July 29, 2013

Fair Value: A Primer

Holland & Knight Shareholder Rights Blog
Michael J. Zdeb

Disagreements among owners of business enterprises can result in the threat of litigation and frequently in litigation. The litigation can be in the nature of breach of fiduciary duties, shareholder oppression, member oppression, dissolution proceedings and dissenters' rights.

Prior to the prospect of the court ordering a result, the parties need to consider what the court can order. In cases involving oppression or breach of fiduciary duties among them, one commonly applied remedy is the buy-out order.

That is, if the court finds the need to separate the parties, it may order one to sell and the other to buy. Whether the oppressing or oppressed party is a forced buyer or seller is a separate discussion. In any event, the "price" is central as one will buy-out the other by court order.

In dissenters' rights matters, such as a vote against a merger, reverse split, etc., the court determines what the dissenter is to be paid for the interest. So, when decisions are made that can rise to statutory dissenters' rights, early in the process the parties need to have considered the value of their interests. Value or "price" again is critical.

In either dissenters' rights matters or court ordered buy-out remedies, the court will have to conduct an appraisal to determine the value. Therefore, for a dissenter, shareholder or oppressed minority shareholder, it is critical that they have an understanding of the standard of value the court will apply. It is equally critical that controlling shareholders and managers understand the value and process. The control or majority will need to be able to finance the buy-out and consider the implications of the capital requirement.

In virtually all jurisdictions in the U.S., the standard of value applied in these matters is called "fair value." It is not "fair market value." Fair value also is not necessarily a financial concept. Rather, it is a conclusion of value the court deems fair under the circumstances before it and the laws of the particular state.
The potential spread in amount between a "fair value" determination and "fair market value" can be substantial and surprising to the uninformed.

The differences arise from varying applications of many factors:

  • Adjustments to income and expenses
  • Projections and discount cash flow considerations
  • Capitalizations or discount rates
  • Uses of comparable "public" companies' values
  • Discounts for lack of control or application of control premiums
  • Discounts for lack of a market for the interest
  • Adjustments for historic gains in asset values and potential built-in gain taxes
  • Key-man discounts

The list can be longer in a particular case, but it is important to realize that these adjustments and discounts are complex, impactful and frequently disputed. For example, the discount for lack of marketability could reduce a value or shares or the LLC interest by between 5% and 50%. A 20% share of a member interest in a $50 million business could be reduced from $10 million (20% as a proportional interest of the business) to $6,500,000 with a 35% discount.

In the final conclusion of fair value, it is equally likely non-financial considerations of "fairness" could significantly impact the result. Therefore, in any business decision or action that could result in an appraisal proceeding, the parties should have experienced  advisors guiding them regarding the implications of fair value on their decision.

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