Valuing Closely Held Corporations in North Carolina: Royals v. Piedmont Electric Repair Co. and Practical Considerations
May 11, 2001
Law and Valuation – Spring 2001
Professor Alan R. Palmiter
Wake Forest University School of Law
This paper discusses the method North Carolina courts use to value closely held corporations upon dissolution proceedings brought by complaining shareholders. Specifically it will analyze the impact of "practical considerations" on those valuations. It concludes that PERCO, the only North Carolina case to reduce an award of fair value for "practical considerations," was decided wrongly. In an attempt to protect minority shareholders, it inadvertently deprived them rights to which they are entitled.
The North Carolina legislature and courts have long recognized the need for fair adjudication of problems that arise in closely held corporations. North Carolina has become a leader in the field of minority shareholder rights and remedies within closely held corporations. However, North Carolina’s valuation of minority interests and its determination of fair value has become distorted and actually takes away rights to which minority shareholders are entitled.
The first case decided after Meiselman, and thus after the revocation of 55-125 and promulgation of 55-14-30, was Royals v. Piedmont Electric Repair Co. v. Royals, decided by the North Carolina Business Court. This case is of Seminole importance because of its thorough discussion of the pertinent valuation issues. Most notably, its discussion of the various applicable discounts is of interest and raises an important issue.
The determining factor for the court was the price it thought Buck and/or PERCO could pay without having dissolve PERCO. The court was wary of effectively ordering liquidation of PERCO. If dissolution had resulted, the court believed the minority would have gotten much less than they actually received. The court reduced the independent valuators determination of fair value from $846 per share to $635 per share. The just remedy would have been for the court to award the minority shareholder her full fair value, $846 per share. Under 55-14-30 and 31, she is entitled to $846. Just because the court does not believe that she will be able to collect the full amount for her shares does not mean that to what see is legally entitled should be reduced.
The court in PERCO overstepped its bounds. By failing to consider the practical outcome of its decision, the court denied the minority shareholder a right to which she was entitled.
North Carolina is home to many small, often family owned, textile, furniture, and retail companies. Many of these businesses are organized as closely held corporations. Because these businesses form the backbone of the local economy, their well-being is vital to North Carolina. The North Carolina legislature and courts have long recognized the need for fair adjudication of problems that arise in closely held corporations. Therefore, North Carolina has become a leader in the field of minority shareholder rights and remedies within closely held corporations. As a result, North Carolina’s corporate dissolution statute allows for liberal relief from a majority’s frustration of minority expectations. However, North Carolina’s valuation of minority interests and its determination of fair value has become distorted and actually takes away rights to which minority shareholders are entitled.
This paper will discuss the method North Carolina courts use to value closely held corporations upon dissolution proceedings brought by complaining shareholders. Specifically it will analyze the impact of "practical considerations" on those valuations. First, it will set a foundation for its analysis by detailing the basis for relief for minority shareholders who feel their reasonable expectations are frustrated by the majority. Second, it will discuss the valuation methods employed by North Carolina courts and the applicability of minority and marketability discounts used to reach "fair value." Finally, the paper will analyze the use of "practical considerations" in the determination of fair value for complaining minority shareholders.
II. North Carolina Valuation
To properly understand the impact of practical considerations on business valuations, one must first understand the dissolution procedures used by North Carolina courts and the methods that valuators use to reach a minority interest’s "fair value." This section will broadly define the basis and methods used by North Carolina courts to determine the "fair value" of a minority interest in a closely held corporation.
A. Basis for Relief
North Carolina General Statute 55-14-30 (2000) details the remedies complaining minority shareholders may seek and when relief is available. The sole remedy allowed is dissolution, and it is available when "liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholder."
Before the enactment of 55-14-30, courts were given plenary power to frame any relief they saw fit to protect the rights of complaining shareholders. While dissolution was available, it was such an extreme remedy that more targeted remedies were preferred. Because the legislature feared an opening of the litigation "flood gates," 55-14-30 changed the procedures for relief and the remedies available. The resulting changes in 55-14-30 revoked the flexibility previously available to trial courts to fashion individual remedies and created a substantial bar for relief.
Although Meiselman v. Meiselman interpreted the earlier dissolution statute, North Carolina continues to use its test to determine when relief is proper. Under the Meiselman test relief is reasonably necessary to protect the complaining shareholder plaintiff where:
(1) The shareholder has shown that she had substantial reasonable expectations that were known or assumed by the other shareholders.
(2) The shareholder’s reasonable expectations have been frustrated.
(3) The shareholder has shown that the frustration was without his fault and was beyond his control.
