SHARE-HOLDER Divorce

California CPA, Nov, 2000 by Mark S. Luttrell

When a shareholder wants out, the buyout price is a hotly contested issue

CPAs are frequently called upon to provide valuation services in connection with marital dissolution matters. But divorce between husband and wife isn't the only dissolution that requires CPA expertise. Increasingly, CPAs are being called upon to provide valuation services for corporate dissolution.

In the simplest terms, a corporate dissolution action commences when a shareholder (or group of shareholders) proves the existence of certain facts set forth in Chapters 18 or 19 of the California Corporations Code and brings an action for corporate dissolution. Examples of factual requirements include the extent of share ownership and proof of issues such as voting deadlock, persistent and pervasive fraud, mismanagement, or unfairness by the remaining shareholders.

If the complaining shareholder prevails in the action to dissolve the corporation, the remaining shareholders, or the corporation, may purchase the complaining shareholder's shares under CCC Sec. 2000. The valuation assignment that arises from this action requires that the CPA possess expertise beyond the more typical fair market value assignment.

The standard of value in a Sec. 2000 engagement is "fair value," not "fair market value."

Fair value is a well-known valuation standard, but by its very definition it does not have a universal meaning. Fair value was created to facilitate valuations performed under specific instructions promulgated by a legislative body or other overriding source, often in the context of litigation. For example, valuations performed in the context of marital dissolution are subject to the fair-value concept. In that instance, the meaning of fair value varies with the law from state to state. Thus, the appraiser must understand the pertinent legal issues in a given jurisdiction before commencing work. The meaning of fair value in a Sec. 2000 engagement is similar in this regard.

Since fair value is subject to interpretation and is typically encountered in litigation matters, the appraiser may receive contradictory explanations of its meaning. For this reason, it is important for the appraiser to develop an independent understanding of the term.

If appraisers solely rely on the attorney who hired them to explain the meaning of fair value, they risk performing a valuation that could be challenged due to a misapplication of the law. An exaggerated, but not entirely unrealistic, portrayal of valuation instructions given to a CPA by the attorneys in a Sec. 2000 engagement is as follows.

TWO ATTORNEYS, TWO VIEWS

The purchasing party's attorney might present this case: "The minority (complaining) shareholder brought an action to have this corporation dissolved. Thus, the minority should receive nothing more than if his wish was granted and all assets were liquidated and debts paid. In performing this liquidation calculation, you should include all associated costs, such as commissions, fees and taxes. Keep in mind that the corporation would have filed notice for liquidation and ceased all activities. Thus, it is very unlikely that all assets would have been sold or liquidated at anything close to their market values. If you believe there was the possibility of selling the business as a whole, keep in mind that this had to be accomplished in a limited timeframe for cash. Since the buyer would have been aware of the distressed nature of the sale, he or she would have required significant discounts. Finally, keep in mind that this business had no covenants or employment agreements with the shareholders, and it is unlikel y that a buyer would have paid much for intangible value without these assurances."

On the other hand, the complaining party's attorney might have this perspective: "The statutes are designed to protect the minority shareholder against the injustices of the controlling shareholder. Thus, the valuation process must ensure that the controlling shareholder is not unjustly enriched by a buyout of the minority. You should value the stock as if the corporation was sold as a going concern to the highest bidder in a hypothetical market. There is no time limit on such a sale, and you should appraise the stock as if the directors could have waited for an optimum time in the market to achieve the best possible result. Also, remember that the phrase 'liquidation value' in the CCC does not suggest a piecemeal liquidation under any circumstances. You should presume that all existing employees were bound to the corporation by both employment agreements and covenants not to compete. If the value is highest to the shareholders, you should assume they are the buyers. Reductions in value for issues such as li quidation costs, income taxes and lack of control are strictly prohibited."

In the above examples, the attorneys are advocating the most favorable positions for their clients. A more reasonable interpreta2tion of fair value would comprise portions of each of their comments. For example, it is clear from certain appellate cases (see box) that fair value should not be reduced for issues such as liquidation costs, income taxes, or lack of control. Likewise, the appraiser should assume that a covenant not to compete exists and therefore not discount the value for reliance of the business on the personal attributes of the controlling shareholder. Further, the valuation must be performed as if the buyer paid cash for the business and its assets. Finally, the appraiser cannot assume that the directors can time the market for an unusually long period to bring the highest possible value. This stated, there is no rule that imposes an immediate timeframe on the process.