THE APPLICATION OF FAIR VALUE IN SHAREHOLDER OPPRESSION LITIGATION

1
THE APPLICATION OF FAIR VALUEIN SHAREHOLDER
OPPRESSION LITIGATION
Rob Hancock CPA/ABV, CVA APRIL 9, 2002 Presented
for Vinson Elkins L.L.P.
2
ISSUES TO BE DISCUSSED

• The Contents of an Experts Fair Value Report
• What is Fair Value
• A Few Cases
• Fair Value Calculations on the Same Company
• Beyond Control and Minority Values - Oppression
  Not Found
• 2 Situations and Related Cases

3
THE EXPERTS REPORT
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A Fair Value Report Should

• Explain rationale of valuation date(s)
• Explain approach to fair value
• Reference to statutory case law
• Reference to professional publications

See sample excerpt from fair value report.
5
A Fair Value Report Should (cont.)

• Explain rationale for business enterprise value
• Income, market or asset approach
• Going concern or liquidation premise
• Application of discounts or premiums
• Application of personal goodwill/key person
  discount
• Control (including synergistic) v. minority
  valuation

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A Fair Value Report Should (cont.)

• Address the conduct of the parties
• Employment termination
• Management termination
• Dividend withholding
• Diversion of business
• Perks to Controlling Shareholder
• Buy-out at low price
• Withholding information
• Excessive compensation
• Shareholder Borrowing
• . . . and link the conduct to the valuation.

7
A Fair Value Report Should (cont.)

• Consider Reasonable expectations of the parties
• Consider Multiple valuation calculations
  (discussed later with sample calculations)
• See accompanying excerpts from sample fair value
  report.

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WHAT IS FAIR VALUE?
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SHOULD FAIR VALUE BE?

• A CONTROLLING INTEREST (i.e. a pro rata portion
  of the value of the enterprise as a whole).
  Courts reaching this conclusion have not allowed
  a minority interest discount or a marketability
  discount. Or,
• A MARKETABLE MINORITY VALUE (as if the companys
  shares enjoy a public market). Courts following
  this line of reasoning have allowed a minority
  interest discount in valuation. Or,
• A NONMARKETABLE MINORITY INTEREST VALUE (which
  considers the illiquidity for the companys
  shares) or,
• A SYNERGISTIC VALUE (normally the result of
  merger and acquisition activity)

10
SHOULD FAIR VALUE BE?
Control Premium
Minority Interest Discount
Marketability Discount
11

• Consensus towards construing fair value to mean a
  propor-tionate value of the company as a going
  concern.

12
GOING CONCERN VALUE

• Three Basic Methods
• 1. Multiples of historical and projected
  earnings/cash flow based on comparable or
  guideline companies
• 2. Multiples of historical and projected
  earnings/cash flow based on comparable mergers
  and acquisitions
• 3. Discounted cash flow
• Others Liquidation value (a floor), asset value,
  book value, dividend yields, revenues
• Industry norms/standards (website hits, tons in
  reserve, numbers of hours available, etc.)

13
DEFINITION OF FAIR MARKET VALUE

• . . .the price at which the property would change
  hands between a willing buyer and willing seller
  when the former is not under any compulsion to
  buy and the latter is not under any compulsion to
  sell, both parties having reasonable knowledge of
  relevant facts. Court decisions frequently state
  in addition that the hypothetical buyer and
  seller are assumed to be able, as well as
  willing, to trade and to be well informed about
  the property and concerning the market for such
  property.

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DIFFERENCES BETWEEN

• FAIR MARKET VALUE FAIR VALUE
• ? Hypothetical parties ?Actual
  parties
• ? Hypothetical transaction
  ?Actual transaction or oppressive events
• ? Includes willing parties, not com- ? May
  include non-willing parties
• pelled to buy/sell
  compelled to sell or economically
  deprived
• ? Includes parties knowledgeable of ? May
  include parties not knowledgeable
• relevant facts
  of relevant facts
• ? Actual value ? May include several
  potential fair
• ? Typically one amount values
• ? Typically incorporates discounts ? Typically
  excludes discounts
• Value should be at least what a dissenting
  shareholder would reasonably expect
• to receive in a statutory appraisal action.
  (Metropolitan Life Issuance vs
• Aramark Corp. - Delaware 16142, 2-50-98
  transcript). Such value may set a floor.
• The consensus is that fair value is the
  proportionate interest in the going concern.

