Without A Shareholders Agreement, Unforeseen Consequences Can Arise

Not all shareholders agreements are the same. Many shareholders agreements provide for the value of existing shareholders shares to be set by an accountant. Seems a fair and sensible way of obtaining a value. But, is it fair and sensible?

How Do Accountants Value A Share In A Propriety Limited Company?

Shares in a public company have a known market value. At any time, the offer and last sale price of every ASX listed company are known. Propriety limited companies have no equivalent market for the value of their shares.

The primary method accountants use to determine a quasi-market value for propriety limited company shares is the maintainable earning method.

The major factors to be determined in undertaking a valuation on this basis are:

  • the level of earning to be capitalised
  • the rate at which earnings should be capitalised
  • the discount rate (if any) that should be applied to future earnings

When determining the level of earnings to be capitalised accountants consider the ‘maintainable earnings’ of the company. They look at the level of earnings expected from the business on a continuing basis.

As the profits of a business can fluctuate dramatically, the reasons for fluctuation must be examined. It is, not appropriate to look at the history of the company and make adjustments for exceptional or non-recurring items to arrive at maintainable earnings. Future earnings must be considered in the determination of maintainable earnings.

To presume that the past profits of a business entity provide a guide to the future and add a degree of realism is a common mistake made in the valuation of companies.

Maintainable earnings as a valuation methodology fails to take into consideration the potential of the underlying business. The ‘blue sky’ is not considered.

A few years ago, we were involved in a case where a maintainable earnings value was as is often the case used to value a person’s shares.

Like many others, the company had a financial backer, who held two thirds of the shares and a sweat equity shareholder. A person that has shares because of the work and time they devote to the company, who owned the remaining one third of the shares. The company operated five divisions.  Out of the blue, a non-related third party offered to buy one division for $1,000,000.00. The financial shareholder wanted to accept the offer. The sweat equity shareholder wished to grow the business further before selling. Based upon the uninvited offer for one division, the value of the two shareholders entitlements would have been:

  • Financial shareholder $666,666.66 plus two thirds of the value of the remaining four divisions
  • Sweat Equity Shareholder $333,333,34 plus one third of the value of the remaining four divisions

As a result of the offer, the shareholders fell out.

The background to the growth of the company was that it had been operating for about five years. All of the profits were retained and used to grow and develop the five divisions. No dividends had been declared.

Due to the difference in opinion about accepting the offer, the financial shareholder sought to remove the sweat equity shareholder as a director. The sweat equity shareholder sort orders that:

  1. a provisional liquidator be appointed,
  2. or the court order the financial shareholder to purchase his shares in the company

The Supreme Court ordered that the financial shareholder buy the sweat equity shareholders shares. The price for the shares being determined by a major accounting firm. All seemed well for the sweat equity shareholder. Or so we thought.

The accounting firm valued the shares using the maintainable earnings method being the most used method to determine the value of an unlisted proprietary company’s shares.

As the financial shareholder and sweat equity shareholder:

  • had used all past earnings to develop the business rather than pay dividends; and
  • as the sale of the division was only an offer and nothing more

The accountant concluded that upon a maintainable earnings basis one third of the company (the total of the sweat equity shareholders shares were worth) $34,000.00. Happily, the financial shareholder paid the $34,000.00 to the sweat equity shareholder.

The financial shareholder sold the division for $1,000,000.00 and retained and continued to operate the remaining four divisions.

How do you avoid this result in your shareholders’ agreement? You use a method we call the Dutch auction or market equivalence method. This method allows a shareholder to take into consideration the ‘blue sky’. It does not preclude a shareholder considering the value determined by maintainable earnings or any other method, such as discounted cash flow or a multiple of EBITDA or EBIT (earnings before interest, tax and depreciation of assets).

Take this situation if there is a deadlock between two groups of shareholders. Without a deadlock breaking mechanism, the company is stalled from operating.

Take this example: there are 100 shares split between three shareholders X, Y and Z as follows: X – 20; Y – 60; and Z – 20.

X triggers the Dutch auction process. Being unsatisfied with remaining a shareholder with Y and Z, X under the provisions of the clause offers to sell their shares to Y and Z. The sale price per share is set by X.

X is free to use whatever method X wishes to get the sale price. X values the shares at $2000 per share.

Y and Z take the view that $2000 is too much to pay. Yes, it will get them the business, but the price is too high. At this price, they would prefer to sell than buy X’s shares. Y and Z decline to accept X’s offer.

Immediately upon Y and Z’s decline of X’s offer, X must buy Y and Z’s shares at X’s offer price of $2000 per share.

If, X has foolishly triggered the Dutch auction provision without being able to buy Y and Z’s shares the Dutch auction provision then allows Y and Z to sell the business or all of the shareholders’ shares.

Sale price less costs of sale, balance divided among the ‘Innocent Shareholders’ being paid the share price per share as set by the shareholder that triggered the Dutch auction process. The balance, if it is sufficient at the same price, is given to the shareholder that triggered the process, and any surplus is divided at the ratio inter se between all of the shareholders. For instance:

  • Y and Z arrange a sale of the business to D for $175,000.
  • The $175,000 is divided as follows:

o Sale costs $5,000. Balance $170,000. As X offered to sell for $2000 per share and triggered the Dutch auction process, and X failed to buy Y and Z’s shares at the value determined by X; then Y and Z receive $2000 per share for their shares, that is: Y receives $120,000 ($2000 x 60); and Z receives $40,000 ($2000 x 20);

  • Leaving $10,000 paid in full and final satisfaction to X for X’s shares.

The process does not prevent any shareholding buyer from using funds from third parties. If Y and Z had the thought that buying X’s shares at $2000 per share was fair, but they did not have the funds to buy X’s shares, they could have borrowed the money or found a new financial shareholder to back them to purchase X’s shares. On obtaining control of the company Y and Z could sell and or allot shares to the new financial shareholder or shareholders at such percentage shareholding in the company as they can negotiate.

Without any shareholders agreement or with a shareholders agreement that does not have a Dutch auction provision, disputing shareholders must either live with their disagreements and remain in deadlock or one or the other must approach (under section 461(1)(k) of the Corporations Act 2001) the Supreme Court, or Federal Court seeking an order that a liquidator be appointed to maintain the status quo while the Court determines who should buy out the other and for how much. As seen above, the value to be placed upon the shares would most likely be a maintainable earnings value and would not take account of the potential of the business. The Dutch auction method allows the ‘blue sky’ seen by shareholders to be accounted for in the valuation process. The process yields at least a dollar more than the least wealthy shareholder can pay. Check you have a shareholders’ agreement. Check it has a Dutch auction provision. If not be prepared to deal with the unfortunate consequences of an accountant using maintainable earnings to value the shares in your proprietary limited company.

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