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Valuation Issues to Consider for Large Block Minority Shareholder Redemptions Jeffrey S

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Valuation Issues to Consider for Large Block Minority Shareholder Redemptions Jeffrey S Shareholder Forensic Analysis Insights Valuation Issues to Consider for Large Block Minority Shareholder Redemptions Jeffrey S. Burns and Nathan P. Novak The purpose of this discussion is to identify certain issues to consider when performing a valuation analysis for the purpose of a closely held company shareholder redemption. Specifically, the focus of this discussion is on certain qualitative and quantitative factors that commonly arise when a closely held company is going through the process of redeeming or buying out an ownership interest of a significantly large but noncontrolling shareholder. Several considerations that are unique to large block noncontrolling shareholder redemptions are discussed below. Additionally, an example is provided to illustrate how certain of the issues can occur and can be handled in a hypothetical, but realistic, situation. NTRODUCTION such as if a shareholder claims he or she is being I oppressed by the company and a court orders that A shareholder redemption, as that term is used company to redeem the oppressed shareholder’s throughout this discussion, occurs when a share- shares. holder (or otherwise owner) of a company sells his or her shares back to the company. The shares may This discussion focuses on the valuation issues be retired or may be distributed among the remain- that arise during a litigious shareholder redemp- ing shareholders. tion, such as the issues related to the dissociation of an owner. Further, there are certain issues that Ultimately, the result is the same either way: are unique to the redemption of a noncontrolling 1. There will be one less shareholder. shareholder that holds a significantly large block of the company stock. 2. The remaining shareholders will own pro- portionately more of the company. 3. The overall value of the remaining share- holders’ interests should be unaffected by ISSUES TO CONSIDER the redemption.1 There are certain general issues that commonly occur when a large block noncontrolling sharehold- er has his or her shares redeemed. That is, in an equitable shareholder redemption, neither the redeemed shareholder nor the remain- First and foremost, relevant statutes or judicial ing shareholders should gain or lose wealth from the decisions should be considered, especially if the transaction. redemption is the product of litigation proceedings. Additionally, there are often key person risks that There are several situations that can give rise to should be considered. a shareholder redemption. A shareholder redemp- tion can be mutual, such as if a shareholder wishes There are also a number of issues related to how to sell his or her shares and the company agrees to the company will fund the shareholder redemption buy them so as to avoid the presence of a new share- and the effect that it will have on the company going holder. Or, a shareholder redemption can be forced, forward. www .willamette .com INSIGHTS • AUTUMN 2015 51 Legal Issues Further, there are statutes that specify general valuation guidelines upon the dissociation of a part- “. there are The laws that govern relations ner from a partnership. Section 701 of the Revised between business owners vary diverse legal Uniform Partnership Act states, depending on the jurisdiction and issues that need type of business that is owned. [T]he buyout price of a dissociated partner’s to be considered State laws on owner’s rights differ interest is the amount that would have been from state to state and, similarly, distributable to the dissociating partner . depending on the federal laws differ from the if, on the date of dissociation, the assets of state laws. the partnership were sold at a price equal the context of to the greater of the liquidation value or the the shareholder Additionally, the laws that gov- value based on a sale of the entire business ern partnerships are often separate as a going concern without the dissociated from the laws that govern limited redemption or partner.5 liability companies or corpora- buy-out.” tions. Clearly, there are diverse legal issues that need to Since a stock redemption can be considered depending on the context of the share- be effectuated through litigation, holder redemption or buy-out. Certain states, such the relevant statutes can have a as Illinois, specify the use of fair value when valuing significant impact on the appropriate considerations shares for the purpose of a forced LLC shareholder when valuing a company for purposes of a stock buy-out. Other states, such as California and Utah, redemption. Again, these statutes vary from state to specify the use of fair market value for purposes of a state. buy-out whereas other states are silent on the appro- An article authored by Sandra K. Miller from the priate standard of value. Spring 2011 issue of the University of Pennsylvania Similarly, certain