Business ownership is complicated, particularly when there are a number of shareholders. The odds of disagreement and conflict can be very high. When shareholder relationships break down there should be a mechanism in place for dealing with the dispute and for enabling one or more of the shareholders to exit the business in a pre-determined manner. This mechanism should include agreement among the shareholders to obtain and review, on an annual basis, an independent valuation of the business in order to minimize the likelihood of disagreement over the value of the business in the event of a dispute.
There are many instances where a shareholder, officer or director will seek relief under the oppression remedy of the Ontario Business Corporation Act (OBCA) or the Canada Business Corporation Act (CBCA) where he/she has been “oppressed” or “unfairly prejudiced or disregarded” by the corporation or its directors. These cases generally involve a minority shareholder claiming he/she has been unfairly treated by the majority shareholder(s) or director(s) and can include termination of employment or disputes over the shotgun/buy-sell clause in the Unanimous Shareholder Agreement (“USA”).
In these circumstances, the parties wish to terminate their business relationship without harming the value of the company. Terminating a business relationship between shareholders inevitably requires a valuation of the business and, specifically, the departing shareholder’s equity interest. Valuation is a significant issue as this determines the price at which the departing (often minority) shareholder’s interest will be acquired by the corporation or the other shareholder(s). In situations where the parties cannot agree on the value of the departing shareholder’s share interest, the expertise of a business valuation professional (a Chartered Business Valuator in Canada) is often required.
If the company has never obtained an independent valuation and the shareholders have never discussed (and agreed to) business value in the past, the likelihood of agreeing to value now that there is a dispute is extremely remote. After all, the departing shareholder will want to maximize the amount he/she receives in a buy-out and the remaining shareholder(s) will want to minimize the amount they pay in a buy-out.
Under these circumstances, many questions arise…
- Is there a shareholder agreement, or USA?
- If not, how and where do we begin to determine value?
- If so, does the USA address the process by which the business and the departing shareholder’s interest will be valued and the terms by which the purchase price will be paid (and perhaps financed)?
- Does the USA address the appropriate standard of value (e.g. fair market value or fair value) and the appropriateness of applying a minority interest discount?
- Does the process involve an independent expert business valuator, or CBV in Canada?
- Will one business valuator be jointly retained by the parties or will each party be retaining a separate CBV to conduct a business valuation?
Many valuation issues and challenges arise in shareholder disputes, especially when two separate CBVs have been retained. In theory, you may expect two separate valuators to arrive at similar value conclusions (given the same set of facts and circumstances). In practice, however, it is common for two valuators to arrive at conclusions that differ significantly. This can be the result of differences in:
- Understanding of the background facts and circumstances;
- Understanding shareholder roles, responsibilities and economic compensation;
- Opinion as to where the business will be located and economic rent (particularly if there is no long-term lease in place and there has been recent discussions about moving office space);
- The impact of various strengths, weaknesses, opportunities and threats (i.e. risk factors) facing the business; and
- The extent of risk associated with, and ability to achieve, the future cash flow projections provided by management.
These differences are quite common and can have a significant impact on the conclusion of business value. Consequences of this to the shareholders include:
- Continued disagreement over the price to be paid in a buy-out leading to litigation or alternate dispute resolution (i.e. court, arbitration or mediation);
- Significantly increased legal and expert fees;
- Increased stress for all parties involved (and their families);
- Delays in the departing shareholder receiving payment;
- Distractions from the business which could negatively affect its value.
The departing shareholder will usually provide a more optimistic view of the current business and its future potential whereas the acquiring shareholder(s) will usually present a more pessimistic view of the current business and the future threats facing the business. Although business valuators will do their best to independently verify the facts and corroborate the underlying assumptions provided by their clients, it is impossible to assess the risk associated with achieving the future cash flow projections with 100% certainty.
To avoid these consequences, the shareholders should formalize a process to prepare cash flow/income statement projections and to obtain an independent business valuation annually. When the shareholders meet to review the annual financial statements and tax returns they should also discuss the cash flow projections for the coming years (having consideration for the actual results over the past year) and the business valuation.
Committing to this process allows the shareholders to discuss and agree to the current value of the business before any potential disagreements arise. In the event of a dispute, the valuation issue will have already been dealt with. The return on investment of an independent and annual business valuation can be tremendous if it means avoiding a costly, time-consuming and perhaps devastating shareholder dispute down the road.
Call us at VSP to assist you in establishing a base valuation of your business and to discuss your process for determining business value in the event of a shareholder dispute. Obtaining an independent valuation today will help you avoid significant legal and expert fees in the event of a shareholder dispute down the road.