Valuation discounts for lack of control and marketability are major points of contention when companies or controlling shareholders are required to buy out shareholders who own minority interests. What’s appropriate depends on the facts of the case — and there’s an important distinction between statutory and contractual buyouts.

Statutory buyouts

In many jurisdictions, minority shareholders who are oppressed by controlling shareholders or who dissent to major business decisions are entitled to receive the “fair value” of their shares. Statutory appraisal rights provisions protect investors from being shortchanged in minority shareholder squeeze-outs, privatizations and leveraged buyouts, especially when the deal involves company insiders who may have a potential conflict of interest.

It’s up to the court to determine a fair buyout price in these cases, but both sides usually hire business valuation experts to testify on the fair value of the shares. Courts often perceive the price paid in a merger or acquisition to be an objective indicator of fair value — particularly if the deal was subject to a robust market check and involved arm’s length negotiations.

However, the court may decide that the merger value is unfair if a deal involves related parties with potential conflicts of interest. When merger value could potentially be unfair, the judge may turn to other appraisal techniques, such as the discounted cash flow and the guideline public stock methods, to estimate the value of the shares.

When applying these valuation methods to estimate fair value, discounts are often disallowed. The reasoning is simple: Discounts for lack of control and marketability don’t apply when selling shares to a controlling interest in a closed-market sale, because the discounts improperly punish minority shareholders and create a windfall for controlling shareholders.

Contractual buyouts

Shareholders’ agreements and other contractual agreements between business owners may call for shareholder buyouts under certain situations. Examples of events that may trigger the buyout provision include the death, disability or termination of a shareholder. Are discounts allowed in these situations? The answer generally depends on the terms of the agreement.

A recent Indiana Supreme Court case differentiates buyouts that are required under statutory appraisal rights laws from those mandated under shareholder agreements where “fair market value” is the implied standard of value. (Hartman v. BigInch Fabricators & Construction Holding Company, Inc., No. 20S-PL-618, Supreme Court of Indiana, January 28, 2021.)

In Hartman, a shareholders’ agreement called for the company to buy back the shares of a terminated shareholder at their “appraised market value.” The state supreme court held that the plain language of the agreement contemplated a “fair market value” standard, under which discounts for lack of control and marketability were appropriate. Further, the court ruled that the state’s appraisal rights law didn’t control the valuation method for selling shares to the company; rather, the parties could contract to whatever terms they see fit.

The effect of the high court’s decision on the value of the shareholder’s interest was significant. The undiscounted value of the interest was roughly $3.5 million, compared to $2.4 million on a minority, non-marketable basis. Notably, the terminated shareholder didn’t hire his own valuation expert to estimate the buyout price of the shares or to quantify the appropriate valuation discounts.

To discount or not to discount?

Courts are typically granted significant leeway when deciding on the appropriate buyout price in compulsory shareholder buyouts. When it comes to the issue of valuation discounts, however, it’s important to understand the relevant standard of value that applies under state law and/or the terms of any contractual agreements between the parties.

(This is Blog Post #1198)