issues in Shareholder Disputes · Valuation Issues in Shareholder Disputes ... •...

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Valuation Issues in Shareholder Disputes

Presentation to the Illinois CPA SocietyBusiness Valuation Symposium

May 10, 2011Chicago, Illinois

Presentation by Robert F. Reilly, CPA, ABV, CFFManaging Director

Willamette Management AssociatesChicago, Illinois

[email protected]

Willamette Management Associates 1

Discussion Outline• Common types of shareholder disputes

• The type of shareholder dispute affects the valuation assignment

• The type of shareholder dispute affects the appropriate valuation adjustments

• Defining the elements of the valuation analyst assignment

• Valuation considerations specific to a shareholder dispute

• Simplified illustrative example


The Application of Valuation Adjustments are Influenced by the Type of Shareholder Dispute

• There are various types of shareholder disputes that could be categorized as a “business divorce.”

• The type of the shareholder dispute could influence both (1) the valuation analyst’s assignment and (2) the application of various types of valuation adjustments.


Common Types of “Business Divorce” Litigation Claims

• Some of the common types of shareholder disputes include the following:– dissenting shareholder appraisal rights– minority shareholder freeze-out– shareholder oppression– request for a corporate dissolution without oppression– partnership or LLC dissolution– joint venture agreement dissolution– breach of contract– breach of noncompete agreement– buy/sell agreement interpretations/violations– shareholder derivative actions


The Type of Shareholder Dispute Affects the Valuation Analyst

• The valuation analyst should have a clear understanding of the type of shareholder dispute that is the subject of the pending or threatened litigation.

• The valuation analyst should develop a clear understanding of how the type of shareholder dispute affects:1. the analyst’s specific assignment,2. the valuation analysis purpose and objective,3. the judicially acceptable valuation approaches and methods,4. the types of valuation adjustments that are/are not judicially

allowed, and5. the format and content of the valuation report.


Valuation Analyst’s Assignment in the Shareholder Dispute

• The valuation analyst should obtain clear instructions from the client’s legal counsel with regard to the valuation and/or economic damages implications of the subject shareholder dispute.

• These instructions from the legal counsel are “legal instructions” that may (1) affect the analyst’s assignment and (2) direct the analyst’s actions.

• The valuation analyst typically prefers to receive these legal instructions in writing.

• These legal instructions are based on the lawyer’s interpretation of the jurisdiction-appropriate statutory authority and judicial precedent.


Valuation Analyst’s Assignment in the Shareholder Dispute (cont.)

• The lawyer’s legal instructions may cite or include the appropriate statutory authority and judicial precedent. And, the analyst may read these legal authorities as a layperson.

• However, the analyst is not a lawyer. The analyst should not attempt to practice law. That is, the analyst should not attempt to develop a legal interpretation of the appropriate legal authority.

• The analyst should rely on the client’s legal counsel for any and all legal interpretations to any and all legal authorities.


Defining the Valuation Analyst’s Assignment• The client’s legal counsel will typically provide the following

direction regarding the analyst’s assignment:– will the analyst value the entire subject company as is?– will the analyst value the entire subject company to the control owner?– will the analyst value the entire subject company to the market?– will the analyst value the subject equity securities as is?– will the analyst value the subject equity securities to the control

owner?– will the analyst value the subject equity securities to the market?– will the analyst estimate historical lost profits to the plaintiff?– will the analyst estimate expected future lost profits to the plaintiff?– will the analyst estimate historical unjust enrichment to the

defendant?– will the analyst estimate expected future unjust enrichment to the

defendant?


Defining the Valuation Analyst’s Assignment (cont.)• The client’s legal counsel will typically provide the following

elements of the analyst’s assignment:– valuation “as of” date(s)– damages period (e.g., event, mitigation) dates– standard of value—value to who?– legal definition of value—fair value, fair market value, etc.– plaintiff's specific ownership interest– period that the plaintiff owned the interest– legal rights/limitations of the plaintiff ownership interest– all other shareholders’ ownership interests– ownership levels for various control events under state statute– legally-determined level of value for the assignment


Defining the Valuation Analyst’s Assignment (cont.)• The client’s legal counsel should also indicate to the analyst if

the subject business interest is subject to:– buy/sell agreement– other shareholder agreements– put/call options– unusual shareholder rights/obligations– other contractual terms or conditions


Defining the Assignment Levels of Value• After consideration of state statutes and relevant judicial

precedent, the client’s legal counsel should instruct the analyst as to the assignment level of value:– value the entity or security

• as if marketable• as if nonmarketable

– value the entity or security• as if a controlling ownership interest• as if a noncontrolling ownership interest


Defining the Assignment Levels of Value (cont.)