(4) And, the shareholder has shown that "under all of the circumstances… [she] is entitled to some form of equitable relief.
An important caveat to the sole remedy of dissolution allowed by § 55-14-30 is that § 55-14-31 allows the target corporation, if the court determines that dissolution is appropriate, to purchase the complaining stockholders shares at their fair value. This alternative allows the corporation to avoid dissolution while still providing the complaining shareholder with fair value for her shares.
B. Commercial Valuation Methods
After the complaining shareholder has satisfied the four-part Meiselman test, assuming the corporation elects to purchase the complaining shareholder’s shares, the court must determine the "fair value" of those shares. The statute gives no guidance as to the meaning of "fair value." Instead it leaves the task to the sole discretion of the court. In fact the only guidance available to determine fair value is case law, and in North Carolina there is very little case law explaining the methods used to reach fair value of a minority interest.
For the past fifteen years, Delaware courts have consistently endorsed and employed the Discounted Cash Flow (DCF) method. However, Delaware is also careful to note that "any techniques or methods which are generally considered acceptable in the financial community" are available for courts to use. For instance, the Delaware Block Method, the Market Comparables approach, Net Asset Value approach, valuations based on Book Value or earnings, and combinations of these methods are all accepted and employed methods.
Nevertheless, the DCF has remained the outstanding method. Essentially, it consists of three basic components. First, a valuator must estimate a growth rate for the company for a period of years into the future. The growth rate is based on historical earnings and existing and predicted company conditions. Second, a terminal value must be established to compensate for all earnings past the projected period. Last, the cost of capital must be determined with which the projected earnings and terminal value are discounted to present value. Although this method has been the prominent method used, it still involves a large degree of guess-work and discretion on the part of the valuator. For this reason the North Carolina Business Court favors appointing an independent valuator to perform a single valuation for the company.
C. Minority Discounts
Because publicly traded shares trade at a natural discount due to their lack of control, a question arises as to whether the court should apply a minority discount to reflect the shareholder’s lack of control over company proceedings. Minority discounts are not an issue in publicly traded companies where no shareholder has a controlling interest, but in closely held corporations there is generally a shareholder or group of shareholders that have such a large block of stock that they are able to control the business. If fair value was solely based on fair market value, then a minority discount would be applicable to closely held stock. Just as shares of publicly held corporations trade at a discount that reflects their lack of control, so too would shares of closely held corporations if they were sold in an open market. However, if shares are purchased by someone who is either purchasing control or already has control of the corporation, then applying a minority discount is inappropriate because the purchaser will be able to sell the shares as part of a majority block (without a minority discount). Therefore, whether a minority discount will be applied and how great that discount should be is generally a hotly contested issue in North Carolina Courts.
An argument for applying a minority discount is that if the corporation were dissolved, as directed by statute, shareholders would receive only the liquidation value of their shares. For most businesses, liquidation value (the value of their tangible assets) is much less than the value of the company as a going concern. Since the majority would only receive liquidation value upon dissolution there is a great incentive for the majority shareholder to elect to purchase the minorities shares. The argument is that the minority shareholder should not benefit from forcing the majority to elect to purchase her shares rather than dissolve the company.
There are many arguments against applying a minority discount. First, upon dissolution a minority shareholder is entitled to the percentage value of the company as represented by her shares. Under this circumstance, no weight is given to the fact that the minority shareholder does not carry a controlling interest. The argument is that when a minority shareholder brings an action for dissolution, she should not receive less value for her shares simply because the majority shareholder elects to purchase the shares. Second, courts do not want to unfairly advantage majority shareholders. If courts allowed majority shareholders to purchase minority shares at a discount, then they could later sell those same shares as part of a majority block without a minority discount. In this way, majority shareholders would benefit from their own wrongful conduct. This argument is often cited as the basis for denying a minority discount. Last, as a policy argument, statutes such as 55-14-30 were enacted to protect minority shareholders. Therefore, to apply a minority discount to the value of their shares is arguably against legislative intent.
D. Marketability Discounts
The very nature of a closely held corporation means there is little or no market for the business’ shares. Because of this absence of a market, an issue arises as to whether shares be discounted for their lack of marketability. North Carolina Courts generally do not favor a marketability discount. The reason for this decision is that a lack of marketability is one of the same justifications for applying a minority discount. Discounting for marketability after applying a minority discount would double discount the shares. Further, the minority shareholder is not selling her shares on the market but is forced to sell them to the majority, if the majority elects to purchase the shares. In essence, the valuation assumes that the minority shareholder is willing to maintain her investment position had the majority not frustrated her reasonable expectations.