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DEFINITIONS OF FAIR VALUE

• Model Business Corporation Act
• American Law Institute Principles

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The Model Business Corporation Act, Section
13.01(3) Defines Fair Value As

• . . .the value of the shares immediately before
  the effectuation of the corporate action to which
  the dissenter objects, excluding any appreciation
  or depreciation in anticipation of the corporate
  action unless exclusion would be inequitable.

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AMERICAN LAW INSTITUTES PRINCIPLES OF CORPORATE
GOVERNANCE ANALYSIS AND RECOMMENDATIONS

• The fair value of shares under Section 7.21
  should be the value of the eligible holders
  proportionate interest in the corporation,
  without any discount for minority status or,
  absent extraordinary circumstances, lack of
  marketability.
• This definition construes extraordinary
  circumstances to be those in which the
  dissenting shareholder held out in order to
  exploit the transaction giving rise to appraisal
  so as to divert value to itself when such value
  could not be made available proportionately to
  other shareholders.

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OTHER FAIR VALUE SOURCES

• ONeal Thompson
• Squeeze outs (cash out merger)
• Partial Squeeze outs (halting of dividends and/or
  compensation
• Freeze outs
• Law Reviews
• February, 1998 Duke Law Journal article by Barry
  Wertheimer
• Summer 1997 Montana Law Review article by John
  Citzinger
• June 1991 University of Pennsylvania Law Review
  article by John Contes IV
• 1990 Notre Dame Law Review article by Charles
  Murdock

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LAW REVIEWS

• Notre Dame Law Review
• The impact of dissolution on value
• Reasonable expectation of the partner
• Valuation adjustments related to oppressive
  conduct
• Minority and Marketability discounts are
  inconsistent with fair value
• University of Pennsylvania Law Review
• Corporate level discounts v. S/H level discounts
• Control Premiums and Minority discounts
• Duke Law Journal
• Rapid American Corp. v. Harris-Delaware Supreme
  Court upheld a control premium. Trapp Family
  Lodge, Inc. (Vt. 1999) valuation also
  acknowledged control premium
• Recognizes that courts should determine fair
  value in a manner consistent with the purposes of
  the remedy

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CASES
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CONDUCT OF THE PARTIES

• Balsamides v. Protameen Chemicals (New Jersey,
  July 14, 1999)
• 15 S/H dissented and demanded Fair Value, court
  rejected marketability discount
• Wheaton v. Smith (New Jersey, July 14, 1999)
• 50 oppressed S/H was allowed to buy-out other
  50 S/H with a marketability discount.

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TWO TEXAS CASES

• The First Reported Shareholder Oppression Case in
  the Fifth Circuit
• Hollis v. Hill, 232 F. 3d 460 (5th Cir. 2000)
• Court-ordered buy-out of shares of 50
  shareholder where the other 50 shareholder
  engaged in oppressive conduct and breached his
  fiduciary duty. (Fair value includes accrued
  dividend)
• Davis v. Sheerin, 754 S.W. 2d 375 (Tex. App. Ct.
  1988)
• Under its general equity powers a court may order
  a buy-out of a minority shareholders interest at
  fair value for oppressive conduct by the majority
  shareholder.

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FACTORS TO CONSIDER IN FAIR VALUE

• Presence of Oppression
• Dates of valuation
• Conduct of the parties
• Reasonable expectations of the parties
• Application of fair value standard
• Going-concern or liquidation premise
• Income, market or asset approach
• Application of discounts or premiums
• Tax affecting income statements and balance
  sheets
• Control, synergistic or Minority Enterprise Value

24
EXAMPLE CALCULATIONS OF FAIR VALUE OF THE SAME
COMPANY (non-taxable entity) UNDER VARYING
ASSUMPTIONS
25
Reconciling Control Value and Minority Value in
the Same Company