• The client’s legal counsel should instruct the analyst whether or not to consider the value implications of:– the corporate event to which the plaintiff objects– the economic benefits of a proposed merger or other

transaction– the general acquisition price premium (above an ownership

control only price premium) that M&A transaction prices may include

– any jurisdiction-specific definitions of marketability, control, or other valuation terms

• The client’s legal counsel should not place the valuation analyst in the position of (1) legally determining the appropriate level of value or (2) concluding what is “fair” to the litigants.


Common Normalization Adjustments• The valuation analyst will typically make certain financial

statement normalization adjustments in any business or security valuation performed (1) for any assignment purpose and (2) at any level of value.


Common Normalization Adjustments (cont.)

• Some of these typical financial statement normalization adjustments include:– effects of changes in accounting principles– effects of adoption of new accounting principles– effects of results of discontinued operations– effects of extraordinary events– effects of nonrecurring debits or credits

• litigation settlements• environmental expenses/reimbursements• income or other tax disputes/settlements• purchase/sale of nonoperating assets


Common Normalization Adjustments (cont.)

• The valuation analyst should note that these normalization adjustments may affect the subject company income statement, cash flow statement, and balance sheet.

• When using any market approach valuation methods, the valuation analyst should normalize the selected guideline company financial statements, as well as the subject company financial statements.


Common Level of Value Valuation Adjustments

• The valuation analyst will commonly make the following type of financial statement normalization adjustments when valuing the subject company/security on a controlling ownership interest level of value:1. excess compensation expense adjusted to industry average

levels2. excess variable operating expense adjusted to industry

average levels, over time3. excess variable SG&A expense adjusted to industry average

levels, over time4. excess net working capital (especially cash balances)

adjusted to industry average levels, over time5. unusual debt/equity ratio adjusted to industry average levels,

in the discount rate analysis


Common Level of Value Valuation Adjustments (cont.)

6. deferred/inadequate capital expenditures adjusted to industry average levels

7. unusual depreciation policy adjusted to industry normal policy8. excess cost of capital components adjusted to industry

normal costs9. excess non-operating assets are assumed to be liquidated10. dividend policy is adjusted to industry normal distribution

level (after considering the subject company cash needs)

• The analyst should note that these control level of value adjustments may affect the subject company income statement, cash flow statement, and balance sheet.


Common Shareholder Oppression Valuation Adjustments

• In addition to the typical control level normalization adjustments, the valuation analyst may investigate and consider the following shareholder oppression type of normalization adjustments in the business/security valuation:1. unproductive/ghost friend or relative employees on payroll2. company payment (a) for personal-use automobile and other

forms of travel or (b) for personal vacations and other non-business travel

3. company payment (a) for personal household expenditures or (b) for housing capital expenditures of control owner or of friends and relatives

4. company payment of personal income tax liability of control owner or others


Common Shareholder Oppression Valuation Adjustments (cont.)

5. company payment of personal hobby expenditures of control owner or others

6. company payment of personal loans or credit cards of control owner or others

7. company payment of expenses/capital expenditures of another business owned separately by control owner—or redirection of company sales/receipts to another business owned directly by control owner

8. company rental of real estate or other assets owned by control owner at above-market rates

9. reserves for uncollectible accounts, allowance for inventory shrinkage, or other contra-asset expense accounts that can be directly controlled by control owner

10. expensing of capital expenditures or excessively rapid depreciation expense that can be controlled by control owner


Common Shareholder Oppression Valuation Adjustments (cont.)

• The analyst should note that these valuation adjustments can affect the subject company income statement, cash flow statement, and balance sheet.

• The analyst should note that these valuation adjustments can affect the results of all income approach, market approach, and asset-based approach business/security valuation methods.