The first case decided after Meiselman, and thus after the revocation of 55-125 and promulgation of 55-14-30, was Royals v. Piedmont Electric Repair Co. v. Royals, decided by the North Carolina Business Court. This case is of Seminole importance because of its thorough discussion of the pertinent valuation issues. Most notably, its discussion of the various applicable discounts is of interest and raises an important valuation issue.
Piedmont Electric Repair Co. (PERCO) was a closely held corporation, operating since 1937, that had 990 outstanding shares in 1999. The family or estate of A.G. Draughn, "the backbone of PERCO" from 1938 until 1994, owned all but 49 shares of the company. Buck, Draughan’s son, and Short, Draughan’s nephew, began work at PERCO in 1951. Draughan and Short’s father each owned fifty percent of PERCO. In 1958, Short’s father retired, selling his fifty-percent interest to Short. Short funded his retirement through the sale of his shares. In 1989, Draughan, Buck and Short were the only holders of PERCO stock, and in that year they signed an agreement which imposed a right of first refusal by the corporation and shareholders before any of PERCO’s stock could be sold.
In 1992, it became apparent that Draughan had engaged in what might constitute sexual harassment. Due to his conduct, Buck, as president of PERCO requested Draughan withdraw from PERCO’s group health insurance program. In 1993, due to his activities, Buck and Short barred Draughan from portions of PERCO’s premises. Later in 1993, Draughan was barred from PERCO’s premises completely. That same year Draughan’s salary was reduced to $15,000 from a past average of $42,000. As a result, Draughan changed his will, which had originally provided for Buck to receive all of his shares in PERCO for a fraction of their value, to leave his shares to his wife and daughters. Later in 1993, Draughan and Buck, Short, and PERCO entered into negotiations for the purchase of Draughan’s shares. Per the 1989 agreement, Draughan was required to offer his shares to Buck, Short, and PERCO first before seeking outside buyers. Draughan made it well known that he needed the money from the sale of his shares to fund his retirement and testamentary trust, just as Short had done in 1958.
In 1994, Short sold all but 100 of his shares to Buck. This sale was in violation of the 1989 agreement because he did not first offer the shares to Draughan or PERCO and did not disclose the sale until after it was final. This sale gave Buck a fifty-one percent interest and control of PERCO. Relations between the parties deteriorated further when Buck and Short elected themselves to two-person executive committee, effectively excluding Draughan’s shares from representation. The executive committee then offered to purchase Draughan’s remaining thirty-nine percent interest for less than half their book value. After Draughan refused the committee’s offer, PERCO terminated his employment and the payment of his $15,000 salary.
From 1994 all management decisions of PERCO were conducted exclusively by the executive committee consisting of Buck and Short. In 1996, Draughan died. The owners of his shares brought suit claiming Draughan’s shares would never be sold at their fair market value and without such a sale, no value for those shares would ever be realized. The complaining shareholders sought dissolution of PERCO under 55-14-30. The court agreed with the minority shareholders that their reasonable expectations were known to the defendants and had been frustrated by the majority shareholders. After the court determined that the Meiselman test had been satisfied and dissolution was reasonably necessary to protect the interests of the minority shareholders, the court attempted to determine the fair value of their shares under 55-14-31(d).
B. PERCO Valuation
The parties agreed to have an independent and objective business appraiser prepare a valuation of PERCO. The court relied heavily on this valuation. The report was prepared in accordance with the Business Valuation Standards of the American Society of Appraisers and the Uniform Standards of Professional Appraisal Practice. While the court did not divulge the details of the PERCO valuation, it stated that Hawkins estimated the fair market value of PERCO’s shares as a going concern both with and without a minority discount and marketability discount. This led to a high valuation of $846.61 per share and a low valuation of $462.27 per share. The court found that it would be inequitable, after determining that dissolution was appropriate, to value the minority shares at less than the full value they would have had if the company were sold and they received their pro rata share of the total sales price. The court wanted to avoid allowing the majority to buy at a discounted price when they could resell those shares at full price. To do otherwise would provide an incentive for the majority to oppress minority shareholders and force them to seek relief under 55-14-30 and 31. Therefore the court rejected both a minority and marketability discount.
