Get the Shareholders’ Agreement Right, Save Money Later
By Owen Sizemore, CPA, CVA
Ohio’s Seventh District Court of Appeals recently ruled that the trial court erred when it valued a company’s stock because it ignored the plain language of the parties’ shareholder agreement.
At issue was the value of shares held by a minority shareholder that was terminated from an insurance brokerage (the Company) in August of 2014. The minority shareholder became an employee and shareholder when his insurance brokerage was acquired for seven shares of the Company in April of 2009. The minority shareholder subsequently purchased 14.4 shares for $107,838 (approximately $7,500 per share), owning nearly 20% of the shares at the time of termination. The shareholders’ agreement dictated that if the minority shareholder was terminated, either the single majority owner or the Company itself was obligated to repurchase the shares.
There were two methods for calculating the agreement price.
- First, all stockholders would convene and unanimously agree and evaluate the fair market value of each outstanding share and issue a certificate of valuation that was valid for 12 months. If this was not done, then the second method was to be used.
- The second method provided that the Company’s board of directors would appoint a qualified appraiser who would determine the agreement price. This provision outlined exactly what factors the qualified appraiser was to use when determining the agreement price. Additionally, this method required “giving great weight to any prior valuations of the shares of stock which have been agreed upon by the stockholders.”
The stockholders disagreed as to the value the shares at the time of termination, among other things. No annual valuations of the shares had taken place. In fact, no value was assigned to the shares except when they were purchased by the minority shareholder in 2009. As a result, the first method of valuing the shares per the shareholder agreement wasn’t used by the owners and a qualified business appraiser was hired.
The appraiser determined the value of the minority shares to be $1,980 per share after discounts for lack of control and marketability were applied. The appraiser also testified that she gave the minority shareholder’s 2009 purchase price of $7,500 “little to no weight.”
However, the trial court determined the share price was $7,500 (2009 purchase price) and disregarded the appraiser’s share price of $1,980, thus ruling for a share price in favor of the minority owner.
As a result, the case was appealed by the majority owner. The Court of Appeals determined that the appraiser was wrong for ignoring the 2009 purchase price in her valuation but that trial court was also wrong for ignoring the plain language of the parties’ shareholders’ agreement by completely disregarding the value determined by the appraiser. As a result, the Court of Appeals sent the case back to the trial court to issue a new valuation decision.
- The shareholders’ agreement didn’t outline the methods for determining value clearly enough.
- Since the shareholders’ agreement stated that the board of directors of the Company would appoint an appraiser, the value determined by the appraiser likely resulted in a value that favored the Company. This also introduced an additional risk of valuation dispute.
- Parties in such a dispute need to ensure their appraiser adheres to the valuation guidelines agreed on in the shareholder agreement, otherwise the litigation process is likely to be further drawn out as shown.
Getting a shareholder agreement right up front is necessary to reduce litigation risk in the future. Having a valuation expert involved while such agreements are being drawn up is a simple way to set value expectations and procedures for all parties, which reduces litigation risk and cost down the road. If already in litigation, involving a valuation expert that understands the prevailing case law, as well as valuation theory, is critical to an efficient resolution.
If you have a business valuation concern, please contact us!
Owen Sizemore, CPA, CVA (513) 373-8217 or osizemore[email protected]
Mike Stover, CPA/ABV (937) 223-5247 or [email protected]
Michael Blake, CFA, ASA, ABAR, BCA (678) 350-9500 or [email protected]