If you are a minority interest shareholder in a privately held company, watch out for these Red Flags:
· The majority shareholder grants himself a salary and benefit package way above the going market rate – in effect granting him a constructive dividend
· No dividends are paid from a very profitable company
· He begins using the company as his personal piggy bank
· You are removed from your Board of Director position
· Company financial information is withheld from you
· You are fired from the company without cause
If one or of these events has occurred, watch out! The next shoe to fall is an unsolicited offer to buy out your shares. The offer price seems unusually low. If you protest, expect the buyer to refer you to the shareholder agreement where the corporation has the right of first refusal to buy your shares at net book value. That number, for most companies, values your shares at pennies on the dollar.
You next get the speech that the majority shareholder will never sell his company. The price I am offering is all the company can afford. We are not going to pay any dividends. This is a risky market and the business could falter. This is the only way you are going to get any liquidity for your stock.
In family situations this can be devastating. It is usually the result of children inheriting the business through either gifting or from dad’s estate. Because 90% of his net worth is tied up in the business, to be fair, he has to give essentially equal shares to all of his children. Maybe Son A and Daughter C work in the business and Son B and Daughter D do not. Dad gives 30% ownership to each sibling in the business and 20% to each sibling that is not involved.
The two siblings running the business begin to blur the lines between stock ownership and employment. They develop an attitude of entitlement. Those other two siblings did nothing to grow this business. The company-involved owners begin to view their stock as more valuable than the other siblings. Their salaries and perks get bloated and no dividends get paid to the other shareholders. I don’t think Bill Gates refuses to pay dividends to his stockholders because “they did nothing to grow this business”.
Here is where the problems begin. Dad has left a company shareholder agreement in place that makes it almost impossible for a minority shareholder to get a fair price for their company stock. Dad has also done a great job of estate tax planning, using all available legal means to minimize the gift and estate taxes resulting from transferring ownership to the next generation.
The most common approach is to form two or more Family LLC's that would be the owners of the company stock and then dad gives a gift of an equal share of the LLC's to each heir. This effectively breaks the company into several minority interest ownership positions. Now a qualified valuation firm is hired to value the LLC’s. All of a sudden the value of the company evaporates.
Here is how it works. Let’s say that Johnson Corporation would command a price of $9 million if an M&A firm in a competitive market transaction sold it. However, Johnson Corporation is 33% minority owned by three different Family LLC’s. The valuation firm values the company stock held in each LLC not at $3 million, but at $3 million less a 40% lack of control discount, or $1.8 million. Next they apply a lack of marketability discount (after all, the shareholder agreement restricts the sale to outside investors) and the valuation drops further to $1,080,000. Now the three LLC’s are added back together and the $9 million company is valued at $2,240,000 for “Gift and Estate Tax Purposes”.
This document is submitted as supporting documentation with the gift or estate tax filing – very official. The IRS examiner reviews it and accepts it as the basis for the tax payment. Two years later the two siblings running the company approach the other two siblings and present them with a buy-out offer accompanied with this valuation that was filed and accepted by the IRS. Son B owns 20% of the company stock through his interests in the three Family LLC’s. He is offered 20% of $3,240,000 or $648,000 for his company ownership. The fair value is 20% of $9,000,000 or $1,800,000.
He has no idea what the company is worth and has never been given any information of earnings or comparable M&A transactions in the market. Even though the valuation has on its cover, “For Gift and Estate Tax Purposes Only,” he does not understand the implications of that standard blanket disclaimer.
His natural reaction is that this document was filed with the IRS and accepted. It must be pretty close to what my stock is worth. If someone were not involved in this area of law professionally (estate tax attorney, estate planner, tax accountant, valuation firm, investment banker, or IRS agent), they would likely accept this as the accurate value of their shares. I tell clients that it would be like being handed an MRI of my heart and being asked to interpret it. I am not experienced in this very specialized area and therefore would depend on my doctor to interpret it for me.
A nationally recognized and credentialed valuation firm complete with 50 pages of discounted cash flow and other sophisticated analysis and data completed this valuation. It next passed the scrutiny of the IRS examiners. Now a family member is interpreting it for you. What conclusion are your supposed to draw?
Unfortunately this happens all the time. Usually it results in the non-involved siblings having a standard of living that is significantly different than what dad had intended when he equally divided his estate among all his children. Dad would not approve.
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Dave Kauppi is a business broker and President of MidMarket Capital. We help business owners with all aspects of Mergers and Acquisitions.
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