Buyouts of Closely Held Shares: All’s Fair Value in Love and War

Deadlock, majority oppression, or usurpation of corporate opportunities are all well-tread grounds for disputes between co-owners of closely held entities. These disputes often culminate in one shareholder buying out the other as an alternative to dissolution or a freeze-out merger. In such instances, ascertaining the value at which that co-owner’s shares must be purchased can be a heavily fought battle, turning on the distinction between fair value and fair market value, and on which metric is most appropriate for valuing closely held shares.

Fair Value Versus Fair Market Value

In general, courts define fair market value as what a willing buyer would pay a willing seller in an arm’s length, market transaction.[1] Per a 1959 IRS Revenue Ruling, fair market value is the appropriate standard for valuing closely held shares for estate and gift tax purposes.[2] Akin to the courts’ definition of fair market value, the Revenue Ruling defines it as “the price at which [] property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell.”[3]

Unlike in the estate and gift tax context, however, in the closely held buyout context, the voluntary element of the transaction that is critical to adopting a fair market value measure may be missing. Shareholders in closely held buyouts are usually being compelled to give up their interests in response to oppressive conduct by a majority shareholder, including a freeze-out merger or dilution of a minority interest. Under these circumstances, the minority shareholder has no choice but to exercise its shareholder dissenter rights by seeking the “fair” price of its stock in an appraisal proceeding. As one court put it, “[d]issenting shareholders, by nature, do not replicate the willing and ready buyers of the open market. Rather, they are unwilling sellers with no bargaining power.”[4]

To correct this inequity, instead of valuing a minority’s shares based on the value it would command on the open market (i.e. the fair market value), courts fashion a price based on what should be its “fair value.” While there is no commonly accepted definition of fair value, “[t]he very nature of the term…suggests that courts must take fairness and equity into account.”[5]

Application of Marketability and Minority Discounts 

Two key discounts are relevant in arriving at the fair market value of closely held shares. One is a marketability discount, reflecting the illiquidity of the shares and the fact that they do not have a ready public market. The other is a minority discount, reflecting the fact that the shares being purchased represent a minority interest, lacking voting power to control corporate actions. The IRS Revenue Ruling mentioned above contemplates both discounts as factoring into the determination of fair market value. Specifically, it references “[s]ales of the stock [i.e. marketability] and the size of the block of stock to be valued [i.e. minority interest],” as factors in the determination of fair market value.[6] Both marketability and minority discounts are a percentage figure that is shaved off the proportionate value of the going concern value of an owner’s shares, yielding the fair market value.

Several courts reject the application of either discount when a minority’s shares in a closely held entity are purchased by the majority. These courts reason that because the sale by the minority was forced, in that it was reactive to majority oppression, and because the minority did not participate in the determination of and terms of the sale, applying a discount would result in a transfer of wealth to the majority. Hence in Morrow v. Martschink, the court did not apply either discount to the value of a minority’s shares where the minority was being brought out by the other shareholders of a family-owned business subsequent to petitioning for dissolution.[7] The court stated that “normally applied discounts should not be imposed in a forced sale situation.”[8] Likewise, in Cavalier Oil Corp. v. Harnett, discounts were not imposed because “to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result.”[9]

While wrongdoing by the majority is a frequent justification for not applying marketability and minority discounts, a recent decision from the Nebraska Supreme Court held that blameworthy conduct by the majority is not required.  A minority’s right to receive fair value, “can be triggered merely by the majority’s benign decision to engage in a merger or some other corporate transaction.”[10] Per the court, “[m]inority shareholders in these cases are protected from discounts for lack of marketability or minority status, not because there has been fault but simply to protect the vulnerability of the dissenter.”[11] The court reached a similar conclusion in First Western Bank Wall v. Olsen on the grounds that because the shareholder dissenter rights statute premised recovery on “fair value” and not on “fair market value,” the legislature had to have intended that dissenters receive the full proportionate share of their interest in the company without such discounts as might apply were the court trying to ascertain “fair market value.”[12] And, a further reason for courts rejecting marketability discounts in closely held buyouts, that is not tied to majority wrongdoing,  is that there is already a willing purchaser of the shares, making any asserted illiquidity concerns irrelevant.[13]

