A shareholder who owns a minority interest in a closely held corporation can be in a difficult position when faced with management decisions with which they disagree. Whereas a shareholder in a corporation whose shares are publicly traded can simply sell his or her shares on the open market at the current market price, no comparable market or well-established market price exists for shares of closely held corporations.1 Instead, shareholders who own a minority interest in a closely held corporation must rely on statutory or contractual provisions providing for the valuation and liquidation of their shares in such situations. However, when considering whether to obtain a valuation pursuant to Florida’s statutory provisions, a minority shareholder must be aware that Florida law is unsettled with respect to how minority shares should be valued, and there are two conflicting views that can produce vastly different results.
Under Florida law, shareholders in corporations whose shares are not publicly traded have the statutory right to dissent from certain corporate actions, such as a merger, share exchange, sale of assets of the corporation other than in the ordinary course of business, or amendment to a corporation’s articles of incorporation.2 In exchange, those shareholders have the statutory right to receive the “fair value” of their shares. These statutory rights are commonly referred to as “dissenters’ rights” or “appraisal rights.”3 Florida law also provides that, under certain circumstances, shareholders have the statutory right to petition to dissolve a corporation in which they own an interest, such as when the directors are deadlocked in the management of the corporation, or when, in certain closely held corporations, corporate assets are being wasted or those in control of the corporation are acting illegally or fraudulently.4 In those circumstances, rather than allow the corporation to be dissolved, the corporation itself, or another shareholder of the corporation, may elect to purchase the petitioning shareholder’s shares for the fair value of those shares.5
However, there is significant disagreement as to what “fair value” means and two conflicting views have developed. One view equates fair value with “fair market value” and factors in certain reductions in determining the value of a minority ownership interest (referred to as “discounts”) that are common in a fair market value analysis, most notably, a discount for lack of control and a discount for lack of marketability.6 The opposing view rejects the use of those two discounts in determining the fair value of a minority ownership interest. This is a critical distinction because the use of the two discounts can significantly reduce the buyout price of minority ownership interest, often reducing the buyout price by more than 50 percent.
For instance, suppose a shareholder who owns 49 percent of the shares in a closely held corporation with a value of $2 million is faced with a “squeeze out” by the majority owner and petitions to dissolve the corporation pursuant to Florida’s dissolution statute. In response, the majority owner elects to purchase the minority owner’s shares at their “fair value,” as provided in the dissolution statute. If the value of the minority owner’s interest is determined as the value of a proportionate interest in the corporation, the minority owner would receive $980,000. However, if a discount for lack of control were factored in, the value of the minority owner’s shares could conceivably be reduced by 33 percent, to $653,333. If a discount for lack of marketability were also factored in, the value of the minority owner’s shares could be reduced by an additional 50 percent, to $326,666. The result is that the minority owner, whose proportionate interest in the corporation is $980,000, is forced to sell his or her interest at a vastly reduced price. The majority shareholder, whose improper actions necessitated the minority’s petition, would get complete control of the corporation at an enormous discount. Although such a scenario appears inequitable, it is a distinct possibility under existing Florida law.
A recent amendment to Florida’s appraisal rights statute that defines fair value and addresses the use of the two discounts both clarifies and confuses the determination of fair value, creating a two-tier scheme in which the two discounts are not used if a closely held corporation has 10 shareholders or less, but are used if it has more than 10 shareholders.7 Moreover, this recent amendment does not reference the definition of fair value under Florida’s dissolution statutes, nor is there a corresponding amendment to the dissolution statutes that similarly defines fair value. As a result, there is the possibility that the definition and determination of fair value under Florida’s appraisal statutes could be treated differently than the definition and determination of fair value under Florida’s dissolution statutes.
Because the use of the two discounts can have a significant impact on the buy-out price of a minority shareholder’s interest in a closely held corporation, it is important for an attorney dealing with an appraisal or dissolution case (or deciding whether to bring either action) to have an understanding of this issue, the relevant Florida statutes and decisions, as well as significant cases from around the country that address this issue.
