Valuation Pitfalls in Shareholder Agreements

Feb 15, 2024

Shareholder agreements can provide valuable roadmaps for private companies navigating ownership transitions.

In my career as a business valuation expert, I have seen hundreds of shareholder agreements. Often, my valuation assignments are conducted in fulfillment of a shareholder agreement when a buyout is triggered.

While it is impossible to cover every scenario in an agreement, most of the agreements I have seen have very thoughtful provisions to address the most likely sources of conflict. For example, most agreements lay out a process to resolve disputes over valuation. A common provision describes how a valuation expert (appraiser) will be chosen and outlines procedures for what happens if either party disputes the valuation.

Generally, I have seen these processes work well in resolving shareholder disputes without litigation. However, there is one source of confusion that I have seen frequently lead to conflict: that is the definition of fair market value to be used in the valuation. Specifically, the issue arises over whether the subject interest (which is usually a minority interest) should be valued on a non-marketable, minority interest basis, with corresponding valuation discounts, or on a control basis with no such discounts.

Discount Confusion

The issue may seem like a nuance of semantics, but it carries significant consequences. Under the fair market value standard, a minority interest in a private company is typically valued at a significant discount from its pro rata portion of the whole. Such discounts can add up to 30-50% of gross value in many cases.

These discounts result in a loss of value for the seller and a transfer of value to the remaining shareholders. This dynamic is most clearly observed in a two-owner scenario. After buying out the other owner at a discount, the remaining owner can now sell the entire company and suffer no discounts, creating a windfall from the buyout.

For this reason, many shareholder agreements are written with the intention of having the valuation performed without discounts. Unfortunately, the language used to indicate this intention often becomes a source of confusion.

The valuation community can take some of the blame for this, since many of our standards use very specific terminology when addressing the topic of discounts and minority interests. This is further complicated by the fact that discounts for minority interests are typically applied in two parts: one for lack of control, and another for lack of marketability. Moreover, some valuation methods can capture lack of control without the discrete application of a discount. Finally, there is the fact that valuation practitioners use the term “discount” for a number of other valuation factors that have nothing to do with control or marketability.  

Best Practices 

Depending on the situation, there can be legitimate reasons why shareholders and the board would want discounts to apply and equally legitimate reasons they would not want discounts to apply. The point of this article is not to advocate for one or the other in shareholder agreements. The goal, instead, is to be clear on the intent.

If the intent is for discounts to apply, then the agreement should define the price along these lines: “the
fair market value of the stock, as determined by a qualified appraiser, on a non-marketable, minority
interest basis, with appropriate discounts for lack of control and lack of marketability.”

If the intent is not to apply discounts, then language like this will make that clear: “the fair market value of the stock, as determined by a qualified appraiser, on a marketable, controlling interest basis, with no discounts for lack of control or lack of marketability.”

While no agreement is airtight, using this language to define the price that will apply in a shareholder agreement can go a long way to reduce costly disputes and litigation. And, just to be safe, it is always a good idea to have a valuation expert review the relevant sections of the shareholder agreement while it
is being drafted.

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