• FACTS AND CIRCUMSTANCES
• 2 Shareholders (30 - 70) Principal Payments
  180,000
• Pre Tax Net Income 1,000,000 Corporate Waste
  250,000
• Depreciation
  400,000 Perks 50,000
• W/C Requirement 100,000 Non-recurring bad
  debt 20,000
• Capital Expend. 200,000 L/T Indebtedness
  2,000,000
• Interest Exp. (A/T) 150,000 Personal
  Goodwill 100,000 (30 owner)
• L/T Debt Rate 10 (Optimum) Personal
  Goodwill 275,000 (70owner)
• Tax Rate 40 Risk Free Rate 5
• Equity Risk Premium 4
• Value of Debt to Equity for
• WACC 20 Equity Risk Premium,
• Small Company 3
• Specific Co. Risk 8
• (A/T) After Tax

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• Control Cash Flow
• Pre-tax Income 1,000,000
• Non-cash charges 400,000
• - W/C Requirements (100,000)
• - Capital Expenditures (200,000)
• Interest exp. A/T 150,000
• Excess Compensation 250,000
• Perks 50,000
• Non-recurring items 20,000
• Control Cash Flow 1,570,000
• Different from minority cash flow

• Minority Cash Flow
• Pre-tax Income 1,000,000
• Non-cash charges 400,000
• - W/C Requirements (100,000)
• - Capital Expenditures (200,000)
• - Principal Debt Payments (180,000)
• Non-recurring items 20,000
• Minority Cash Flow 940,000
• Different from control cash flow

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Linking the Calculations Together

• CONTROL CASH FLOW (w/rounding) MINORITY
  VALUATION (w/rounding)
• Control Cash Flow 1,570,000 Different Minority
  Cash Flow 940,000
• Control Cap. rate (WACC) ? 17.2 Different Min
  ority Cap Rate ? 20
• Control Capitalization 9,130,000 Minority
  Capitalization 4,700,000
• Less Debt. ( 2,000,000) Different Less Debt
  N/A
• Control Equity Value
  7,130,000 Minority Equity Value 4,700,000
• Equity Interest 30 Equity Interest
  30
• Control Value (Fair Value?) 2,140,000 Different
  Minority Value(Fair Value?) 1,400,000
• (35) Less lack of control discount
  (740,000) Different Less lack of control
  discount N/A
• Non-marketable minority value
  1,400,000 Same Non-marketable minority value
  1,400,000
• (35) Less marketability discount
  (500,000) (35) Less marketability discount (
  500,000)
• 900,000 900,000
• Less personal goodwill (100,000) Less
  personal goodwill (
  100,000)
• Value 800,000 Same Value
  800,000
• Sum of parts do
• not equal
  whole

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MORE SAMPLE CALCULATIONS

• Is It Advisable To Run Multiple Calculations?
• SEE HANDOUTS

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CALCULATING FAIR VALUES FOR THE SAME COMPANY 30
- 70, INC. (AN S CORPORATION)

• Income and Cash Flow
• Net Income 1,000,000
• Depreciation
  400,000
• Working Capital Requirement 100,000
• Capital Expenditures 200,000
• Interest Expense
  150,000
• Principal Debt Payments 180,000
• Corporate Waste 300,000
• Non-Recurring Bad Debt 20,000
• Income Taxes, Hypothetical 400,000

Balance Sheet Adjusted Net Book Value
500,000 Long-Term Debt 2,000,000
Other 30 Personal
Goodwill 100,000 70 Personal
Goodwill 275,000 Risk Free Rate
5 Equity
Risk Premium
4 Equity Risk Premium, Small Company
3 Specific Company
Risk 8 100 Value
Based on Private Company Guidelines
2,000,000 100 Value Based on
Public Company Guidelines
1,400,000 Control Premium
20 Each Discount
20
30
INCOME APPROACH VALUES(in thousands)(same
company in each example)

• Net Income
• Depreciation
• -W/C Requirements
• Capital Expenditures
• -Principal Debt Payments
• Non-Recurring Items
• Interest Expense
• Corporate Waste
• -Income Tax
• Cash Flow
• Capitalization Rate
• Value (Fair Value?)
• Debt
• 100 Going Concern Fair Value?
• Plus Premiums/Less Discounts
• Control
• -Minority
• -Marketability
• -Key Person

