March 01, 2010

A Look at a Few State Court Decisions Regarding the Applicability of Shareholder/Partnership Agreements in Valuing Closely Held Corporations and Partnerships

The Minority View – The Agreement Controls

The following cases are in the minority in that the court in each case placed a value on the subject interest based in accordance with the terms of a shareholder or partnership agreement.

McDiarmid v McDiarmid, 649 A. 2d 810 – DC: Court of Appeals 1994

The trial court determined that the value of Robert McDiarmid’s interest in his law firm was $428,197, including a goodwill value of $63,184. Mr. McDiarmid appealed the decisions arguing that the Spiegel & McDiarmid partnership agreement provided that goodwill was nonsalable and, thus, the trial court should not have allowed the inclusion of goodwill in the value.

The Court of Appeals determined that because Mr. McDiarmid was bound by the agreement, there was no way that Mr. McDiarmid could ever realize the value of the goodwill, whether he terminated his employment or sold his interest. Thus, the case was remanded for revaluation of the partnership interest eliminating the goodwill component in accordance with the agreement.

Hertz v Hertz, 657 P. 2d 1169 – NM: Supreme Court 1983

Husband was a shareholder in a law practice. Wife’s expert valued the interest in the practice based on accrual earnings using the excess earnings method. Husband’s expert presented testimony that the interest should be valued on a cash basis pursuant to a stock transfer agreement which placed a value of $1 on goodwill. Further, Husband’s expert testified that all previous purchases and sales of ownership interests had been transacted in accordance with the agreement. The trial court adopted Wife’s valuation with some modifications.

Husband appealed and the Supreme Court reversed the decision, holding that a “non-shareholder spouse is bound to the same terms of a valuation agreement.” The Supreme Court went on to say that “if the professional spouse’s stock in the corporation is subject to restrictive stock agreements and if the value of goodwill is fixed by those shareholder agreements, then, absent evidence that shareholders have disregarded this amount, the district court cannot determine a goodwill value above that amount.”

The Case-Specific View – The Agreement May Control

The courts in the following cases placed a value on the subject interests based in accordance with the terms of a shareholder or partnership agreement for case-specific reasons but did not go so far as to rule that an agreement would be binding under different circumstances.

Inzer v Inzer, 2009 WL 2263818 (Tenn.Ct.App)

Mr. Inzer worked for and owned a 24% ownership interest the Sonic Drive-in in McMinnville, Tennessee. At the time Mr. Inzer acquired his ownership interest, he signed an Operating Agreement outlining the terms of his ownership and employment. Mrs. Inez also signed an acknowledgement agreeing to the terms of the Operating Agreement.

The relevant portion of the Operating Agreement provided that the members of the LLC would have a continuing option to purchase Mr. Inzer’s interest upon a 51% majority vote. In addition, Mr. Inzer’s ability to sell his interest was limited by a provision granting the members the right of first refusal to purchase his interest. Further, the buy-out price was to be determined by the book value subject to certain adjustments for intangible assets, accounts payable, and inventory.

Wife’s expert valued the interest in Sonic at $509,263 using a discounted cash flow method. Husband’s expert concluded that the value was $33,102 based on the restrictive covenant in the Operating Agreement. The trial court fixed the value of the interest at $207,546. Mr. Inzer appealed the decision.

The Court found that because Mrs. Inzer had signed a separate agreement acknowledging her consent to the terms of the Operating Agreement, she was bound by the agreement. Thus, the value of Mr. Inzer’s 24% interest in Sonic was to be determined in accordance with the terms of the Operating Agreement. The Court made it clear that had Mrs. Inzer not signed the agreement, they would have reached a different conclusion stating that adherence to the provisions of a shareholder agreement depends on whether or not the nonshareholder spouse consented to the terms of a buy-sell agreement.

Because Husband’s expert had not provided adequate explanation of how he arrived at the $33,102 value, the case was remanded for a hearing to determine a value in accordance with the terms of the Operating Agreement.

Harmon v Harmon, 173 AD 2d 98 – NY: Supreme Court, Appellate Div., 1st Dept 1992

As a partner in a New York City law firm, Mr. Harmon had signed a partnership agreement which defined his rights on death, disability, retirement, or withdrawal from the firm. The partnership agreement provided, in part, that a withdrawing partner had no interest in, “work in process, uncollected accounts, goodwill or any other matter or cause” and the withdrawing partner’s interest was limited to the return of his capital account. The agreement also contained a death provision that provided for the payment of an amount equal to the deceased partner’s capital plus an amount equal to his average salary for the three years prior to death multiplied by 175%.

Both Husband and Wife presented expert testimony. Wife’s expert utilized the death provision of the agreement to value the interest at $308,000. Husband’s expert also relied on the agreement, using both the withdrawal provision, limiting Husband’s interest to the value of his capital account and the death provision, but reducing the amount to be received under the death provision by potential estate taxes. The trial court adopted the Wife’s expert’s methodology using the death provision.

Husband appealed. The Appellate Division upheld the trial court, stating that the acceptance of the death benefit valuation was justified because it was based on an agreement by the partners as to the value of their respective interests in the firm. And, further, absent evidence that the valuation was unreasonable or other evidence showing evidence of a different value, it should not be disturbed.

It is interesting in this case that both experts relied on the partnership agreement to determine the value of Husband’s interest rather than presenting alternative valuation analyses.

