Private Equity

Distinguishing between an entity and the ownership of equity in that entity is not difficult. But it is surprising how often those two distinct concepts become conflated or obscured in the drafting of commercial agreements. Thus, in a New York case involving the interpretation of a prenuptial agreement, a spouse was denied a share of the proceeds of the sale of stock owned by her ex in a company because the agreement, as drafted, specified that she was only entitled to a share of the proceeds from a sale of the entire company.^[1] And this result was mandated by New York’s contractarian principles despite the fact that a concurring opinion suggested that “the contractual provision does not comport with either party’s understanding of it, and, in fact, under other scenarios, could cause unintended mischief.” The “unintended mischief” that the failure to clearly distinguish between a company and the ownership of shares in that company was more recently on display in an Indiana Supreme Court decision involving the proper means of determining the “fair market value” of shares, Hartman v. BigInch Fabricators & Construction Holding Co., Inc., 2021 WL 325883 (Ind. Jan. 28, 2021).

BigInch Fabricators involved the interpretation of a buyback provision in a shareholders agreement that was triggered by the termination of a shareholder’s employment with the company. Pursuant to the buyback provision, the company was obligated to repurchase a shareholder’s stock in the company if that shareholder was terminated as an employee of the company “without cause.” The “price per Share” at which the company was required to repurchase the stock of the terminated employee/shareholder was its “appraised market value” as determined “by a third party valuation company.” In making its determination of the “appraised market value” of the “price per Share,” the third party valuation firm applied a “marketability” and “minority” discount to the valuation of the terminated employee/shareholder’s shares.

The terminated employee/shareholder objected, arguing that, in calculating the “appraised market value” to determine a “price per Share,” it was necessary for the valuation firm to first determine the market value of the company itself and then divide the resulting value of the company by the total number of outstanding shares. According to the terminated employee/shareholder, applying marketability and minority discounts in a forced sale where the company is the buyer would “improperly punish minority shareholders and create a windfall for the majority shareholders.” Indeed, an earlier Indiana case, involving a valuation of shares in a statutory (not contract-based) buyout, had held that “a minority discount is inappropriate . . . because ‘a sale to a majority shareholder or to the corporation simply consolidates or increases the interest of those already in control’ … [and] a marketability discount ‘ignores the fact’ that there already was a ready-made market for the shares.”

While all that may be true in statutory appraisal actions, in BigInch Fabricators, the Indiana Supreme Court held that the language of the shareholders agreement dictated the outcome here, and there was no overriding rule that prevented a shareholder from agreeing that the value of its shares was to be determined based upon the “fair market value”^[2] of those shares as opposed to the shareholder’s proportionate share of the fair market value of the company as a whole. According to the court:

The value of corporate shares may not correspond proportionally to the company’s overall value. Shares are usually valued less if they represent a noncontrolling interest or if they are not publicly traded. When valuing such shares, an appraiser will often account for this reality by applying “minority” and “marketability” discounts.

Here, when tasked with valuing shares, an appraiser applied these discounts, even though the shares would be sold in a compulsory, closed-market sale. The selling shareholder takes issue with the valuation, arguing that minority and marketability discounts are open-market concepts inapplicable to the buyback provision of his shareholder agreement with the company.

While we recognize the public policy rationale underlying the shareholder’s position, we hold that the parties’ freedom to contract may permit these discounts, even for shares in a closed-market transaction. And under the plain language of this shareholder agreement—which calls for the “appraised market value” of the shares—the discounts apply.

In most private equity transactions, buyback provisions are based upon a hypothetical sale of the company followed by a hypothetical distribution of proceeds through a waterfall; as a result this particular issue may never arise. But sometimes, parties do in fact tie buyback provisions to a “fair market value” determination of the equity ownership interest of the affected minority party. When they do so, the failure to clearly exclude the application of minority or marketability discounts can result in “unintended mischief” from the application of those discounts that are built into the valuation of shares’ “fair market value,” unless that is truly what you intended.^[3] But avoiding “unintended mischief” is as simple as recognizing the distinction between an entity and the ownership of equity in that entity; or, more precisely, recognizing the distinction between the fair market value of shares in a company versus the shareholder’s proportionate share of the fair market value of the company.