Appraisers often apply discounts for lack of marketability or minority interests when valuing shares in closely held businesses for estate planning and other purposes. The discounts, which generally fall in the range of 15% to 35%, are applied to take into consideration the minority shareholder’s lack of voting power relative to director elections, dividends and other distributions, and other management and operational decision-making.
Illinois courts, which are generally considered more protective of shareholder, as opposed to management, rights, have traditionally applied lack of marketability and minority discounts in shareholder disputes. However, this position is contrary to the prevalent trend toward rejection of such discounts. Courts in most jurisdictions now reject application of discounts because they fail to fully credit a minority shareholder’s stake in the value of a business in its entirety.
The issue of valuation often arises in the context of cash-out mergers, reverse stock splits, and disputes relating to alleged minority oppression resulting from acts by the majority shareholders. In the latter instance, the majority generally is alleged to have benefited itself to the detriment of the minority by failing to make distributions, by stacking the board or management so as to authorize compensation or other benefits for controlling shareholders to the exclusion of the minority, or by taking other actions that violate fiduciary duties of the majority in their capacity as shareholders and/or as officers or directors of the corporation, such as self-dealing or over-reaching.
Most courts, other than Illinois, now treat minority shareholder valuation as an issue of law, not one of fact, and apply a “fair value,” as opposed to a “fair market value,” standard. Illinois courts have treated valuation as a matter of fact. The difference between these approaches results in Illinois courts granting deference to determinations of value by trial courts, since trial courts are considered to have the best means of evaluating facts and appellate courts generally are not anxious to “second-guess” facts presented at trial.
Illinois trial courts generally have determined value based upon “fair market value” which is generally defined as the price that would be obtained in an arms-length transaction between a willing buyer and seller on the open market, where neither is under a compulsion to act and each has access to all relevant facts.
The fair market value approach results in application of lack of marketability and minority discounts, because it is presumed that a willing buyer would not otherwise want to step into the shoes of a minority shareholder who has little or no voice or control over the business or operations.
The fair value approach generally involves a broader evaluation, including recognition that lack of marketability and minority discounts are not appropriate where the buyer and seller are the majority and minority shareholders. Application of such discounts in the context of cash-out mergers, reverse stock splits, and disputes relating to alleged oppression of the minority shareholders ignores the fact that a majority shareholder does not step into a voiceless and feckless position when it acquires minority shares. Indeed, acquisition of minority shares may strengthen control of the majority shareholder and eliminate a potential source of shareholder and derivative claims.
Commentators have called for revision of the Illinois approach to valuation, which would bring Illinois within the view expressed by the majority of jurisdictions and would be consistent with Illinois’ perceived status as protector of shareholder rights. We will keep you advised of new rulings in this developing area.