- Discount for Lack of Control (Minority Interest Discount) — By definition, a minority ownership interest in a business lacks sufficient voting power to independently control the operations of the business.8 Because of its lack of control, shares of a minority interest in a business are less valuable to investors than shares of a controlling interest.9 If this lack of control is considered in determining the value of shares of a minority interest, in most cases, that minority interest will be valued significantly less than its prorata proportion of the overall value of the entire business.10 The average discount for lack of control for shares of a minority ownership interest is about one third of the value of controlling shares.11 Consequently, the impact of a minority discount on the final amount of a buyout price can be significant. 12
- Discount for Lack of Marketability — Business owners and investors prefer liquidity to illiquidity.13 As a result, an ownership interest in a business is worth more if it can be easily sold (marketed) than if it cannot be easily sold.14 Because shares in closely held corporations are not traded on a public market, it is considerably more difficult to sell those shares than shares in a publicly held corporation.15 Factors contributing to this difficulty include the smaller pool of potential buyers for shares in closely held corporations and the greater time and expense associated with selling such shares.16 If this relative lack of marketability is factored into determining the value of shares of a minority interest in a closely held corporation, the value of those shares can be reduced by an additional 35 to 50 percent.17
Conflicting Approaches to the Use of Discounts for Lack of Marketability and Control
Two conflicting positions have developed regarding whether the determination of the fair value of a minority ownership interest in a closely held corporation should include the use of discounts for lack of control and lack of marketability.
The first position equates fair value with fair market value and incorporates discounts that a fair market analysis would apply.18 Fair market value is commonly defined as “the price at which property would change hands between a willing buyer and a willing seller when neither party is under an obligation to act.” Thus, a fair market value analysis focuses on what someone would pay for a particular ownership interest, taking into account all of its unique characteristics. When considering a minority ownership interest in a closely held corporation, it is fairly standard in a fair market value analysis to substantially reduce the purchase price of those shares for lack of control and marketability.19
The second position equates fair value with “enterprise value,”20 which views a shareholder in an appraisal setting as an investor forced to relinquish his or her ownership position, rather than as an investor looking to sell his or her shares. This view assumes that, absent the actions forcing the shareholder to exercise his or her appraisal rights, the investor would have retained his or her ownership position in the corporation.21 Therefore, the value of that shareholder’s ownership interest should not be determined by what that ownership interest would be sold for in a hypothetical market sale, but instead should simply be that shareholder’s pro rata share of the overall value of the business, without factoring in either of the two discounts.22
The Majority View
The majority of courts across the country that have considered this issue have held, as a matter of law,23 that discounts for lack of marketability or lack of control should not be considered in determining fair value when a minority shareholder is selling his or her ownership interest to the majority shareholder(s) or the corporation.24 For example, courts in Arizona, Colorado, Connecticut, Delaware, Georgia, Indiana, Kansas, Nebraska, Maine, Montana, Oklahoma, South Dakota, Washington, and Wyoming have found that one or both discounts should not be used.25
Two main rationales are typically given for the inapplicability of the two discounts. First, a sale to the majority is different from a sale to a third party because a sale to the majority increases the interests of that majority who is already in control.26 As a result, there is no need to apply a discount designed to account for the value of shares being worth less in the hands of a third party who gains no right to control or manage the corporation.27 As more fully explained by the Montana Supreme Court in Hansen v. 75 Ranch Co., 957 P.2d 32, 41 (1998):
Applying a discount is inappropriate when the shareholder is selling shares to a majority shareholder or to the corporation. The sale differs from a sale to a third party and, thus, different interest must be recognized. When selling to a third party, the value of the shares is either the same as or less than it was in the hands of the transferor because the third party gains no right to control or manage the corporation. However, a sale to a majority shareholder or to the corporation simply consolidates or increases the interest of those already in control. Therefore, requiring the application of a minority discount when selling to an “insider” would result in a windfall to the transferee. This is particularly true since the transferring shareholder would expect that the shares would have the same value in her hands as in the hands of the transferee.28
