Take-Away: When we talk about valuing an individual’s interest in a business, the question often arises if there will be valuation discounts applied to that business interest. Existing buy-sell agreements may, or may not, indicate if a valuation discount is to be applied when an individual owner’s interest is the subject of a buyout.

Background: This is an update of a previously reported decision from the Indiana Court of Appeals: Blake v. Biginch Fabricators & Construction Holding Company, Inc. The Indiana Supreme Court reversed an Indiana Court of Appeals decision. Indiana Supreme Court, Case No. 20S-PL- 618 (Decided January 28, 2021.)

Facts: Mr. Hartman was a founder and former president of Biginch from 1998 to 2014. There were 10 shareholders of Biginch. No shareholder ever held a majority of the voting interests in Biginch.

The shareholders and Biginch entered into a Shareholder Agreement in 2004 that addressed a buyout of a shareholder’s stock. The Agreement provided:

“The price per share for the shares of the corporation to be sold pursuant to [this Agreement] shall be the 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 within the 24 months preceding the transfer of shares, with adjustments for changes in the number of outstanding shares since such year end, and in the case of sales under [this Agreement] if the value is less than the price paid to acquire the shares paid by the involuntary transferee.”

The terms of the Agreement also included a mandatory sale/redemption if a shareholder was terminated from employment by the company.

However, the Agreement did not define the phrase appraised market value.

Mr. Hartman was terminated as director and officer of Biginch in 2018, which triggered the Agreement’s mandatory sale-and-purchase provisions. A professional appraiser was hired as required by the Agreement, who concluded that Mr. Hartman’s 17.77% shareholder interest in Biginch was worth $3,526,060. The appraiser then discounted the value of Mr. Hartman’s shareholder interest due to its lack of control of Biginch and also due a lack of marketability of his interest, as Mr. Hartman did not have a market in which to sell his shares of Biginch stock. After these valuation discounts were applied, Mr. Hartman’s 17.77% interest in Biginch was valued at $2,398,000, or about one-third less than its appraised proportionate value of the corporation’s assets as a going concern.

Litigation: Mr. Hartman filed a lawsuit in which he claimed the application of valuation discounts applied by the appraiser was incorrect, as there was no mention of the use of discounts in the Shareholder Agreement which only referred to appraised market value. Biginch responded that the use of valuation discounts was appropriate as the language implied a fair market value was intended by the shareholders.

Trial Judge: The judge granted Biginch’s motion, finding that the use of valuation discounts was appropriate to determine the amount that Biginch had to pay Mr. Hartman to redeem his stock in Biginch.

Court of Appeals: The Court of Appeals reversed the trial judge. This court found that, as a matter of law, the value of Mr. Hartman’s Biginch shares under the mandatory redemption provision of the Agreement required the corporation to apply the appraised market value, could not be discounted for either lack or control or lack of marketability when the corporation is required to purchase the terminated shareholder’s stock, i.e. in a mandatory redemption agreement valuation discounts will be ignored.

Indiana Supreme Court: In a unanimous decision, the Indiana Supreme Court reversed the Court of Appeals decision, and reinstituted the trial judge’s decision. As part of its decision, the Indiana Supreme Court observed:

The value of corporate shares may not correspond proportionally to the company’s overall value. Shares are usually valued less if they represent a noncontrolling interest or if they are not publicly traded. When valuing such shares, an appraiser will often discount for this reality by applying ‘minority’ and ‘marketability’ discounts.

Here, when tasked with valuing shares, an appraiser applied these discounts, even though the shares would be sold in a compulsory, closed-market sale. The selling shareholder takes issue with the valuation, arguing that minority and marketability discounts are open-market concepts inapplicable to the buy-back provision of his shareholder agreement with the company.

While we recognize the public policy rationale underlying the shareholder’s position, we hold that the parties’ freedom to contract may permit these discounts, even for shares in a closed-market transaction. And under the plain language of this shareholder agreement- which calls for the ‘appraised market value’ of the shares- the discounts apply.

Comment: The problem with many shareholder redemption or buy-sell agreements, or LLC membership Operating Agreements, is that not much thought is given to the phrases that are used to value a closely hold interest that is to later be valued and used to establish a buy-out purchase price. Mr. Hartman’s understanding of ‘appraised market value’ was different from how Biginch (or its remaining shareholders) interpreted that phrase.

Other comparable phrases are frequently used in similar corporate or partnership agreements where there is a compulsory, closed-market, redemption agreed upon. For example, the phrase fair market value usually carries with it connotations of the application of valuation discounts. In contrast, the phrase fair value used in an entity buyout agreement does not, normally, carry with it the application of any valuation discounts. All of which underscores the need to use definition for these “valuation’ phrases [appraised market value vs. fair market value vs. fair value] in these types of entity buy-out agreements to avoid any ambiguity and misunderstanding. As the Indiana Supreme Court noted, the value of a shareholder or LLC member’s interest in the entity does not have to correspond proportionally to the entity’s overall value as a matter of contract. In estate planning, however, where fair market value between a willing buyer and a willing drive transfer taxes, the need to be precise in terminology is equally important. Simply assuming that value of an interest in a business or a hard-to-value asset like real estate will not include valuation discounts is a dangerous practice in which to engage.

Conclusion: The use of valuation discounts has been a ‘hot topic’ in Washington over this past summer with the House Ways and Means Committee’s proposal to deny valuation discounts with the transfer of an interest in a ‘nonbusiness entity’ between family members. While that proposal was not part of the bill that the House finally adopted, it is anyone’s guess whether it reappears in later proposed legislation when Congress’ goal is to raise more revenues through gift and estate taxes by denying valuation discounts. While the legislatively proposed denial of valuation discounts would not have applied to Mr. Hartman’s situation [Biginch was an active trade or business and the other shareholders were not his family members] the magnitude of the difference in disputed values associated with Mr. Hartman’s 17.77% shareholder interest of $1.1 million is a reminder of just how important valuation discounts can be.