Conversely, courts have applied marketability discounts to closely held buyouts where the distinct aspects of a case render it equitable. One such instance is where the appraised share value, without discounts, is disproportionately high in comparison to the entity’s financials. In Devivo v. Devivo, a minority shareholder sought dissolution, claiming majority oppression and deadlock in management.[14] In response, the majority elected to purchase his shares pursuant to a Connecticut statute allowing for such election.[15] Because the appraised value of the shares was significantly higher than the entity’s net income (over 7 times), operating cash flow (over 2.76 times), and net worth (1.6 times), the court deemed it fair to apply a 35% marketability discount to the pro rata value of the minority’s shares.[16] Further, in Advanced Commc’n Design, Inc. v. Follett the court held that a 35 to 55 percent marketability discount was appropriate, because the appraised share value without any discounts was over five times the corporation’s net worth, almost seven times its operating cash flow for the past five years, and over eight times its average net income for that same period.[17]

Unlike in most jurisdictions, the standard in New York is for courts to apply a marketability discount to sales of closely held shares. However, like other jurisdictions, New York courts do not typically apply minority discounts. For example, in Matter of Blake, which involved a corporation electing to buy back the shares of a minority who petitioned for dissolution, the appellate court applied a 25 percent marketability discount, while making clear that “said discount should only reflect the lack of marketability of petitioner’s shares in the closely held corporation. No discount should be applied simply because the interest to be valued represents a minority interest in the corporation.”[18] A standard marketability discount in New York is between 10 and 25 percent.[19]

The ‘Inimical’ Minority

Although it is usually the majority shareholder doing the oppressing, sometimes it is the minority’s bad acts that cause upheaval to the entity. This situation was addressed in Congel v. Malfitano, where a minority partner’s wrongful, unilateral, dissolution of the partnership, triggered a proceeding to determine the value of his interest in the partnership.[20] New York’s Court of Appeals upheld the application of a 66 percent minority discount to his interest, holding that unlike in shareholder dissent and appraisal proceedings, wrongful dissolution is not necessarily preceded by upheaval “inimical to the position of the minority.”[21] Rather, “here the upheaval took the form of an action by a minority partner inimical to the majority’s interests.”[22]

Similarly, in Balsamides v. Protameen Chemicals, Inc. a New Jersey court applied a 35 percent marketability discount where a 50 percent shareholder, found to have engaged in a vendetta against his co-shareholder, was the one ordered to sell his shares to the 50 percent oppressed shareholder.[23] The court held that application of the discount was the “fair and equitable” solution” because “if Perle [the 50% selling shareholder] is not required to sell his shares at a price that reflects [the company’s] lack of marketability, Balsamides [the 50% buying shareholder] will suffer the full effect of [the company’s] lack of marketability at the time he sells,” which “would be unfair,…since Perle [selling shareholder] was the oppressor and Balsamides [buying shareholder] was the oppressed shareholder.[24] Thus because the oppressing shareholder was the one buying out his co-owner, applying a marketability discount against the seller was found fair.

Conclusion

As is often repeated, “[v]aluation is an art rather than a science.”[25] There is thus no inflexible test for determining fair value, and a survey of the case law will not necessarily provide precise guidance on when marketability and minority discounts will be applied.

To avoid the whims of a court, shareholders may consider incorporating a provision in their operative agreements that specifies in advance the method of valuation on buyout, including whether the buyout is at fair market value, and what discounts, if any, may be taken. That said, it is understandable that business owners may be hesitant to prophesy the future by delineating specifics that may later turn out not to be in their favor.

