Disagreements in business may arise from a host of reasons, including personality conflicts, mishandling of corporate information, or differences of opinion on strategy. Best practice for private companies is to have a buy-sell agreement in place that includes some form of valuation methodology determined in advance that can be used to enable a shareholder to exit in the event of conflicts. Absent a buy-sell agreement, or when the agreement does not provide sufficient clarity, the California Corporations Code (the “Code”) prevails and specifically addresses the proceedings for involuntary and voluntary dissolution.
Involuntary dissolution, covered by Section 1800 of the Code, is a rather extreme judicial remedy where the court, upon a complaint filed by dissenting shareholders on certain grounds, forces a sale of the entire business. Voluntary dissolution, covered by Section 1900 of the Code, is a proceeding commenced by shareholders holding at least 50 percent or more of the voting power who elect to wind up and settle the affairs of the corporation.
Section 2000 of the Code provides an alternative to voluntary or involuntary dissolution, allowing the corporation or 50 percent or more of the voting shareholders to avoid dissolution by buying out the parties who initiated the proceedings. The shareholders seeking dissolution are referred to as the “moving party,” while the party seeking to avoid dissolution is referred to as the “buying party.” Section 2000 also provides the buying party with a manner for determining the value at which it will buy the shares of the moving party. Section 2000(a) defines the applicable standard of value as follows:
“The fair value shall be determined on the basis of liquidation value as of the valuation date but taking into account the possibility, if any, of the sale of the entire business as a going concern in liquidation.”
If the parties cannot agree on the fair value of the moving party’s shares, the court will stay the dissolution proceedings and appoint three appraisers to determine fair value (Section 2000(b)). The conclusion of the appraisers, when approved by the court, is then final. The appointment of the three appraisers is contingent on the purchasing party posting a bond to cover the moving party’s share of attorney’s and appraisers’ fees if the purchasing party does not buy the shares at the concluded value in a timely manner. That is, when the court confirms the fair value of the shares, the buying party can either move forward with the purchase at that appraised amount or elect not to if they deem the price too high and instead let the company go through with dissolution. It is in that second scenario that the buying party would be liable for the moving party’s share of legal and appraisal costs. Of note, there is no comparable provision for the moving party, which does not benefit from the right to refuse to sell their shares at a price they may deem to be too low.
Valuation Standards and Premises
The main difficulty in appraising shares for Section 2000 relates to the above definition of fair value, which calls on the appraiser to consider both liquidation and going concern value. This standard differs from the more widely used fair market value standard defined in Revenue Ruling 59-60 as “the amount 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.” Many critical concepts in Revenue Ruling 59-60’s fair market value definition are absent from Section 2000’s fair value standard. First, no “willing seller” is involved – the seller is instead involved in a dissolution proceeding. Second, the seller is in fact “under compulsion to sell” upon conclusion of the proceedings and cannot, as is usually assumed under fair market value, wait for the best offer.
Even more critical to the appraisal is the [fundamental] premise of value under Section 2000. The fair value definition under the statute refers to both “liquidation value” and “going concern in a liquidation.” While Section 2000 does not define liquidation value, business valuation professionals usually interpret “liquidation value” as the net amount that can be realized if the business is terminated and the assets are sold piecemeal. In addition to liquidation value, the appraisers must also consider the value of the business “as a going concern in liquidation,” if selling the entire company as a going concern in a liquidation proceeding is a realistic outcome.
Both “liquidation value” and “going concern in liquidation value” differs from the more widely used “going concern” premise. The distinction is critical to the valuation process and conclusion of value. To better understand why the premise is different and to guide the appraisers in their approach, it is useful to remember the purpose of Section 2000: to provide the moving party with the same benefit they sought under Section 1800 or Section 1900 (i.e., dissolution) while offering the buying party the possibility to avoid dissolution. In Brown v. Allied Corrugated Box Co., the court neatly summed up the goal of the appraisal proceeding “to award plaintiffs what they would have received had their involuntary dissolution action been allowed to proceed to a successful conclusion.” Appraisal for Section 2000 purposes is thereby a theoretical exercise meant to simulate the amount the moving party would have received in an actual dissolution.