Rather than accepting the Banister valuation, the court included "equitable factors which were not appropriate for the Banister Valuation." In reaching fair value the court heavily considered market value but did not base its finding upon market value. If it had then it would have awarded the minority shareholders $846.61 per share. The court divided the equitable factors into three categories: (1) changes in condition, (2) equitable considerations, (3) practical considerations. Under the changes in condition subheading, the court applied a "key man" discount. Because Buck was president and had been for a long time, there was no succession plan in place, and PERCO’s business was essentially a personal services business, the court discounted the company’s value due to the risk of losing key management. Additionally, there was the risk that Buck would dissolve the company upon retirement. The court did not make clear the exact impact this consideration had on the valuation. Under the equitable considerations subheading, the court recognized that Buck was not solely responsible for the failure of the Draughan’s expectations. The court even went so far as to say that Draughan precipitated the crisis. So while the minority shareholders should not have their shares held hostage by the majority to coerce a bargain buyout, their expectation could have been nothing more than a return on their equity or a buyout at a fair price. The court did not make it clear to what degree this consideration impacted the valuation. Under the practical considerations subheading, the court reduced its determination of fair value in light of the burden placed on PERCO and/or Buck in having to fund the purchase of Draughan’s shares. The court held a fair price is not a price that automatically results in dissolution. The court took into account the possibility that its valuation could make purchase of the shares impractical or impossible. The reason for this consideration was that if the court effectively forced dissolution by its valuation, then the "minority shareholders would receive less in liquidation than they would at a price less than ‘market valuation…’ [and] their interests may be better served by the fair value price which is greater than the liquidation price." In addition, the court noted that Short had the same expectations that Draughan had; to have his shares bought by PERCO or Buck to fund his retirement. As Short was near retirement age, the majority was likely going to be forced to make a similar purchase of Short’s shares in the near future. This additional purchase would add even greater stress to PERCO and/or Draughan. Taking these equitable factors into account, the court determined that the "fair value" of the minority shares under 55-12-31(d) was $635 per share.
IV. Analysis of Practical Considerations
Unfortunately the court was not mathematically explicit in its determination of fair value. It made clear that neither minority nor marketability discounts were applied and that its three categories of equitable factors were considered, but it made no attempt to make clear the exact impact these factors had on its determination of fair value. Other than knowing that the Banister valuation was completed according to Business Valuation Standards and Uniform Standards of Professional Appraiser Practice, all other information regarding the valuation was not revealed.
Although little information regarding the valuation was given, by analyzing the court’s language, one can surmise how the court arrived at its value of $635 per share. First, because the court did not apply marketability or minority discounts, it is reasonable to assume that Hawkins’ valuation that included minority and marketability discounts bore little weight in the final valuation. Additionally, the court appears to have accepted Hawkins’ other valuation number of $846 per share as a base from which fair value was determined. The court recognized that fair value was not market value, $846 per share, and then began reducing its award from market value to reach fair value. Although it is clear the equitable factors used by the court reduced the valuation, it is not clear the exact impact that each factor had on the valuation. However, it appears that the court’s practical considerations played the largest role in discounting market value.
At first appearance the court looks to have discounted market value in one of two ways: (1) splitting the difference between market value without minority or marketability discounts and market value with both discounts (i.e. the difference between $846 per share and $462 per share) or (2) applying a 25% discount to the market value of $846 per share. However, neither of these assumptions is correct. The determining factor for the court was the price it thought Buck and/or PERCO could pay without having dissolve PERCO. The court was wary of effectively ordering liquidation of PERCO. If dissolution had resulted, the court believed the minority would have gotten much less than they actually received. This conclusion is supported by the fact that the court structured the terms of the buyout so that the majority had the right to purchase the minority’s shares over three to four years with a secured note. In essence, the court set fair value at as a high a value as it thought it could without forcing the majority to dissolve the business.
Allowing these practical considerations to affect the determination of fair value creates a problem. On the one hand, fair value should not be based on what the corporation can afford while avoiding dissolution. There is a strong argument that since the court accepted Hawkins’ valuation as reasonable and fair, it should have accepted one of the two values suggested by him. Doing otherwise creates a degree of unpredictability and inconsistency. Minority shareholders can longer be sure that they will receive their true mathematically fair value. Instead the economic well-being of the company and the majority shareholder will color the minority shareholder’s award. For instance a minority shareholder attacking a company that is cash rich with a majority shareholder who is wealthy will likely not have its determination of fair value reduced by practical considerations, but a minority shareholder in a company that is cash poor or highly leveraged and with a majority shareholder who is not wealthy will likely have its award of fair value impacted. It does not seem fair to disadvantage a minority shareholder for the poor financial management of a company over which it had little or no control.