With all this in mind, business owners should be mindful of the implications of there being “no simple, precise mathematical formula for determining the ‘fair value’ of corporate stock.”[26] It is because “[e]ach case presents different elements of value and each must be viewed separately,”[27] that a thorough understanding of the factual and legal underpinnings unique to each one is required in order to convince a court what fair value means.

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[1]  See e.g. Lee v. 33 Captain Claws Inc., 2023 WL 8194455, at *1 (1^st Dept. Nov. 28, 2023) (“F]air market value is the price at which an asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of any relevant facts.”); Estate of Godley v. Comm’r, 286 F.3d 210, 214 (4th Cir. 2002) (same) (citing United States v. Cartwright, 411 U.S. 546, 551 (1973)

[2] Rev. Rul. 59-60, 1959-1 C.B. 237 (1959).

[3] Id.

[4] Swope v. Siegel-Robert, Inc., 243 F.3d 486, 492 (8th Cir. 2001) (citing Harry J. Haynsworth, Valuation of Business Interests, 33 Mercer L.Rev. 457, 459 (1982)).

[5] Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383, 400 (1999).

[6] Rev. Rul. 59-60, 1959-1 C.B. 237 (1959).

[7] Morrow v. Martschink, 922 F. Supp. 1093, 1105 (D.S.C. 1995).

[8] Id.

[9] 564 A.2d 1137, 1145 (Del. 1989).

[10] Bohac v. Benes Serv. Co., 310 Neb. 722, 735 (2022).

[11] Id.

[12] 621 N.W.2d 611, 617 (S.D.2001).

[13] Institutional Equipment & Interiors, Inc. v. Hughes, 204 Ill. App. 3d 922, 150 Ill. Dec. 132, 562 N.E.2d 662 (2d Dist. 1990); Hansen v. 75 Ranch Co., 288 Mont. 310, 325 (1998) (“discounts should not be taken when determining fair value of minority shares sold to another shareholder or to the corporation”).

[14] 2001 WL 577072 (Conn. Super. Ct. May 8, 2001).

[15] Id. Similar statutes exist in other states allowing a buyout election upon one shareholder seeking dissolution.

[16] Id., at *11.

[17] 615 N.W.2d 285, 293 (Minn. 2000).

 

[18] 107 A.D.2d 139, 149 (1985); see also Friedman v. Beway Realty Corp., 87 N.Y.2d 161 (1995); Matter of Fleischer, 107 A.D.2d 97, 101 (2d Dept. 1985); Ferolito v. Arizona Beverages USA LLC, 2014 WL 5834862, at *19 (N.Y. Sup. Ct. 2014).

[19] Lehman v. Piontkowski, 203 A.D.2d 257, 259 (2d Dept. 1994) (25%). Matter of Fleischer, 107 A.D.2d at 101 (upholding 25 percent marketability discount); Ferolito, 2014 WL 5834862, at *19 (applying 25% marketability discount “to reflect that the shareholders in a closely held company cannot readily liquidate their shares”); Giaimo v. Vitale, 101 A.D.3d 523, 525 (1^st Dept. 2012) (applying 16% marketability discount).

[20] 31 N.Y.3d 272 (2018). The valuation of his interest was necessitated because the partnership’s business was continued by the other partners after the dissolution, which meant under New York’s partnership law that the partner who wrongfully caused the dissolution is “to have the value of his interest in the partnership, less any damages caused to his copartners by the dissolution.” New York Partnership Law § 69 (2)(c)(II).

[21] Id. at 297.

[22] Id. In addition to the minority discount, a 35 percent marketability discount was taken by the lower courts. However, the Court of Appeals did not pass on the appropriateness of taking such discount as the issue was not preserved for appeal.

[23] 160 N.J. 352 (1999).

[24] Id. at 378.

[25] Lawson, 160 N.J. at 397.

[26] Dreiseszun v. FLM Indus., Inc., 577 S.W.2d 902, 907 (Mo. Ct. App. 1979).

[27] Id.