• The analyst should also note that these valuation analysts not only affect subject company/security value. They may also affect the plaintiff economic damages analysis. And, they may also affect the subject company’s historical, current, and expected future ability to pay dividends or other owner distributions.


Valuation Analyst’s Conclusions and Opinions

• The shareholder dispute valuation involves analyses that are not always performed in the valuation prepared for other purposes.

• In addition to capital market analysis and financial analysis, the valuation analyst may also perform the following tasks in a shareholder dispute assignment: forensic and investigative accounting, financial accounting and financial statement preparation, forensic IT analysis, fraud investigation, general ledger and accounting system analysis, internal control investigation, etc.

• The valuation analyst should clearly understand the scope of the shareholder dispute valuation assignment.


Valuation Analyst’s Conclusions and Opinions (cont.)

• The valuation analyst should clearly understand the quality and quantity of the subject company financial statements, accounting systems, and actual transaction documentation that will be available for analysis.

• And, the valuation analyst should clearly understand the scope of the valuation and/or economic damages and/or forensic accounting opinions that the assignment calls for.

• These assignment understandings should be agreed to between the analyst, the client, and the client’s legal counsel.

• In addition, the analyst’s report should clearly describe (1) the scope of the analyst’s assignment and (2) the analyst’s business/security valuation conclusion, plaintiff economic damages conclusion, and/or any subject company forensic accounting/internal control opinion.


The Economics of Fairness—A Simplified Illustrative Example

• Five years ago, Andy Alpha and Ben Beta started a company that they called Alpha Beta Corporation. Andy owns 60% of the common stock of the corporation and Ben owns the remaining 40% of the common stock of the corporation.

• After five years of successful operations, Andy and Ben can no longer agree on the management direction of Alpha Beta Corporation. To eliminate their interpersonal conflict, Andy wants to buy out Ben, an

• Andy and Ben agree that if they sold 100% of Alpha Beta Corporation, say to a competitor, the total company stock would sell for $10,000,000. There are 100,000 shares of Alpha Beta Corporation stock outstanding.


The Economics of Fairness—A Simplified Illustrative Example (cont.)

• As an aside, Andy and Ben both work full time for the company, and they both earn generous salaries and bonuses. The company does not pay dividends on its common stock.

• Assuming a $10,000 total company equity value, Ben expects that Andy will buy him out as follows:

Alpha Beta Corporation total equity value $10,000,000

÷ total number of common shares outstanding 100,000

= pro rata total equity value per share $100

× number of shares owned by Ben(i.e., 100,000 shares outstanding × 40%)

40,000

= pro rata equity value of Ben’s shares $4,000,000



• In other words, Ben believes that the fair value of his Alpha Beta Corporation ownership interest is $4,000,000.

• Assuming the $10,000,000 total equity value is correct, a valuation analyst would conclude that the value of the Alpha Beta Corporation stock, on a marketable, controlling ownership interest basis, is $100 per share.



• However, based on a $10,000,000 total company equity value, Andy offers to buy out Ben as follows:

Alpha Beta Corporation total equity value $10,000,000÷ total number of common shares outstanding 100,000= pro rata total equity value per share $100

(i.e., value of common stock on a marketable, controlling interest basis)

− discount for lack of control @ 25% -$25= value of common stock on a marketable, noncontrolling interest basis $75− discount for lack of marketability @ 33% -$25= value on a nonmarketable, noncontrolling interest basis $50

× number of shares owned by Ben 40,000(i.e., 100,000 shares outstanding × 40%)

= fair market value of Ben’s shares $2,000,000



• In other words, Andy believes that the fair market value of Ben’s Alpha Beta Corporation ownership interest is $2,000,000.

• Assuming the $10,000,000 total equity value is correct, a valuation analyst would conclude that the value of the Alpha Beta Corporation stock, on a nonmarketable, noncontrolling ownership interest basis, is $50 per share.


The Economics of Fairness—The Disputed Transaction

• At first, Andy and Ben can’t agree on the share price at which Andy will buy out Ben’s 40% ownership interest in Alpha Beta Corporation.

• Ben concludes that the $50 per share offer from Andy is not a “fair” price. Ben asserts that the stock is clearly worth $100 per share to Andy. This is because Andy could sell the entire company for $100 per share.