• Control Basis
• 1,000 1,000 1,000 1,000
• 400 400 400 400
• (100) (100) (100) (100)
• (200) (200) (200) (200)
• - - - -
• 20 20 20 20
• 150 150 150 150
• 300 300 300 300
• (400) - ( 400) -
• 1,170 1,570 1,170 1,570
• 17.2 17.2 17.2 17.2
• 6,802 9,128 6,802 9,128
• (2,000) (2,000) (2,000) (2,000)
• 4,802 7,128 4,802 7,128
• - - - -
• - - (960) (1,426)
• - - (960) (1,426)

• Minority Basis
• 1,000 1,000 1,000 1,000
  1,000
• 400 400 400 400
  400
• (100) (100) (100) (100)
  (100)
• (200) (200) (200) (200)
  (200)
• (180) (180) (180) (180)
  (180)
• 20 20 20
  20 20
• - - -
  - -
• - - 300
  - -
• (400) - -
  (400) -
• 540 940 1,240 540
  940
• 20 20 20 20
  20
• 2,700 4,700 6,200 2,700
  4,700
• - - -
  - -
• 2,700 4,700 6,200 2,700
  4,700
• - 940 1,240 -
  -
• - - -
  - -
• - - -
  (540) (940)

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MARKET APPROACH VALUES

• Value Based on Public
• Company Guidelines (A) 1,400,000
  1,400,000 1,400,000
• Control Premium 280,000
  - -
• 1,680,000
  1,400,000 1,400,000
• Marketability Discount -
  - (420,000)
• 1,680,000 1,400,000
  980,000
• Equity Interest 30
  30 30
• Fair Value? 504,000 420,000
  294,000
• 100 83
  58

• Value Based on Private
• Company Guidelines (A) 2,000,000
  2,000,000 2,000,000
• Minority Discount -
  (400,000) (400,000)
• 2,000,000 1,600,000
  1,600,000
• Marketability Discount -
  - (480,000)
• 2,000,000 1,600,000
  1,120,000
• Equity Interest 30
  30 30
• 600,000 480,000
  336,000
• 100 80
  56

(A) The treatment of corporate waste is also a
factor here.
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BEYOND CONTROL VS. MINORITY VALUES

• Fair Value Calculations Cannot Be Done With
  Cookie Cutter Approach
• If Oppression Is Not Found, What About Component
  Money Damages
• Lost Wages
• Dividends
• Past
• Future

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WHADAYA DO?

• Corporate Divorce Via Split-up One corporation
  (18 million in debt) with two separate and
  distinct divisions desires to split up.
  Preliminary valuations indicate one division has
  a higher value using the asset approach, while
  the other division has a higher value using the
  income approach. Whadaya do? (A)
• (A) Bell v. Kirby Lumber (Delaware 1980)

34
WHADAYA DO?

• Squeeze out of Minority Shareholder A
  corporation enters into a letter of intent to
  sell all assets. Prior to the sale, the
  corporation retires minority shareholders at a
  FMV price, on a minority basis, inclusive of
  discounts. The corporation sells all assets
  subsequent to the minority shareholder squeeze
  out. Whadaya do? (B)
• (B) Cede Co. v. Technicolor, Inc. (Delaware
  1996) Cavalier Oil Corporation v. Harnett
  (Delaware 1989)

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REFERENCE SOURCES

• The Handbook of Advanced Business Valuation,
  Robert F. Reilly Robert P. Schweihs,
  McGraw-Hill
• Business Valuations for the Legal Practitioner,
  An ABA-CLE Publication, The American Bar
  Association
• ONeals Oppression of Minority Shareholders,
  2nd edition, (especially Chapter 5), F. Hodge
  ONeal Robert B. Thompson, The West Group

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END

• Robert A. Hancock CPA/ABV, CVA
• Mann Frankfort Stein Lipp Advisors, Inc.
• 12 Greenway Plaza, 8th Floor
• Houston, Texas 77046
• 713/407-3832
• RobH_at_mfslhou.com