Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Well Written Shareholder Agreements Avoid Costly Litigation

“A shareholder agreement is an understanding between shareholders and a corporation, under the law, about various aspects ranging from the shareholder duties to rights, in relation to the company. The shareholder agreement is the basis of company inception and paves the way for its future course. It lays down the guidelines about the duties and the powers of the board of directors and the management.”

The Tragic Story of Three Shareholders & Friends

Carl, Dave and Ed were three close friends who went to State University together.  They each ultimately graduated with an engineering degree.  After graduation, each got married to their college sweetheart.  For the first ten years after graduation, the friends worked for various employers.  One day Carl, Dave and Ed decided to pool their cash and buy a small high-tech manufacturing company located in their old hometown.  It didn’t hurt the group’s effort to purchase the company that Dave had a wealthy aunt who would help bankroll the acquisition.  She loaned the money directly to Dave. They decided to change the name of the company to Aunt-Tech Manufacturing, Inc. in honor of Dave’s kind kin.

Carl, Dave And Ed Became Equal Shareholders In The Corporation

They remembered reading in one of their business classes that having a shareholder agreement which included a buy-sell provision was a good thing since it would eliminate a lot of confusion about what each shareholder’s interest in the company was worth should any of the three a) voluntarily or involuntarily leave the company, or b) meet his untimely demise.  They would draw up the agreement themselves and save the cost of an attorney.  They decided to keep the agreement simple.  The company would buy back any terminating or deceased shareholder’s stock at company book value.

After a few years the company’s annual gross revenues had grown to almost $8,000,000.  This was due to the excellent commitment and management Carl and Dave gave to the company.  Ed liked the great out-doors a lot, and often was gone for a week or two at a time on skiing, hunting, or hiking trips.  It was routine, however, for the three to each equally take hundreds of thousands of dollars in compensation out of Aunt-Tech each year.  Business was good.  Life was good.

You’ve Guessed What’s Coming Next

Ed, an avid, accomplished, and super-confident skier, decided to take one of those helicopter skiing trips to some snow-covered peak up in Alaska.  This was one of those skiing jaunts where the helicopter flies a group of skiers up to the top of the peak, drops them off, and they ski down.  Ed had never done anything like this before.  Nevertheless, he thought he would be the perfect leader for the rest of the group to follow on their descent down the peak.

The last the group ever saw of Ed was the back of his skis as he rode them down into a huge crevice that he failed to notice while navigating an unusually tricky jump.

Back home, Carl and Dave were stunned to hear of Ed’s tragic ending.  They now had the unenviable task of dealing with the buy-sell clause in their shareholder agreement – and of paying Ed’s widow, Arlene, as noted in the agreement, for his one-third share of the book value of Aunt-Tech.  They acted quickly.  The company had a book value, or net worth, of $1,200,000.  They personally delivered a check to Ed’s widow for $400,000 and, once again, told her how sorry they were about Ed’s passing.

Six months after giving Ed’s widow the check, Aunt-Tech Manufacturing, Inc. was sold for $15,000,000 to a strategic buyer.  In fact, Carl and David had gotten an indication of interest from the buyer when Ed had gone out on his last skiing trip, and were going to mention the potential buyer’s interest when Ed returned.

Arlene filed litigation against Carl and David for her share of the $15,000,000, less the $400,000 already received.  The jury decided that the$400,000 payment was all that Arlene was entitled to.  They considered that a) the stock redemption price was stipulated by the buy-sell clause, and that b) Ed was not a contributor, at least in recent years, to the increased revenues and profitability of the company.

Arlene could have had a larger check from Carl and David had the shareholder agreement been clear that the value of the stock to be redeemed would be at fair market value, and that if the Company were sold within one year of the death of any shareholders, that the stock price would be based on the sales price of the Company, if it would result in a higher per share value.  The buy-sell provision was vague on what date was to be used to value the stock to be redeemed.  The agreement also was not clear on whether book value per the tax return or the company’s financial statements should be used to value Ed’s stock.  The agreement did not give consideration on whether a minority interest discount should be applied to Ed’s stock, or whether his widow (or estate) would receive a one-third interest in 100% of the value of the company.

Below are some important issues that should have been addressed by Carl, David, Ed and their attorneys when drafting the buy-sell portion of their shareholder agreement.

a) Valuation date: What is the date of the valuation of the departing (or deceased’s stock)?  Is it the date of termination?  The date of death (as may be required for estate tax purposes)?  Or the date of the end of the latest fiscal year?
b) Value to be used: Will it be book value (possibly useful for companies with a high concentration of liquid receivables and inventory assets as compared to fixed assets); or, adjusted net asset value (the fair market value of tangible assets less liabilities, plus the value of intangibles such as goodwill, patents, and copyrights); or, a fair market value based on the economic earnings of the company, or the ratio of selling price to revenues of similar companies (a direct market data method of business valuation)?
c) Discounts: Will minority and marketability discounts be applied to the shares or will they be redeemed at one-third of the 100% of the value of the company, however value is determined?
d) Annual valuations: Will the stock be valued on an annual basis so that the changing economics of the company are considered on a somewhat timely basis?
e) Appraisers: Will a competent business appraiser be engaged to value the stock?  (For estate tax purposes the Internal Revenue Services requires an independent opinion of value rendered by a qualified business appraiser)?  Or will the value of the stock be negotiated by the remaining owners of the company?
f) Life insurance: Will the purchase of the stock be funded by life insurance?
g) Unwanted owners: Does the shareholder agreement stipulate that the departing or deceased shareholder cannot sell its shares to anyone other than the remaining stockholder?

Conclusion

When the business first commences operations and shareholder agreements are drafted and signed by the shareholders, there are many critical issues, as noted above, that are often not adequately addressed.  Failure to clarify these issues greatly increases the potential for litigation as does the reluctance to amend the agreement to address current facts and circumstances.

Don Bays, CPA/ABV, CVA, CFF