• Andy believes that no other buyer would pay Ben more than $50 per share for Ben’s Alpha Beta stock. Andy believes that $50 per share price is the “market price” for Ben’s stock to any third party investor in the company.


The Economics of Fairness—The Disputed Transaction (cont.)

• In response to Ben’s suggestion that they both sell the entire company, Andy indicates to Ben that he has no current interest in selling Alpha Beta Corporation.

• Several months pass, and no stock purchase/sale transaction occurs between Andy and Ben. Then, Ben’s family develops serious health problems and other liquidity needs. Ben urgently needs cash for his wife’s operation, his son’s education, his daughter’s wedding, and his brother-in-law’s gambling debts.

• Desperate for cash, Ben sells his Alpha Beta Corporation stock to Andy for $2,000,000, or $50 per share.


The Economics of Fairness—The Disputed Transaction (cont.)

• Three weeks later, Andy sells 100% of the Alpha Beta Corporation stock in response to an unsolicited offer from a competitor for $10,000,000 or $100 per share.

• Upon hearing of Andy’s sale of the entire company, Ben sues Andy. Ben claims that the did not receive “fair value” for the 40,000 shares of Alpha Beta Corporation stock that he sold to Andy.


The Economics of Fairness—What is Fair?

• Unquestionably, Andy sold 100% of the Alpha Beta Corporation stock for $10,000,000, or $100 per share.

• Also, unquestionably, weeks earlier, Andy bought Ben’s 40% block of Alpha Beta Corporation stock for $2,000,000, or $50 per share.


The Economics of Fairness—What is Fair? (cont.)

• If Ben still owned the 40% block of Alpha Beta Corporation stock when Andy sold the entire company, then the allocation of the Alpha Beta Corporation stock sale proceeds would have been as follows:

Proceeds ProceedsAllocation Allocationto Andy to Ben

Total share ownership % 60% 40%Total number of shares 60,000 40,000Total sale proceeds, $10,000,000 $6,000,000 $4,000,000Total sale proceeds per share $100 $100



• However, Ben had already sold his Alpha Beta Corporation stock to Andy by the time that Andy sold the entire company to the competitor. So, Ben only received $2,000,000 for his stock from Andy, instead of $4,000,000 for his stock from the competitor.

• Therefore, Ben will claim that he lost out on $2,000,000 of fair value (i.e., the $4,000,000 allocated company sale price – the $2,000,000 stock sale price actually received from Andy).



• Andy received the entire $10,000,000 sale proceeds for 100% of the company stock from the competitor, instead of the $6,000,000 sale price allocation he would have received if Ben still owned 40% of the company stock.

• Ben will claim that Andy was unjustly enriched by the amount of $2,000,000 (i.e., the $10,000,000 total equity price – the $6,000,000 that Andy would have received for his 60% interest – the $2,000,000 that Andy actually paid to Ben for Ben’s 40% interest).


The Economics of Fairness—What is Fair Value?

• The question that the judicial finder of fact may have to answer is: Is the fair value of the Alpha Beta Corporation stock to Ben $50 per share at the same time that Andy can turn around and sell the Alpha Beta Corporation stock for $100 per share?

• Or, is the fair value of Alpha Beta Corporation stock the same value per share to all shareholders (e.g., pro rata $10,000,000 total equity value) (1) to all shareholders (2) regardless of how many shares that shareholder owns (i.e., controls)?

• In other words, is “fair value” a conclusion that is the same for all shares of a corporation, regardless of the relative ownership interests of the various corporate shareholders?


The Economics of Fairness—What is Fair Value? (cont.)

• Alternatively, is fair value per share different from fair market value per share, in that fair market value considers (1) the size/liquidity of the subject block of stock relative to (2) the size/liquidity of other blocks of stock in the subject company?

• Lastly, is fair value an equity-derived concept? Is fair value intended to be a figure that is equally fair, equitable, just, etc. to all parties to the dispute?

• In contrast, is fair market value a market-derived concept? Is fair market value intended to be a figure that willing market participants would pay/accept for the subject interest? And, is the market sometimes not fair, equitable, or just?


Summary and Conclusion• Seek legal instruction regarding the valuation assignment.

• Seek legal instruction regarding any element of the analysis that could be affected by statutory authority, administrative ruling, or judicial precedent.

• Don’t practice law without a license.

• Questions and discussion.

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