The second rationale given for not using the two discounts in determining fair value is that the use of the discounts to value a minority shareholder’s interest is unfair to the shareholder who did not pick the timing of the transaction triggering the valuation and who is not a willing seller.29 As explained by one commentator with respect to a buyout under threat of dissolution:
It should be clear that the “voluntary sale” model contemplated by the fair market value approach is a poor fit in the oppression context. The oppressed minority investor was not looking to sell, and the oppressive majority investor, absent the threat of dissolution or other judicial sanction, was not looking to buy. Instead of a voluntary sale conception, it is more accurate to characterize an oppression buyout as a compelled redemption of the minority’s ownership position. The oppressive conduct has forced the minority to relinquish his investment, and a court order (or threat of dissolution) has forced the majority to “cash out” that investment. The buyout, in other words, should be viewed as a proceeding in which the majority compensates that minority for the investment that the minority has unwillingly surrendered. It is the value of that investment that the buyout proceeding should award.30
The American Law Institute has come to a similar conclusion as the majority of jurisdictions. Section 7.22, Standards for Determining Fair Value, states, “(a) The fair value of shares under §7.21 should be the value of the proportionate interest in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability.”31
In contrast, the view that the two discounts should be applied has been adopted by only a minority of courts that have considered the issue.32 Most of these decisions fail to provide a rationale for the use of discounts,33 apparently taking the position that there is no compelling reason to treat valuation of a minority interest being sold to the majority differently than any other valuation in which discounts are routinely used.34
Florida’s approach to fair value to date is confused and conflicting. Until recently, Florida’s appraisal and dissolution statutes, while providing for the payment of fair value to a minority shareholder, did not address whether the determination of fair value included the use of discounts for lack of control or lack of marketability.
A recent amendment to Florida’s appraisal statute that provides that the determination of fair value should not include discounts for lack of control or lack of marketability both clarifies and further confuses the issue. On the surface, the amendment appears to bring Florida law in line with the majority of courts that do not allow the use of such discounts in determining fair value. However, the amendment is arguably applicable only to the determination of fair value pursuant to Florida’s appraisal statutes and not to the determination of fair value pursuant to Florida’s dissolution statutes, raising the possibility that fair value under the appraisal statutes might be different than fair value under the dissolution statutes. Moreover, the amendment’s limitation to corporations with less than 10 shareholders seemingly creates a two-tiered scheme in which the two discounts are used in some instances and not in others. This state of affairs creates the likelihood of unique litigation issues, not to mention corporate gamesmanship in shareholder struggles.
Fair Value Pursuant to Florida’s Appraisal Statutes
- Statutory Definition — F.S. §607.1302, Right of Shareholders to Appraisal, provides that a shareholder in a corporation is entitled to appraisal rights and to obtain payment of the fair value of that shareholder’s shares in the event the shareholder exercises dissenters’ rights to certain defined conversions or mergers of the corporation, share exchanges, dispositions of assets, or amendments to the corporation’s articles of incorporation.35 This appraisal right is not available to shareholders in corporations whose shares are publicly traded.36
The definition of fair value as used in §607.1302 is set forth in §607.1301(4), which was recently amended to define “fair value” as the value of the corporation’s shares determined:
(a) Immediately before the effectuation of the corporate action to which a shareholder objects.
(b) Using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable to the corporation and its remaining shareholders.
(c) For a corporation with 10 or fewer shareholders, without discounting for lack of marketability or minority status.37
- Distinction Between Corporations with More Than 10 Shareholders and 10 or Less Shareholders — Although clearly providing that fair value is to be determined without discounting for lack of marketability or minority status, §607.1301(4)(c) arbitrarily limits this provision to corporations with 10 or fewer shareholders. This creates the inference that those discounts would be applied in appraisal proceedings brought by shareholders in corporations that have more than 10 shareholders. A recent commentator has argued that this distinction is illogical because there is often no market for a private corporation’s shares, regardless of whether the corporation has 10, 11, or 50 shareholders.38 Instead, as the commentator argues, the appropriate distinction should only be whether there is an established market for a corporation’s shares.39 If there is an established market, there is no need for an appraisal remedy; if there is no established market, then discounts for lack of control or lack of marketability should not apply.40 The courts have not yet addressed the issue.
