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Minority Shareholders Navigating a Buyout: Know The Landscape

Minority ownership of a closely held company can be a lucrative but risky proposition. A minority shareholder’s marginal voting position can unfairly empower other shareholders, especially if they vote together.

To illustrate this point, consider a family business owned by three siblings working for the company. Without laws protecting each individual shareholder, one sibling would be powerless to stop the others from cutting her out of a profitable deal or firing her and refusing to pay dividends, thereby depriving her of any ownership benefit. The two siblings could also vote on a risky business change – like selling all of the company’s assets in a blue chip market to finance the production of a fad product – without opposition from the minority owner. 

South Carolina has attempted to balance the power enjoyed by majority shareholders through laws that permit an alienated owner to force the company to buy out her shares. These laws are applicable to situations like those discussed above, when a minority shareholder is being treated grossly unfair (often called “minority oppression”) and also when a minority shareholder dissents on a vote that would fundamentally change the way the business operates or is owned, as in a merger (often called “dissenter’s rights”).      

If a minority shareholder is successful in showing he or she is entitled to a buyout under these laws, the company can be forced to pay the “fair value” of a minority owner’s shares. This is a legal term with a complex meaning. 

Fair value is established through testimony of business experts considering all facts that may be relevant to worth using three valuation models:

  • Net asset value measures the value of a company’s assets – including intangibles like goodwill – less its liabilities.
  • Market value measures the value of stock in public markets and requires that the court attempt to artificially construct a market where one does not exist.
  • Earnings value (sometimes called investment value) measures the return an investor would likely earn from buying a portion of the company and therefore often considers future cash flow.

Because these valuation methods produce different results from industry to industry, the court weighs each method consistent with its relevance to the business and may assign all, none or a combination of merit to any particular model. A closely held family company operating in a niche industry does not want the court to favor market value, because there is no proven market to consider and potential risk in artificially created one for that purpose. 

On the other hand, a real estate investment firm would favor the net asset approach because real estate holdings are easily appraised. A manufacturing firm may favor earnings value because of the nature of inventory and production. This process permits considerable discretion of the court on a key element to establish an accurate fair value.

After the court establishes fair value, the majority shareholders likely will argue discounts should be applied to decrease the amount the company has to pay for the buyout. South Carolina law typically does not apply discounts in oppression and dissenter buyouts, but they are not unheard of and can significantly reduce the amount paid to a minority shareholder. Common reductions are “minority discounts” – which recognize that minority interests are less attractive to investors for fear they are purchasing an interest that can be oppressed – and “marketability discounts” – which recognize that otherwise equivalent companies are not as valuable if they are not traded in established, proven markets. 

South Carolina courts have found these discounts are applicable to reduce fair value of a privately held temporary services agency in a business divorce case among equal shareholders. The minority discount also has been applied in a divorce case where the husband’s minority interest in a company was devalued because the remainder was owned by the wife’s father, who could force a “tax squeeze out” of the husband by recording paper profits, but not authorizing dividends, thereby creating a punitive corporate tax liability on part of the husband.

R. Taylor Speer is an attorney at Turner Padget, where he focuses on business, commercial and employment litigation. He has extensive trial experience, with a career representing clients in matters common to the formation, growth and dissolution of small to medium-sized businesses. He may be reached at (864) 552-4618 or by email at tspeer@turnerpadget.com.

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