Thursday, December 28, 2006

Minority Shareholder Squeeze Out

"I can't believe this is happening" is the usual reaction to this series of events:

1. Stockholder with 20% to 49% ownership
2. Was an employee but was fired
3. Gets no dividends or minimal dividends for his shares
4. Gets an offer to buy his shares at what he feels is a terrible price
5. Has a shareholder agreement with right of first refusal for the Corporation or other shareholders to purchase his shares at a punishing valuation.

The first reaction is to sue. Let me tell you it is usually a waste of time and almost always a waste of money. After all, you signed the shareholder agreement that states very clearly:

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 or 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."

It gets worse folks:

……."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."
According to the Coolidge Study "Fixing Value of Minority Interest in a Business" Actual Sales Suggest Discounts as high as 70 percent from what would be considered the fair value of the entire company multiplied by the minority shareholder's percentage ownership.
A number of years of experience has demonstrated that it is extremely difficult to find any market for minority interests…

….despite efforts to do so…..On the relatively rare occasions when an offer is made to buy a minority interest, it is almost always for an amount far less than the fiduciary and beneficiary expect to get.

Why does this happen? The majority shareholders whose attorneys drew up the shareholder's agreement certainly balance the scales way in favor of their clients. Secondly, 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.

Armed with this knowledge and backed by a favorable shareholder agreement, the majority shareholder is under no compunction to offer anything close to a fair price for the squeezed out minority holder. Below is the sad news that results from this environment as reported by the Coolidge Study of actual minority shareholder buy-outs:

Average sale price was 36% below accounting book value
Only 20% were at discounts of less than 20%
53% sold at discounts ranging from 22% - 48%
23% sold at discounts ranging from 54% - 78%

Note: The metric used was accounting book value not fair market value. For most going concerns, net book value is not even close to true market value. Net book value might apply if the company was losing money or making so little money, that the break up value of selling the assets exceeded a valuation based on the earnings capacity of the business. In a company we recently looked at, for example, the net book value was about $3 million. The fair value, however, based on comparables and a discounted cash flow valuation was closer to $10 million. So the best way I can describe these buyout offers is punishing.

Remember the first reaction is the lawsuit. Unless the majority owner does something stupidly oppressive, there are no grounds that can force him to buy your shares at anything other than what is stated in the shareholder agreement. He really does not have to buy your shares at all. He can simply wait you out and pay no dividends, and pass the business down to the next generation. Your family could conceivably get no value for the ownership for a hundred years.
Remember, most likely your benefit from being a minority shareholder was that you were employed by the company.

Many squeezed out shareholders try the route of wrongful termination lawsuits. Again, great for the lawyers, not such a sound risk reward decision. Typically they will spend $100,000 in legal fees to recover one year's wages of $150,000. Other than the satisfaction of sticking it to the majority holder, it is pretty much useless. If you think this wrongful termination lawsuit can somehow be used to leverage the majority shareholder into paying fair value for your stock, you are deluding yourself. Unfortunately, the legal counsel you have hired will support your delusion.

We were advising a client that was attempting this ill-fated approach and had been at it for over a year and spent over $100K on a wrongful termination lawsuit when he found us. Our advice went something like this, "Dan, you are focusing on the wrong thing. You are spending all your time and money thinking your wrongful termination lawsuit can somehow benefit your cause to improving the buyout offer. If you win, your one year in salary recovery will just about break you even with your legal expenses. You have been offered $500 K to purchase your 47% interest in a business with an enterprise value of $9 million. Let us help you focus your efforts on chasing the correct pot of gold."

I know what you are thinking. I already know this. I have lived this. Why have I wasted my time reading this article to have you tell me what I already am painfully aware of? OK, maybe I can shine a ray of sunshine. We have developed an investment banking approach to encourage the majority shareholders to allow the minority shareholders to unlock more value for their shares. It involves a great measure of deal making fineness and we are able to help the majority shareholder recognize what's in it for him. Of course, if he does not want to play nicely in the sandbox, we have already set the stage for him to make an error and we then can bring in our legal team and encourage the oppressor to do it the hard way or do it the easy way.

1 comment:

robert said...

what about the oppressed shareholder regulations in NY state. do other states have such?