There is further unpredictability in the court’s failure to explain exactly what impact the practical considerations had on the determination of fair value. While one may surmise that these considerations impacted the valuation to the point of reducing fair value to a level payable by the company, there is no explanation of how this point was determined. The court merely stated that it believed its adjusted value would be low enough to keep PERCO from dissolving.
On the other hand, should the award for a minority shareholder be effectively minimized by a determination of fair value well above what the company could possibly pay? Because the corporation has the choice of dissolving and granting the minority shareholder her pro rata share, an amount much smaller than an award of fair value adjusted for practical considerations, the court cannot force the majority shareholder or the corporation to purchase the minorities shares. Upon determination of fair value, the corporation and majority shareholder have a period of time in which to decide whether it will elect to purchase the minority’s shares under it 55-14-31(d) rights or dissolve pursuant to 55-14-30. This situation spawns a simple mathematical decision in which the corporation will dissolve if it determines that financially it cannot pay the minority shareholder fair value or the corporation and/or majority shareholder will elect to pay the minority its fair value if that amount is not so great as to destroy the company. This issue was the determinative concern in PERCO. The court believed it was maximizing the minority shareholder’s value by providing them with a legal right to an award greater than their pro rata value under dissolution but less than a value that would force the majority to seek dissolution.
The court was correct in concluding that the well-being of the shareholder and her value maximization is paramount, but the court failed to protect that interest. In attempting to fashion a "practical" remedy, the court inadvertently deprived the minority shareholder of rights the court implicitly agreed were hers. To explain, the court essentially agreed that Hawkins’ value of $846 per share was the value to which the minority was entitled, minus the practical considerations. After the court determined that PERCO / the majority could not afford to purchase the minority’s shares at the value determined by Hawkins, the court reduced the minority’s award to a level sustainable by PERCO / the majority. Therefore, although the court agreed that the minority’s rights were to Hawkins’ value of $846 per share, it reduced that right to only $635 per share solely because this was the highest sustainable purchase price for PERCO / the majority. While the justification for this right, as discussed above, was to maximize the award for the minority shareholder, by protecting the right of the shareholder to receive a buyout price (any buyout price), the court essentially prevented the minority from seeking fair value. The court would not disagree that the mathematical fair value of the minority’s shares was $846 per share. However, by reducing the judicial remedy to $635 per share, the court prevented the minority shareholder from seeking that fair value.
The just remedy would have been for the court to award the minority shareholder her full fair value, $846 per share. Under 55-14-30 and 31, she is entitled to $846. Just because the court does not believe that she will be able to collect the full amount for her shares does not mean that to what see is legally entitled should be reduced. By reducing the minority shareholder’s award, the court prevented exactly what it set out to do: protect the minority shareholder’s interest in the fair value of her shares. Without a judicial right to the $846 per share value, there is certainly no chance she will receive full value for her shares. However, with a legal right to the full fair value, the shareholder at least has the legal right and a chance to collect to that amount.
In spite of the court’s argument that awarding fair value above what is sustainable would force the company into dissolution, this is assuredly not the case. If the court recognized that the minority shareholder would not be able to squeeze its full fair value from the company, then surely both parties recognized that as well. Therefore, the most likely outcome of awarding fair value above the sustainable price would be settlement. Just as the court implicitly argued that fair value should be adjusted for practical considerations because all parties would be better off under a buyout remedy rather than dissolution, both parties would have tangible incentive to settle after an award of fair value had been determined and was above a level sustainable by the corporation or majority. The minority shareholder would be forced to settle because she understands that if she presses for the full fair value award, the company would dissolve and she would be left with only her pro rata share upon dissolution. The majority would be forced to settle because if it was faced with paying full fair value it would have to dissolve. Therefore, had the court awarded the full fair value of $846 per share, not only would the parties have settled but the minority shareholder would have had a legal entitlement to her full fair value as contemplated by 55-14-31(d).
The court in PERCO overstepped its bounds. By failing to consider the practical outcome of its decision, the court denied the minority shareholder a right to which she was entitled. The inclusion of the court’s "practical considerations" destroyed the right of the minority shareholder to the full fair value of her shares. Although there may not have been a great chance that the minority shareholder would have received her full fair value, under the courts ruling there is absolutely no chance that will happen. Additionally, because Royals was a case of first impression in North Carolina any case to arise from this point will have to reconcile itself with Royals’ determination that practical considerations are valid factors. Minority shareholders in North Carolina should be wary that their rights upon an action for dissolution under 55-14-30 are subject to what the court believes the corporation can sustain. In an attempt to protect the rights and value of minority shareholders, North Carolina has stripped its minority shareholders of rights to which they are justly entitled.