Friday, February 17, 2006

Shareholder Agreements Prevent Minority Shareholders
from Receiving Fair Value

Our Investment Banking firm is receiving an unusually high number of inquiries from minority interest shareholders looking for help. Often times they have just been terminated and concurrently receive a Letter of Intent to purchase their minority shareholder stock.

When they look at these offers, they are hit with their second punch in the gut. The offers are often woefully short of what the terminated shareholder expected. However, when they start to investigate, the harsh reality of the situation sets in. IRS Revenue Ruling 59-60 allows steep discounts when valuing minority interests in privately held companies. The lack of marketability discount can be as high as 40%. A second discount for lack of control for up to 40% can be applied on top of that.

Theoretically, if you owned 49.9999% of a company with a $10 million value and these maximum discounts were applied, your $5 million value evaporates into $800,000.

Wait, it gets worse. The oppressive shareholder understands that through either the shareholder agreement or the Corporate By Laws, they have every right to buy your minority stock at an even bigger discount from fair value. I cannot tell you how many times I have seen almost exactly the identical language as below in either By Laws or Shareholder Agreements:

Right of First Refusal: “The Corporation Shall have the power, at its option to purchase any and all of its shares owned and held by any shareholder who should desire to sell……the shareholders shall not assign, transfer, encumber, or in any manner dispose of any of all of the shares of the corporation that may now or hereafter be held or owned by them, and no such shares shall be transferable unless and until such shares have first been offered to the corporation.”

Wait, the pain is just beginning……. “In the event the Corporation exercises its right of first refusal under the above clauses, the purchase price shall be payable in cash or bank check, and shall be the book value of the shares, exclusive of goodwill, as of the first notice, as determined according to generally accepted accounting principles and shall be binding upon the parties.”

In most cases the “book value” of a company net of good will is a small fraction of the true value of the company. I looked at a company recently that had a market value of approximately $10 million. Its book value using this definition was approximately $800,000. A 40% shareholder wanted to sell his shares. According to the shareholder agreement, if, after he was terminated and given his bid from the oppressive shareholder of $500,000, he sought to sell his shares to an outside party, he would have triggered the Right of First Refusal clause. The result would have been a mandatory sale to the Corporation at a value of 40% of $800,000 or $320,000. This is not even close to the fair value of the company multiplied by his shareholder percentage.

Unfortunately, traditional legal remedies are inadequate to help these minority shareholders. Their attorneys are left with going after a wrongful termination lawsuit. Those end up being a frustrating and ineffective attempt to extract some measure of relief from this pain they are experiencing. The poor client will find it hard to win, he will spend the entire amount of a potential settlement on legal fees and most importantly, he is focusing on the lowest potential reward. His prize is in his stock. MidMarket Capital has worked with several clients in this area and has identified a number of successful strategies that are designed to achieve meaningful exits without legal conflict.

Dave Kauppi is president of Mid Market Capital, Inc. MMC is a business broker firm focused on middle market corporate clients. We provide complete M&A services. Dave a licensed business broker and a member of IBBA and the MBBI. Contact (630) 325-0123 or
Dave Kauppi is a business broker and President of MidMarket Capital. We help business owners with all aspects of Mergers and Acquisitions. Dave a licensed business broker and a member of IBBA and the MBBI. Contact (630) 325-0123

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