Defining Value in the Context of a Shareholders’ Agreement
A shareholders’ agreement is a legal document that sets out the rights and responsibilities of the shareholders in a company. It is a crucial document for any company with more than one shareholder because it helps to establish the shareholders’ rights, responsibilities, and obligations. It can also help to resolve disputes and protect the interests of all shareholders.
A shareholders’ agreement may also lay out the buy-sell provisions that govern the buying and selling of shares in a company. A buy-sell provision typically includes details on who is allowed to buy and sell shares, the process for buying and selling shares, and the mechanism to determine the price at which shares can be bought or sold.
The following includes various mechanisms for determining the price at which shares can be bought or sold, including:
- A pre-determined fixed price, which is established beforehand and typically does not change with market conditions.
- A price calculated using a formula outlined in the agreement, which considers factors such as the company’s financial performance, market conditions, and other relevant factors.
- A price based on the net book value of the company, which is equal to the assets minus total liabilities as they appear on the balance sheet. This value does not consider any goodwill or change in the value of tangible assets.
- A price determined through a specific valuation process outlined in the agreement, which could include a financial analysis, market conditions, or by agreement of the shareholders.
- A value assessment conducted by an independent Chartered Business Valuator.
Shareholders’ agreements often overlook the inclusion of a clear definition of value, leading to ambiguity and shareholder disagreements. Instead, these agreements use vague terminology such as “market value” to determine the price at which a shareholder’s interest will be bought out. The lack of clarity may lead to a prolonged legal dispute and an extended litigation process.
Common Standards of Value
Fair Market Value
Fair market value (FMV) is defined as: “The highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Within the field of business valuation, FMV is considered the most commonly accepted standard. It is the main standard applied in valuations for estate tax, gifting, and compliance with tax regulations.
Depending on the size of the specific interest, fair market value may also incorporate discounts to reflect the lack of control or lack of marketability. This is often referred to a ‘minority discount’ and is intended to reflect the many disadvantages of not being able to unilaterally dictate key Board decisions such as the timing of dividend payments, or the strategic direction of the business, including new investments and hiring decisions.
However, consideration of minority discounts frequently causes a great deal of friction when it comes to establishing the buy-out price for a departing shareholder. In transactions between shareholders (not the open market), the departing shareholder is likely to argue that a minority discount should be ignored on the basis that:
- Nobody got a discount when they bought in; and
- The other shareholder’s will very likely not suffer a discount in the future when they exit their investment (i.e. if all shareholders sell as a group). So, if they bought out a partner at a discounted price, and then sold it in the future with no discount, it would provide an unfair ‘windfall gain’.
It is for this reason that many shareholder agreements stipulate that the buy-out price should not include any discount for a non-controlling interest, or a premium for a controlling interest.
Fair Value (FV) is defined as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
As opposed to FMV, fair value is a legal construct rather than a value set by the market. Typically, fair value does not consider discounts for non-marketability or lack of control. It is often used when valuing businesses for shareholder disputes and internal share transfers between shareholders.
Fair value is also the standard used by the Courts when setting a price for the buy-out of a dissenting or oppressed shareholder. When minority shareholders disagree with a merger or other transaction, the fair value standard prevents controlling shareholders from imposing a discounted price on them. As minority shareholders in such situations are not “willing sellers” free from “compulsion to sell” as per the fair market value standard, the fair value standard takes this into account to safeguard the interests of minority shareholders.
It is important to note that although “fair market value” and “fair value” may seem like similar concepts, they are distinct. Therefore, when valuing a business interest, it is crucial to ensure that the Chartered Business Valuator (CBV) adheres to the appropriate and relevant standard of value. It may also be useful to include CBV in the drafting of a shareholder’s agreement to help ensure the correct standard of value is used so there are no unintended consequences when a buy-out is triggered.