states prefer the use of a judi- Journal of Business Law helps illustrate this point cial dissolution of a business rather than a buy-out or specifically in the context of limited liability compa- redemption of a disassociated owner. ny (LLC) member dispute when one member wishes to “get out” of the business. Ultimately, the take-away is that because statutes governing the redemption process differ significantly The Revised Uniform Limited Liability Act depending on the facts of a case, it is important to authorizes judicial dissolution for illegal, seek legal advice as a first step in order to deter- fraudulent, or oppressive conduct, but fails mine which statutes or judicial precedent should to offer provisions for a buy-out in lieu of a be considered in a valuation for purposes of a stock dissolution or any related valuation guide- redemption. lines. In contrast, approximately twenty-two corporate statutes provide for a purchase in And, although the statutes and judicial prece- lieu of a judicial dissolution pursuant to the dents differ between jurisdictions, the overarching theme is that, upon an event that would necessi- Model Business Corporation Act.2 tate a shareholder redemption in some form, the courts appear to want what is most equitable for And further in contrast: both the departing owner as well as the remaining [T]he Delaware LLC statute authorizes judi- owner(s). cial dissolution on the ground that it is not reasonably practicable to carry on business Key Person Risk . [and] the Illinois LLC statute contains a buy-out provision in lieu of dissolution and It is often the case that large shareholders of a pri- specifies that the valuation is to be based on vately held company are heavily involved with the operations of the company. This is especially true for “fair value.”3 smaller companies or for companies that are in the early stages of operations. Finally: Those types of companies may be subject to sig- California and Utah authorize a buy-out in nificant key person dependency. Key person depen- lieu of dissolution and specify that the valua- dence exists when the performance of the company tion should be with reference to “fair market is highly dependent on one or a few key individuals, value.”4 and the loss of any such individuals would materially impact the future success of the company. 52 INSIGHTS • AUTUMN 2015 www .willamette .com The presence of a “key person” or key person pany after the loss of the risk is relevant when valuing a company for the redeemed shareholder. “. key person risk purpose of a shareholder redemption. If the share- Another way to estimate holder to be redeemed could be classified as a key the value of a key person is is relevant when person within the company, then the future finan- to investigate whether or valuing a company cial performance of the company could potentially not the company holds any look very different after that individual shareholder insurance policies for the for the purpose of has left the company. individual (or other individ- a full shareholder As discussed above, the Revised Uniform uals with similar functions Partnership Act specifically states that a buyout within the company). redemption.” price may be based on a sale of the entire business If a company holds an without the dissociated partner. insurance policy on the Accordingly, since a shareholder redemption redeeming shareholder, the face value of that policy inherently involves the departure of the redeemed may provide an estimate of the value that the com- shareholder, the purchase price of the shares should pany places on the contributions of that individual. be analyzed based on projected company perfor- The face value of the insurance policy can be sub- mance in the absence of said shareholder. tracted from the enterprise value of the company in order to reflect the loss in value due to the departure Sandra Miller provides further guidance in her of the individual. article, which states: Finally, there may not be a direct way to quantify [T]here may be unusual cases where a with- the effects that a loss of a key individual will have on drawing LLC member may take goodwill a company. It may not be possible to create a set of and/or other intellectual property with him. financial projections that exclude the individual and In such instances, the buy-out price paid the company may not hold any insurance policies on to the withdrawing LLC member might be the key person. grossly unfair and overstated without con- sidering the value of the intellectual and/or When all else fails, it may be appropriate to intangible value withdrawn by the dissociat- capture the effect of the key person dependency ing LLC member himself. The Comments to through a more judgment-based valuation analyst the Revised Uniform Partnership Act appear adjustment. to recognize the possibility of discounts The key person risk can be captured in an income other than a minority interest discount and approach through an adjustment to the present value mention the key person discount.6 discount rate.
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