When to Value a Company – Part 4: Buying out a Shareholder to Settle a Dispute about how the Company Ought to be Run

There are many stages throughout a company’s life cycle where a business valuation might be helpful, or even required by law. These include the following situations, among others:

1. Raising capital to fund your new venture
2. Expanding the business with equity capital 
3. Attracting and retaining talent by issuing shares or options to key employees 
4. Buying out a shareholder to settle a dispute about how the company ought to be run 
5. Reorganizing share capital to achieve tax planning objectives 
6. Determining the value of family assets in a divorce proceeding 
7. To assist with planning your exit strategy for retirement 
8. To evaluate an unsolicited offer to purchase your business 
9. Purchasing a business at its true value

This article is the fourth part in a series of articles that will describe common circumstances that give rise to the need for some sort of valuation. In these articles, we convey some of the key valuation issues that should be considered in each situation.

In part one of our series on when to value a company, we discussed raising capital to fund a new venture, and how venture capitalists value investment opportunities.

In part two of our series on the subject of when a valuation is required, we discussed raising equity capital to expand your business after it becomes profitable.

In part three of our series, we discussed issuing stock options to attract top talent.

In this fourth installment of our valuation series, we will discuss the process involved in successfully buying out a shareholder and some best practices to follow in order to avoid a nasty and protracted dispute.

Resolving Shareholder Disputes

Not all relationships are perfect and that includes business relationships. Disagreements about the direction of the business can arise, even in closely held or family-owned companies. If a dispute is in deadlock and cannot be resolved, then the only resolution might be a parting of ways through a shareholder buy-out.

Buyouts can occur under the terms of a shareholder’s agreement or similar contract that governs the buy-out process. In the worst-case scenario, if an agreement cannot be reached, the dispute is likely to proceed to litigation. One of the key stumbling blocks to reaching a buy-out agreement is settling on a fair price for the departing shareholder’s shares. That’s why a valuation is likely to be necessary whenever a shareholder dispute occurs.

The Valuation Process – Best Practices

We strongly recommend that a principal valuator be jointly retained by both parties to the dispute. Advantages to a joint valuation engagement include:

• Impartiality – there is a stronger perception of independence and fairness if both parties consider themselves to be the valuator’s client¹. For example, the valuator cannot accept instructions or alterations coming from only one party – both parties would need to agree on key engagement terms (i.e., the valuation date, the type of report, etc.)
• Transparency – a joint engagement provides greater transparency in communications. Both parties to the dispute would be copied on all correspondence. In particular, both parties would be made aware of what information is being provided to the valuator, thus reducing the prospect for misrepresentation or manipulation.
• Cost savings – lower valuation fees are incurred when a single valuator is used, compared to each party hiring a separate valuator, and
• Timeliness – the engagement is typically completed faster since both sides are usually cooperating in order to have the valuation completed as soon as possible.

Resolving a Shareholder Dispute through a Buy-Out

Case Study

The client: a sales representative organization in the alcoholic beverages industry that was founded in 2015 by two principals. One of the two shareholders was looking to exit the business, and both parties agreed that the more active shareholder would buy out the other.

The background

The Company had experienced rapid growth in recent years, and one of the shareholders was spending less time on matters relating to the Company.

The requirement

Smythe was retained by both parties to conduct an independent valuation of the Company to determine a fair buy-out price. Both shareholders wished to know more about how the valuation process works and what methodology Smythe would use to determine fair value.

Smythe’s role

To maintain independence and objectivity, Smythe’s team analyzed historical financial and operational data and estimated forward earnings. Smythe adhered to industry best practices and maintained both parties’ faith in the process and results by following industry best-practices.

The outcome

Both parties were able to agree mutually on a fair buy-out price, and the deal was concluded without a protracted delay or the souring of the relationship. The conclusions drawn up by Smythe were accepted by both parties, and the buy-out was successfully executed.

Selecting a Specific Valuator

During a dispute, the parties may have difficulty agreeing on anything, let alone selecting a valuator. In practice, what we found to have worked in the past is one shareholder suggests three possible candidates. The shareholder would request a proposal for professional services including an estimate of professional fees. The selection criteria should consider the valuator’s qualifications and experience. The other shareholder would then choose one of the three independent valuation valuators to be the principal valuator.

Working with the Valuator

When performing a joint engagement, we recommend that each shareholder participate in the process by providing information and context throughout the entire engagement, and feedback on the draft report. At Smythe, once we’ve completed our draft report, we provide a live presentation of our valuation methodology and conclusions (usually through a video conference call). This provides the parties with a greater understanding of the valuation and an opportunity to ask questions.

The goal of running a fair and transparent process is to increase the probability that both shareholders accept the independent valuator’s conclusion. This acceptance and buy-in goes a long way to helping resolve a difficult situation.

Otherwise, if one side, hires their own valuator and produces a report without the other party’s involvement, the other party might view the valuator to be acting as a hired gun to benefit the other shareholder. If that happens, the tendency is for the other shareholder to hire their own valuator which could result in widely different valuations, thus reducing the prospect of a settlement. This could quickly escalate the dispute and increase the chances of going to court, resulting in higher costs and extending the timeline for resolution.

It is important to view an independent valuation as providing a starting point for negotiations. Once the parties have reviewed the valuation report, they should do their own assessment of what is acceptable to them. In the end, they might decide to accept a lower offer, but with more favorable terms, or make a counter offer if they truly believe it’s in their best interest.

¹ When choosing a valuator, it is essential to confirm the valuator is independent and has no conflicts of interest.