Because it creates a two-tier scheme regarding the determination of fair value, §607.1301(4) also creates the potential for abuse. For instance, in a closely held corporation that has less than 10 shareholders, the corporation or controlling shareholder, to drive down the buyout price of a dissenting shareholder’s shares, could simply add a few nominal shareholders, thereby taking the corporation over the threshold 10 shareholders number, which would then allow a significant reduction in the dissenting shareholder’s buyout price.
- Applicability Beyond Florida’s Appraisal Statutes — Another significant issue is that §607.1301 provides that its definition of fair value applies only to §§607.1302 through 607.1333 — the sections that address the right of a shareholder to an appraisal. Thus, arguably, §607.1301’s definition of fair value is not applicable to any other statutory provisions providing for fair value, including Florida’s dissolution statutes.
Section 607.1301(c) was only recently amended,41 and there are no decisions in Florida addressing either of these issues.
Fair Value Pursuant to Florida’s Dissolution Statutes
In addition to valuations under Ch. 607’s appraisal rights statutes, “fair value” determinations are also provided for in Florida’s dissolution statutes.42 Florida’s dissolution statute states shareholders also have the right to petition to dissolve a corporation in which they own shares pursuant to §607.1430(2) when:
(a) The directors are deadlocked in the management of the corporate affairs, the shareholders are unable to break the deadlock, and irreparable injury to the corporation is threatened or being suffered; or
(b) The shareholders are deadlocked in voting power and have failed to elect successors to directors whose terms have expired or would have expired upon qualification of their successors.43
Additionally, pursuant to §607.1430(3), shareholders in a corporation having 35 or fewer shareholders have the right to petition to dissolve a corporation when:
(a) The corporate assets are being misapplied or wasted, causing material injury to the corporation; or
(b) The directors or those in control of the corporation have acted, are acting, or are reasonably expected to act in a manner that is illegal or fraudulent. 44
Rather than allow the corporation to be dissolved, §607.1436(1) provides that the corporation or its other shareholders may elect to purchase all of the petitioning shareholder’s shares for their fair value. Once this “election to purchase” is made, the parties have 60 days to reach agreement as to the fair value of the petitioning shareholder’s shares and terms of the buyout.45 If the parties are unable to reach an agreement, the court then determines the fair value of the petitioning shareholder’s shares.46
- No Statutory Definition of Fair Value — Despite the requirement of a fair value determination, §607.1436 does not define fair value47 and does not address whether discounts for lack of control or lack of marketability are to be applied in determining fair value.48 As addressed above, the definition of fair value under §607.1301, which excludes discounts for lack of control or lack of marketability, arguably does not apply to §607.1436 because §607.1301 does not include §607.1436 as one of the sections to which its fair value definition applies.49 As a result, it is unclear whether fair value pursuant to §607.1436 should be determined factoring in discounts for lack of marketability or lack of control.
- Florida Case Law — While there is no statutory authority regarding the applicability of discounts to a valuation conducted in a dissolution action, one Florida decision suggests that such discounts would be applied.50 In Munshower v. Kolbenheyer, 732 So. 2d 385 (Fla. 3d DCA 1999), the only Florida decision to consider the issue, the court held that a discount for lack of marketability is properly factored into a fair value determination pursuant to §607.1436.51
However, there are several problems with Munshower, not the least being the sparse and confused consideration that the court gave to these issues. First, Munshower was decided before §607.1301(4)(c) was amended to prohibit the use of such discounts when conducting an appraisal valuation. Second, Munshower is almost devoid of analysis, giving no reasoning for its decision beyond the statement that the court would follow the law of New York.52 However, the New York case law on which it relies is in the clear minority of decisions nationally,53 and no explanation is given for why shares sold to the majority owner should be discounted for lack of marketability when the majority owner is only increasing the size of his or her controlling interest.54
Applicability of Discounts in Valuations Under Florida’s Dissolution Statutes
Because the use of discounts for lack of control and lack of marketability can have a significant effect on the fair value buy-out price of a minority ownership interest, any attorney confronted with an appraisal or dissolution case (or the choice of bringing either action) should be aware of the impact of using those discounts in determining fair value and the potential arguments for why such discounts should or should not be applied.
