Business valuation disputes are not uncommon and they can arise in a myriad of contexts. Sometimes the contest is amicable, with the differences attributable to honest divergences of opinion over unique issues. In other instances, the disputes are more hotly contested, with each side holding passionate and sometimes very personal opinions on the question. If you are facing a business valuation dispute, learn about how our Litigation & Trial Practice team can help!
What is a business valuation dispute?
In the business valuation realm, there may be no single source to define the value of a business, and even less so when the interest to be valued is less than 100% of the company. Unlike publicly traded companies, where there is a market value for the stock, in closely held businesses, determining the value of the enterprise requires an evaluation of many factors. When the value is disputed, the parties turn to experts to accurately appraise a company’s value.
Unless the parties agree upon a single individual, business valuation disputes will often become a battle between two experts, and if the issue is the subject of a litigation dispute, the decision may be made by a Judge. Such disputes can arise among owners or former owners, or between the owners and a taxing authority.
A business valuation dispute among owners
FL&B recently handled a valuation dispute which the parties agreed to submit to binding arbitration. The dispute arose when one of four owners of a closely held business died. The applicable agreements among the owners required that the deceased owner’s shares be purchased by the company but failed to specify the price or even a means for determining the price to be paid. To complicate the matter, the company had purchased life insurance on the lives of the owners, but nowhere specified how the insurance proceeds were to be utilized in the event of the death of one of the owners. 
Many closely held businesses purchase life insurance to fund the buyout of a deceased owner’s interests —often referred to as “key man” insurance— but unless that purpose is spelled out in an agreement among the owners, the beneficiary may not be required to use the proceeds for that purpose. On the contrary, many times the insurance proceeds are earmarked to offset any loss of income arising from the death of a founder or other “key employee,” or can default to the surviving owners.
How life insurance impacts business valuation: Connelly v. United States
In a case decided last year, the U.S. Supreme Court addressed the impact of life insurance proceeds on the valuation of a business and held that the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value, and life insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. That decision, Connelly v. United States, involved the value of a closely held business for estate tax purposes, but the Court’s holding and logic apply more globally to the question of the “fair market value” of a business.
FL&B’s business valuation dispute case
FL&B’s case involved a business valuation dispute between the surviving owners and the deceased owner’s estate. The two issues broadly stated concerned the value of the company itself (or, more specifically, the value of 25% in the company) and the appropriate treatment of so-called “key man” life insurance proceeds that the company received in the amount of $6 million.
The company argued that the correct value for a 25% interest in the business was roughly $2.1 million, and that the insurance proceeds should not be included in the valuation. The estate was willing to accept the proposed value but asserted that the insurance proceeds needed to be taken into account. Doing otherwise would result in a $6 million “windfall” to the surviving owners and violated the Supreme Court’s ruling. The relevant organizational documents had inconsistent provisions for dispute resolution and, to avoid expense and delay, the parties agreed to binding arbitration before a single arbitrator.
In the arbitration, the company attempted to offer two alternatives:
1) that their original valuation was correct, but that the life insurance proceeds should not be taken into account; or,
2) that the original valuation was too high and that if the insurance proceeds were to be considered, then they should be sharply discounted. This valuation was supported by the opinion of a valuation expert.
The result of the second alternative was a slightly lower number than the original calculation without considering the insurance proceeds. On behalf of the estate, the Firm argued that the original valuation proposed by the company was correct, but that the insurance proceeds had to be taken into account, as well as that the law and fairness required that the estate receive at least an equal (i.e., 1/3rd share) of the insurance proceeds, net of the cost of purchasing the decedent’s interests in the business. The estate also presented the testimony of a valuation, which disputed many of the key assumptions proffered by the company’s expert, including the proposed discounts to the insurance proceeds.
Considerations in the FL&B business valuation dispute
After a two-day hearing, and the submission of post-hearing briefs, the Arbitrator ruled in favor of the estate, awarding $2.121 million for the decedent’s interest in the business and an additional $1.293 million for the estate’s interest in the insurance proceeds. In addition, the Arbitrator awarded pre-judgment interest on the entire award at the legal rate of 6% from that date one week after the company first received the insurance proceeds.
The case involved a confluence of a number of legal issues. First and foremost, the case presents a cautionary tale concerning the importance of the correct drafting of shareholders’ agreements and entity documents. The company could have spelled out the method for determining value for a buyout. There are many ways of doing this, including an agreed annual valuation, adopting a formula or appointing an individual to make the decision. Here, the documents referred to an annual valuation, but the parties never complied with the requirement. Under applicable law, the default is “fair market value,” but leaving the value open-ended removed the decision from the hands of the owners.
The same lesson applies to the “key man” life insurance policies. If the intent is to replace lost income to the business, an agreement so stating removes any ambiguity. Likewise, if the intent is to fund a buyout – in whole or in part – a written agreement would serve to help ensure that the parties’ intent is honored (although, given the Supreme Court’s decision in Connelly, there may be limits as to the tax consequences that even careful drafting cannot avoid). In this case, the insurance broker for the policies conceded that the language on the applications is not binding. Moreover, the time to agree upon buyouts, valuation methods and the use of life insurance proceeds is when relationships are good, and before an issue arises.
Expert valuations of closely held businesses are also complex matters, which go way beyond concepts such as book value or the appraisal of property or machinery and equipment. Where an expert’s opinion is disputed, it is critical to rebut that opinion with a credible opinion by a qualified expert who can support and explain not only that expert’s opinion, but also where the competing expert’s opinion is erroneous. This requires close cooperation between counsel and the expert, both to present a credible case but also to challenge the opposing side’s witness and to do so in a manner that is understandable to a judge, arbitrator or other fact-finder.
It is also critical to consider a proffered valuation from a credibility perspective. If the parties agreed upon a value when times were good, a big swing to the contrary when confronted with a compelled buyout won’t survive scrutiny without substantial justification. On the other hand, an overly aggressive demand for a high price is unlikely to hold up, let alone garner credibility for the party. Submitting overly extreme positions by either side under the belief that the judge will “split the baby” is naïve at best.
Finally, it is important to understand that the term “fair market value” is only a starting point. It is generally understood to mean the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. However, this basic definition provides only a starting point. The Courts, the IRS and others have continued to develop and refine this definition over time. Pennsylvania courts have noted that appropriate measures may include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court. As such, any purported attempt to fully define fair market value is subject to constantly evolving standards.
Support for your business valuation dispute
FL&B Corporate, Business & Banking attorneys regularly address shareholders agreements and organizational documents and can guide business owners in making the optimal choices to address their needs as well as unanticipated circumstances.
At the same time, the firm has an experienced Estates and Trust practice that regularly aids business owners and their families in succession planning.
Finally, the firm’s Litigation & Trial Practice attorneys are available and experienced in business valuation cases and shareholder disputes, should the need arise. In this instance, Litigation Department Chair Doug Smillie represented the claimant. With pre-judgment interest, the client’s recovery was approximately $4.18 million.
