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Five Key Considerations When Valuing a Business in a Shareholder Dissolution Case

Posted in Business Valuation, on Aug 2023, By: Mark S. Gottlieb

For the better of the past two years, we have been working on a shareholder buyout dispute centered on the value of a fifty percent interest in a business and its ability to support the buyout provisions. The shareholder’s agreement outlined the valuation standard and the terms of its payment. Despite this direction, each party’s valuation proposed at arbitration was millions of dollars apart. I will save the particulars of this case for another time but share with you that the value opined in our report was accepted in the arbitrator’s binding decision.

One of the reasons for this favorable business divorce case outcome was that our client’s attorney respected our focus on essential valuation fundamentals. In return, his direct case and cross-examination led to a well-versed presentation of the issues at bar.

Attorneys tend to many issues in a shareholder dissolution case; having a command of opposing valuation reports is just one. Here are five key considerations attorneys should consider when reviewing their experts’ reports and those of the opposing side.

1. Standard of Value

The choice of a standard of value is fundamental to the valuation process. Two common standards often considered are fair market value and fair value. Fair market value is defined in Revenue Ruling 59-60 of the Internal Revenue Code:

The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Fair market value is often used in many other instances despite its tax genesis. Fair value, on the other hand, is statutorily defined. Attorneys must know which standard is appropriate in their jurisdiction and instruct the same to their expert.

Many shareholder agreements prescribe a standard of value or even a valuation methodology. Attorneys must be familiar with such provisions, particularly if they did not create the parties’ agreement.

2. Purpose of Valuation 

Valuations might be required for various purposes, including distribution of assets, buyout negotiations, or court proceedings. Each purpose may necessitate a different approach. Attorneys must work closely with valuation experts to clearly define the purpose and scope of the valuation, ensuring that the chosen work performed is specific to the issue at hand.

3. Valuation Methodology

Choosing the appropriate valuation methodology is crucial to arriving at an accurate, credible,  and defensible value. Common valuation methods include the income, market, and asset-based approaches:

  • The income approach estimates the value of the business based on its future earnings potential
  • The market approach compares the business to similar entities sold in the private marketplace or trading prices on public exchanges.
  • The asset-based approach focuses on the net value of the business’s assets and liabilities.

The selection of the most suitable method should consider the nature of the business, its industry, and the availability of relevant data. Attorneys should have a basic understanding of these methodologies and be prepared to compare and contrast their elements.

4. Normalization Adjustments

To determine a fair representation of the Subject’s ongoing earnings, we considered the necessity of adjustments to the company’s historical financial statements. Valuation-related adjustments are often made because of the choices in accounting elections and treatments to minimize taxable income. This is particularly true regarding closely held businesses where there are generally few if any, passive investors to impress through financial statements.

Valuation-related adjustments aim to convert earnings and values from those established based on historical costs and tax accounting regulations to amounts that better estimate fair (market) values. These adjustments are generally made when the amount reflected on the financial statements appears inconsistent with fair (market) values or when better estimates of fair (market) values can be made. Clients are best served when their attorneys understand these adjustments and how they influence the conclusion of value.

5. Discounts and Premiums

Entire books and continuing education classes have been devoted to discounts and premiums. Discounts for lack of control and lack of marketability are often applied to reflect the reduced value of minority interests.

Conversely, control premiums may be considered if a majority stakeholder holds a position of control that enhances the value of their shares. Attorneys are not required to compute discounts and premiums but should understand how appropriate discounts and premiums apply.

A business valuation in shareholder dissolution demands a nuanced understanding of legal principles and business valuation methodologies.

Attorneys have a pivotal role in guiding their clients through this complex process. By considering the standard of value, the purpose of valuation, methodology, normalization adjustments, and discounts/premiums, attorneys can ensure that their client’s interests are protected and that the valuation accurately reflects the value of the closely held business.

To understand how MSGCPA can assist lawyers and their clients in business valuation for a shareholder dissolution case, schedule a 15-minute call with Mark S. Gottlieb, CPA/ABV/CFF, ASA, CVA, CBA, MST.

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