A majority shareholder or a corporation electing to purchase a minority interest owner’s shares will be able to purchase the shares at a lower price if minority status and marketability discounts are used in conducting the valuation. When a dissolution action is at issue, the majority shareholder can argue in favor of discounts by relying on the Third District Court of Appeal’s decision in Munshower as authority that discounts should be applied to the valuation.55 The corporation or majority shareholder can also point to the fact that §607.1301 was amended to include a definition of “fair value” that excludes discounting, and that §607.1301 specifically provides that the definition is applicable to §§607.1302 through 607.1333.56 The legislature, when amending the definition of “fair value” to exclude discounting, could have included the dissolution statute among the statutes to which the definition applied, but did not. This decision to exclude the dissolution statute suggests that the legislature intended “fair value” under the dissolution statutes to have a different meaning than it does under the appraisal statutes.
From the minority shareholder’s perspective, discounting will negatively impact the valuation of the minority’s shares and should be argued against. The minority shareholder can argue that, while it is correct that §607.1301 does not apply the statutory definition of “fair value” to the §607.1436 dissolution statute, the use of the term “fair value,” as opposed to “fair market value,” suggests legislative disapproval of a fair market value approach and the discounting that plays a prominent role in that fair market value approach. While Munshower held that discounts should be applied, that case was decided prior to the amendment to §607.1301, and it is contrary to the position taken by the majority of courts outside Florida.57
In addition, there is no logical basis for treating fair value differently under §670.1301 than under §670.1436. The same rationale for excluding discounts under §607.1301 applies to excluding discounts with respect to dissolution actions under §607.1436. In a sale under the dissolution statute, just as in a sale under the appraisal statutes, the sale to the majority consolidates or increases the interests of those already in control. The purchaser, therefore, is not buying noncontrolling shares, the value of which would be less than controlling shares and, thus, would need to be discounted. In addition, the minority is no more a willing seller under the dissolution statute than under the appraisal statute. The minority has unwillingly surrendered its shares in a forced buyout pursuant to the dissolution statute just as it does under the appraisal statutes.
Moreover, the very nature of a dissolution action argues against the use of discounts for lack of control and lack of marketability when a shareholder petitions to dissolve a company and the corporation or other shareholders elect to purchase the petitioning shareholder’s interest. When a corporation is dissolved, shares of the same class are treated equally, with no distinction between majority and minority shares.58 Thus, a minority shareholder who obtains dissolution of the corporation due to deadlock or majority wrongdoing would be entitled to the same amount per share as the majority upon distribution of the dissolution proceeds.59 Consequently, if the majority elects to purchase the minority’s shares to avoid dissolution, the minority shareholder should not be left in a worse position (by virtue of applying discounts to reduce the value of the shares) than if the corporation had been dissolved and the proceeds distributed pro rata. As a result, for the same reason discounting should not be considered in an appraisal valuation, it should not be considered in a dissolution action valuation pursuant to §670.1436.
The use of discounts for lack of control and lack of marketability can have a significant impact on the buy-out price of a minority shareholder’s interest in a closely held corporation. Thus, it is important for an attorney dealing with an appraisal or dissolution case (or the decision to bring such an action) to have an understanding of this issue and the relevant Florida statutes and decisions, as well as the significant decisions from around the country, in order to be prepared to address the potential arguments regarding the use of the two discounts.