Abstract: Attorneys involved in dissenting shareholder cases quickly learn that business valuation plays an important role in determining damages. This article discusses three critical valuation matters to consider in shareholder disputes: the appropriate standard of value, effective date, and valuation methods. A sidebar summarizes a recent case in which the Arizona Court of Appeals upheld the valuation of a dissenter’s interest based on a failed IPO.
Kottayil v. Insys Therapeutics, Inc., No. 15-0765, Ariz. Ct. App., August 29, 2017
Focus on valuation
Valuation issues are at the forefront in dissenting shareholder cases
Lawsuits from dissenting shareholders are common. Attorneys involved in these popular types of cases quickly learn that business valuation plays an important role in determining damages. Here are several valuation matters to consider.
Standard of value
The standard of value for dissenting shareholder cases in most states is fair value, although the term is subject to different statutory and judicial interpretations. Generally, though, fair value is defined as the value of the plaintiff’s shares immediately before the corporate action that the shareholder objected to. Fair value typically excludes any appreciation or depreciation related to the corporate action unless exclusion would be inequitable.
This definition may not necessarily be synonymous with the “fair market value” standard of value. For instance, the dissenting shareholder is not usually a willing participant in the transaction; nor is the transaction consummated on an objective, unbiased basis. Also, fair value usually doesn’t include discounts for lack of control and marketability. Some jurisdictions may recognize one of these discounts — or leave the application of these discounts to the court’s discretion based on the case’s facts and circumstances. Where such discounts are prohibited, the rationale is that the discounts give controlling shareholders a windfall by cashing out a dissenting shareholder at less than the pro rata value of his or her shares.
Statutes in most states say that fair value should be determined as of the day before the contested corporate action. These statutes are based on the notion that the dissenting shareholder shouldn’t suffer or benefit from the effects of the contested action.
Note that different effective dates might be used in shareholder oppression cases where the plaintiff isn’t challenging a specific action but claiming unfair treatment in general by the controlling shareholders. In those cases, the business may be valued as of the day the lawsuit is filed (or the day before filing), the date of oppression, or a postfiling date (such as the trial date, the judgment date or the date of the buyback order).
Appropriate valuation methods vary depending, in part, on the company’s industry, assets and operating history. Courts accept several different approaches when valuing a dissenting shareholder’s interest:
Income approach. The discounted cash flow method is a common valuation method in these cases, especially in Delaware, where many companies are incorporated. The capitalization of earnings method, which likewise falls under the income approach, is also used to compute fair value, particularly when long-term financial projections aren’t available and the company’s earnings have stabilized.
Market approach. When comparable transaction data is available, a valuation expert also might apply the market approach or consider prior transactions and offers involving the subject company’s stock. (See “Court turns to failed IPO to value dissenter’s interest” below.) Courts tend to give significant weight to transactions negotiated by unrelated third parties. But fair value may be less than the price in an arm’s length transaction because that price might take into account the corporate synergies that would result from the transaction or the buyer’s ability to improve the company’s performance.
Cost (or asset-based) approach. Experts occasionally apply the cost approach in dissenting shareholder cases. But courts are split on adjusting the value of a dissenter’s interest for the tax consequences of built-in gains under the cost approach. Courts in some states ignore the tax consequences unless the company was actually undergoing a sale or liquidation on the valuation date, but others allow it regardless of the likelihood of incurring capital gains tax.
A complicated matter
Business valuations for dissenting shareholder cases involve complicated issues that may require special treatment based on the venue. Attorneys should work closely with experts to ensure that valuations are based on the applicable requirements for the standard of value, effective date, valuation methods and other factors that will affect the expert’s conclusions.
Sidebar: Court turns to failed IPO to value dissenter’s interest
In Kottayil v. Insys Therapeutics, Inc., the Arizona Court of Appeals recently found that traditional valuation methods didn’t provide a “reliable way” to calculate fair value in a dissenting shareholder case. The court pointed out that valuation of a company’s stock isn’t “purely a matter for experts”: rather, “pre-litigation valuations” used by the company or its directors, officers or shareholders also can be helpful when determining fair value.
The minority shareholder challenged the company’s reverse stock split, and the trial court determined that the share price in the split wasn’t fair. It found that the best approach to reach the fair value was to define a range of sales, with the low end of the range around $53 million based on discounted cash flow analyses by unrelated third parties. The court set the high end at about $152 million based on valuations prepared for an unexecuted initial public offering (IPO).
The trial court ultimately based the minority shareholder’s damages on the failed IPO price. The appellate court upheld the lower court’s award, noting that the projections, assumptions and analysis underlying the IPO valuations came directly from the company, representing what management thought the stock was worth based on their intimate understanding of future revenue.