Minority share valuation: Can a shareholder challenge fair value?

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Minority share valuation: Can a shareholder challenge fair value?

Often a minority share valuation is disputed. Every private company shareholder, especially minority shareholders, want a fair valuation. But what is “fair value”?  Here we offer a short commentary  on:

  • How fair value determinations arise;
  • Common provisions in the Company’s articles or the shareholder agreement;
  • How the courts determine questions on fair value;
  • When is a fair value likely to be considered unfair;
  • Consequences if a valuation is unfair; and
  • Tips for ensuring you receive a fair value.

How fair value determinations arise

There are two ways in which shares in privately owned companies can change hands:

1. Share buyback

A share buyback means the company pays the, usually minority, shareholder to cancel his shares. The remaining shareholders benefit, since cancelling the selling shareholder’s shares means the remaining shareholders each hold a greater percentage of the equity.

A share buyback is an attractive means of extracting profits. The remaining shareholders do not fund the increase in their equity.  There are company and tax law issues as well as any provisions in the articles and shareholders’ agreement to consider. The important requirements are:

  • The company must have distributable profits;
  • To benefit from capital treatment for tax purposes a substantial proportion of shares must be bought back.

If the tax rules are not satisfied the selling shareholder will be taxed as if he had received a dividend payment. There are further rules if the selling shareholder wants to claim entrepreneurs’ relief.

The issue of fair value is part of the process as the shareholders are required to approve the transaction.

2. Sale to either another shareholder(s) or a third party.

This depends on Subject to whatever is contained in the articles or shareholders agreement, a departing shareholder can strike a deal to sell his shares. The disposal is subject to capital gains tax on the gain arising. Unlike under the share buy back procedure, there are no restrictions on the percentage of shareholding that can be sold. However, the acquiring shareholder funds the transaction.

Minority share valuation: First check the articles and shareholders’ agreement

The shareholders’ agreement or the articles of association may contain “share buyback valuation” clauses which defines how to value shares. Those clauses may describe who values the shares and the method.

There may be a clause prescribing the order of priority for the acquisition of shares. Often we find corporate documentation stipulating that the:

  • Company has the right of first refusal under the share buy back procedure;
  • Followed by other shareholders;
  • Finally a third party.

Under UK company law, the company directors must approve any share transfer. However, often the need for director approval is displaced by bespoke provisions in the corporate documentation.  There is no general rule.

The court will consider whether the share valuation was fair, if a fair value determination mechanism exists and the company has:

  • Failed to value the shares before they were bought back or sold;
  • Or the valuation has been carried out but is contested by the shareholder.

Court’s approach to fair value in private companies

The following cases illustrate that if no fair value determination mechanism exists,  it’s possible to challenge a fair value determination if the process followed was unfair.  Unless specifically set out in the corporate documentation, or agreed between the parties, the share valuer will not be obliged to give reasons to support of his fair value determination.

The courts recognise that shareholders have an interest in maintaining the value of their shares (Re Bovey Hotel Ventures Ltd).  This is why the court takes a vigorous approach towards share valuation (North Holdings Ltd v Southern Tropics Ltd).

The court will make a number of assumptions, for example, the court will adopt a pro rata basis:

  • According to the number of shares held; and,
  • The power or influence that shareholding brings.

The court is reluctant to arrive at fair value by considering the shareholders as partners that all share the business’ profits and losses.

Timing of share sale impacts on fair value

The timing of the valuation can impact the share price, e.g.

  • The business depends on a key player or customer. If a key player is departing the court may consider the departure negatively impacts the shares’ value.
  • Profits spike and a good year may not represent the real value a share buyer is likely to receive. Often the court wants to see averaged earnings.

When is a share valuation unfair?

The following circumstances demonstrate when the court deemed a minority share valuation unfair:

Inappropriate behavior by the company which affects the value of the shares

In North Holdings Ltd v Southern Tropics Ltd the shareholder’s relationship disintegrated.  A minority shareholder then insisted that the company repurchased the  shares and the court should determine the share value.  The minority shareholder claimed that the other directors-shareholders acted in breach of their fiduciary duties they owed to the company by using its assets for the benefit of a subsidiary company.

The court rejected the application. There was a lack of evidence on breach of fiduciary duties. However, it was observed that where directors behave in breach of their duties to the company,  which diminishes the value of shares,  the subsequent depressed share valuation can be deemed unfair.

Mechanism of fixing value of shares is unfair or arbitrary

In Re a Company (No.004377 of 1986) a shareholder signed a special resolution to amend the company’s articles. The effect was that when a shareholder ceases to be an employee, then his shares are compulsorily repurchased. Soon thereafter the shareholder was dismissed and the company made an offer to repurchase his shares for a nominal value. The shares were valued by the company’s auditors.

The court held that where the mechanism for fixing share value is fair, then the court will not relieve the shareholder from the bargain he made and will honor the shareholders’ agreement.

The method of valuation permits inappropriate minority shareholder discount

In Virdi v Abbey Leisure Ltd the Court of Appeal held that shareholder did not act unreasonably in refusing a valuation of his shares by the company’s auditor, as provided in the articles, on the basis that the shares might be discounted in circumstances where a discount was inappropriate. The court accepted that it would be just and equitable to disregard the articles where the valuation method was unfair.

The valuer was not independent

In Re Benfield Grieg Group plc the court rejected a share valuation based on the fact that the company’s auditor valuation differed from the earlier valuation of shares carried out by them for tax purposes for the same period. It was held that the auditors had failed to act independently when valuing the former director’s shareholding, having already compromised their independence by previously advising the company.

No opportunity to make representations to the valuer offered.

Consequences of an unfair share valuation for private company shares

The aggrieved shareholder can petition to the court. The court will not substitute his judgement for the judgement of the professional valuer. However the court has the power to order an independent valuation where the initial share buyback valuation is manifestly unfair.

In some circumstances the court will accept an application for just and equitable winding up of the company, where shareholders dispute the share valuation. However, the court might consider the application an abuse of process, and dismiss it.

The tendency of the court is not to order a compulsory buy-back, if the shareholder does not agree to have his shares repurchased after he ceased to be an employee or a director. Clearly this only happens in the absence of a compulsory buy-back provision in the articles or shareholders’ agreement.

Getting fair value

To avoid disagreement about the value of company’s shares the company should have effective mechanisms for the fair value enshrined in the articles of association or shareholders’ agreement.

Model articles of association do not contain procedures for share valuation. This means bespoke corporate documentation dealing with the process for determining share value is a must. It is usually not in the interest of any shareholder to be embroiled in fair value arguments.

The courts are usually prepared to accept that a different mechanism for determining fair value can apply to different categories of shareholders. For example, it is common to carve out the process for fair value determination when a founder leaves from the formula applying when an employee or director who in addition to shares has received a salary leaves. The way that this is most commonly handled is via good and bad leaver provisions. In practice you can pick what suits your intentions best. The usual employment law protections do not apply to share based payments.

If the articles or the shareholders’ agreement is silent on fair value and circumstances in which shares must be sold there can be the worst of both worlds.

  • As a shareholder, you may not be able to sell out and move on. The risk is you have to sit and watch your investment decline in value unable for force a sale.
  • As the “other side” remaining shareholders, you may not be able to reclaim the shares when the relationship is no longer working.

Gannons will draft bespoke articles to ensure that departing shareholders leave without creating significant business disruption.