In Re: Marriage Claydon, 715 NE 2d 1201 – Ill: Appellate Court, 4th Dist. 1999

Husband was the owner of 55 shares of Affiliates, an oral surgery practice. The value of the stock was set forth in a buy-sell agreement and was reviewed annually. At the time of trial, the stock was valued at $1,000 per share upon departure prior to retirement and $3,400 upon retirement. Affiliates’ accountant testified that the $1,000 per share was the value for the hard assets of the corporation and the $3,400 included the goodwill value of the corporation. Wife’s expert testified that he did not make an independent valuation of the shares because he thought the buy-sell agreement was binding. The trial court valued the shares at $1,000.

The trial court decision was upheld on appeal. The Appellate Court held that professional goodwill is an aspect of income potential and reflected in maintenance and support awards. The Appellate Court did not, however, rule that the parties were bound by the terms of the buy-sell agreement but stated that the circuit court could have adopted a higher price for the shares if Wife’s expert had presented an alternative Fair Market Value for the interest.

The Majority View – Agreements Are One Factor to be Considered

The majority of states have held that value established by a buy-sell provision in a shareholder agreement is not binding on the non-shareholder spouse but is considered, along with other factors, in valuing the interest of the shareholder.

Barton v Barton, 639 SE 2d – Ga: Supreme Court 2007

Mr. Barton owned 50% of the stock of Triad Specialties, Inc., a closely held corporation. The arbitrator determined a Fair Market Value of the stock at $508,000. Mr. Barton appealed, arguing that the stock should have been valued at $342,000 pursuant to a formula delineated in a buy-sell provision of the stockholder agreement.

The Georgia Supreme Court followed the majority of jurisdictions in finding that the arbitrator’s determination was proper, stating that the buy-sell price in a shareholder agreement does not necessarily reflect true market value and, further, is not binding on the non-shareholder.

In Re Marriage of Heyne, Iowa: Court of Appeals 2004

Husband was one of 150 shareholders in Walnut Telephone Company, albeit the president and largest single shareholder. The Company bylaws create a right of first refusal to purchase shares offered for sale at $150 per share. Husband argued that the purchase price dictated by the bylaws should be determinative of value. Wife argued that the book value of the Company, $700 per share, was more reflective of the true value. The trial court agreed with Wife and concluded that the book value was the better gauge of the Fair Market Value of the shares.

Husband appealed on the basis that there had never been a sale for a price that was not set by the Board of Directors and the $150 dollars was the highest value set. The Court of Appeals upheld the trial court decision stating that a court must determine the intrinsic value of a company through evidence of assets and liabilities of the company. In addition, the Board of Directors (of which Husband was chairman) could authorize the purchase of any stock to match an offered price.

Pelton v Pelton, 167 Mich. App. 22, 421 N.W. 2d 560 (1988)

Husband held a 55% interest in two closely held corporations. Both parties presented expert testimony regarding the value of the interests and Husband presented evidence of an unaccepted offer to purchase the corporations. The trial court rejected the testimony of both experts and arrived at a value higher than that set in a buy-sell agreement, but significantly lower than the value arrived at by the Wife’s expert. Wife appealed the decision.

The Court of Appeals upheld the trial court ruling stating that the trial court has great latitude in determining the value of an ownership interest and is in the best position to determine the credibility of the witnesses.

Douglas v Douglas, 281 AD 2d 709 – NY: Supreme Court, Appellate Div., 3rd Dept 2001

At issue in this case was the increase in the value of Husband’s interest in a law partnership. Husband’s expert presented evidence based solely on the partnership agreement, arriving at a value of $567,481 under the withdrawal clause and $1,082,566 under the death provision of the agreement. Wife’s expert arrived at a value of $1,860,000 using an excess earnings method of valuation. The court adopted Wife’s value and Husband appealed the decision.

The Court of Appeals upheld the decision stating that “there is no uniform rule for fixing the value for equitable distribution purposes and valuation is an exercise properly within the fact-finding power of the trial courts, guided by expert testimony.”

Note that in Harmon v Harmon, the court relied on the death provision of an agreement because alternate evidence was not presented.

Cole v Cole, 110 SW 3d 310 – Ark: Court of Appeals, Div. II 2003

Husband, a 50% owner of a surgery center, presented testimony that the entire surgery center was valued at $750,000 for purposes of a buy-sell agreement with the other 50% owner. It was acknowledged that the $750,000 value was not based on a Fair Market Valuation, but was based on what the doctors felt they could afford to pay each other. Wife’s expert prepared an exhaustive valuation and arrived at a fair market value of $1,274,000 for Husband’s interest. The trial court valued Husband’s interest at $375,000, one-half of the buy-sell value.

Wife appealed and the Court of Appeals reversed on the basis that the trial court did not make an attempt to determine the Fair Market Value of the interest as required by Arkansas law. Rather, the trial court determined that it was bound by the value in the buy-sell agreement. The Arkansas Appellate Court agreed with the majority of courts in holding that “the value established in a buy-sell agreement, not signed by the non-shareholder spouse, is not binding on the non-shareholder spouse, but is considered, along with other factors, in valuing the interest of the shareholder spouse.”

Final Thoughts

No matter the jurisdiction, it is clear that the terms of a shareholder/partnership agreement should not be ignored in valuing an interest in a closely held entity. Such agreements should be reviewed, and testimony offered, for the following provisions:

  • Are there restrictions in the agreement which impact the value the shareholder/partner can realize?
  • Do buy-sell provisions appear to adequately reflect the value of the entity or are they artificially high or low?
  • Is the non-owner spouse a party to the agreement?
  • Have the terms of the agreement been used historically for shareholder/partner buy-ins and buy-outs?