Valuation Assumptions and Methodologies
With a dissolution outcome thus in mind, there are several assumptions to be made and methodologies to employ that differ from typical fair market value and going concern assignments. Additional guidance has been provided by court cases over the years about certain factors to consider:
- Adverse impacts of dissolution announcement – The public announcement of the [potential] dissolution of a company can have a tangible adverse effect on the business. Employees may seek other opportunities, customers and vendors may not renew contracts, competitors may take advantage of the situation and aggressively target the company’s client base, loan obligations may be accelerated, and lenders may reduce or eliminate available credit. Under Section 2000, appraisers should consider these potential adverse impacts when valuing the business.
- Costs of proceedings – Whether piecemeal liquidation or forced sale of the business is considered the most probable outcome, the costs associated with either proceeding should be factored in the analysis. These costs may include legal, brokerage, accounting, auction, and employee termination fees, as well as taxes and other fees that would be incurred in achieving liquidity, and should be deducted to determine fair value.
- Time value of money – Piecemeal liquidation of the assets and distribution of proceeds to shareholders may take months or even years to complete, and appraisers need to factor in the time value of money in their analysis.
- Cash purchase and time constraint requirement – Section 2000 mandates that the business is valued on a cash sale basis. This requirement may substantially limit the pool of potential buyers by eliminating all stock, debt and other non-cash considerations. Installment purchases and contingent considerations are also excluded. By reducing the universe of deal structures to a single one and thus limiting the pool of acquirers, the all-cash assumption generally translates into lower value. The final impact on value may depend on the attractiveness of the particular business. Also, in a liquidation proceeding there would be pressure to conclude the sale promptly, so for a fair value determination under Section 2000 appraisers should assume that the company cannot wait for an optimal offer. A quick sale most often produces a lower value.
- Minority discount – Courts, including in Brown v. Allied Corrugated Box Co. and Ronald v. 4-C’s Electronic Packaging, Inc., have found that it was improper to reduce the value of the moving party’s shares for lack of control. Fair value under Section 2000 is meant to approximate the amount the parties would receive in a dissolution scenario, and that amount would simply be equal to the parties’ pro rata share of the proceeds from the sale of the whole business (or assets in a piecemeal liquidation) – the issue of control or lack would, therefore, be irrelevant.
- Lack of marketability discount – Because shareholders in a closely held corporation lack the ability to trade their shares on the open market freely, it is customary to discount the value of the interest for lack of marketability, either via a specific discount for lack of marketability or through risk considerations in the discount rate. Similarly, it is more difficult to find a buyer for a closely held business, especially one involved in legal proceedings, than it is to trade stocks on a public market. However, because of limited guidance on this matter, the applicability or inapplicability of a lack of marketability discount may depend on specific facts and circumstances.
- Hypothetical assumptions – Over the years, courts have clarified certain assumptions that appraisers must make in determining fair value. In Mart v. Severson, Abrams v. Abrams-Rubaloff & Associates, Inc. and Brown v. Allied Corrugated Box Co., the courts stipulated that the appraisers must assume that the selling shareholder would enter into a non-compete agreement, even though in reality the seller may not agree to do so. In Mart v. Severson, the court indicated that, in addition to the non-compete assumption, appraisers should assume that the parties to a hypothetical sale will negotiate the other requisite terms to a sale agreement.
Despite being intended as a win-win resolution, Section 2000 assignments are complex and may not yield a value that is optimal or even attractive to either party. As with any legal proceeding, a cost-benefit analysis may be helpful to shareholders trying to assess the economic impact and financial costs of invoking that section relative to the benefits of maintaining the corporation as a going concern. Those seeking dissolution under Section 2000 need to understand the role of appraisers in the process and should consult with competent legal counsel to understand the ramifications of the standard and premise of value, as well as guidelines and requirements set forth by the court.