Business partnerships sometimes come to an end. As we have written about previously, it is important going into a partnership to have an agreed-upon exit strategy in place. However, as a recent decision from an Indiana appeals court highlights, it is important for business partners to not only include exit provisions in their partnership agreements, operating agreements, or shareholder agreements but to carefully think through the wording of the provisions to avoid disputes and misunderstandings later.
In Hartman v. BigInch Fabricators & Construction Holding Company, Inc., the dispute considered by the court involved interpretation of a provision in the parties’ shareholder agreement that required the company to purchase the shares of any shareholder who was involuntarily terminated at “appraised market value on the last day of the year preceding the valuation, determined in accordance with generally accepted accounting principles by a third-party valuation company.”
The plaintiff in the case, Blake Hartman, was a co-founder and longtime president and director of the company called BigInch Fabricators & Construction Holding Company. Hartman was one ten shareholders, none of which owned a majority stake in the company. In 2006, the shareholders entered into a shareholder agreement.
The agreement included a buyback provision (also known as a repurchase agreement) requiring the company to purchase the shares of any shareholder who was involuntarily terminated as an officer or director of the company. The purchase was to be made at “appraised market value on the last day of the year preceding the valuation, determined in accordance with generally accepted accounting principles by a third-party valuation company.” The agreement did not define the term “appraised market value” or elaborate on the methodology to be used by a third party in performing the valuation.
In March 2018, Hartman was involuntarily terminated as a director and officer of BigInch. At the time of his termination, Hartman owned 8,884 shares in the company, representing a 17.77% interest. As required by the shareholder agreement, the company hired an appraiser to calculate the value of the company for the purposes of valuing Harman’s shares for repurchase. The appraiser calculated the fair market value of Hartman’s shares to be $2,398,000.00, which included discounts for the marketability of the shares and the lack of control represented by Hartman’s minority interest.
Hartman filed a declaratory judgment action contesting the valuation and requesting that the court declare the value of his shares. Hartman argued that the appraiser’s application of the “fair market value” standard to value his shares was not in accordance with the agreement because that standard presupposes an “open market” of willing sellers and willing buyers.
At the outset of its analysis, the Court began by explaining the utility of buyback provisions or repurchase agreements like those included in the BigInch shareholder agreement. Close corporations generally lack a market for their shares, the Court explained, because the only people interested in owning the business are the “incorporated partners” who are intimately involved with the entity. Because there is often no market for one’s shares, it is difficult and speculative to value a close corporation’s shares, which is why repurchase agreements frequently specify the valuation method to be used.
The Court turned its attention to two popular business valuation methods: the “fair value” method and the “fair market value” method. The Court next outlined the differences between the two methods. The “fair value” standard seeks to ensure that shareholders were fairly compensated. The “fair market value” standard, on the other hand, attempts to determine the amount that a willing seller and willing buyer would arrive at after negotiations. Because the fair market value standard attempts to approximate the results of a real-life negotiation, discounts for lack of control and lack of marketability are appropriate.
The question for the Court was which valuation method did the BigInch shareholder agreement require. The agreement did not specify but instead only required an “appraised market value.” The trial court held that this required application of the fair market value method which permitted discounts for lack of marketability and lack of control. On appeal, the Court disagreed and held that the proper valuation methodology in a forced sale is the fair value method.
The Court concluded that “minority and control discounts have no application in compelled transactions to a controlling party.” Applying such discounts in forced sales involving the company purchasing back shares from a minority shareholder would result in a windfall to the purchasing majority shareholder or shareholders. A windfall would result because “a sale of the minority shareholders’ shares to majority shareholders consolidates or increases the power of those already in control.” Given that the majority shareholders are already benefitting by increasing their power, it does not follow that the majority shareholders should be able to realize this benefit at a discount.