Valuation of Minority Shares

In the context of disputes between companies and their shareholders, the courts are often called upon to formally assess the value of a corporation’s shares at a given point in time.

This can arise in numerous scenarios. For example, as part of its decision to terminate its president, a corporation may include a clause in the termination package which giving it the right to purchase theshares held by the departing president at “fair market value”. A dispute as to what that term means, or how the clause is to be interpreted, will require the court’s adjudication on share valuation Or, if an aggrieved shareholder has launched a successful legal claim against the corporation, the trial court maybe required to set the precise value of the corporation’s shares as part of its damages award in the shareholder’s favour.

The task of assessing share value is highly contingent on numerous factors; it requires a court to use something of a “crystal ball” approach. This involves making reasonable assumptions, evaluating thecurrent financial shape of the corporation, determining the prognosis for its future success, and then applying a complex set of mathematical equations. The exercise also involves scrutinizing the often- conflicting reports from expert valuators, who have themselves made certain presumptions and projections in the course of preparing their opinions.
At the end of the day, the outcome of the court’s valuation assessment is naturally contingent on the complex interplay between these many elements.

A recent Ontario court decision features some noteworthy judicial insights on the proper process for setting the value of minority shares in a company. It explores some of the different conceptualmethods for doing so, and reflects the court’s role in weighing and analyzing competing valuations byexperts.

The facts in Prolink Broker Network Inc. v. Jaitley, 2018 ONSC 7577 involved an insurance agent/broker who had his own start-up brokerage company called My Insurance Brokerage (MIB). He agreed to join a network of insurance brokers called Prolink, and as part of their deal committed to transferring 25 issued and outstanding shares in MIB to Prolink, out of 100 shares that were available.However, as the judge put it: “Troubles developed.” The agent decided to repudiate the agreement,and Prolink accepted that repudiation. Nonetheless, Prolink successfully sued the agent for damages arising from his breach of their contract. The judge was left to determine the specific amount of Prolink’s damages, consisting mainly of its monetary loss in connection with the fair market value ofthe 25 shares in MIB.
The judge observed that while the starting point for this kind of objective assessment generally drawson the traditional meaning of “fair market value” (which is the price agreed to on the open market, by arm’s length parties), the task was complicated by the fact that MIB was a smaller start-up insurance brokerage with few direct comparables. It invited Prolink and the agent to make submissions on damages, which included evidence of expert valuators put forth by each side.

At an initial hearing the judge had assessed the 25 shares as having a fair market value of only$12,656.38, and calculated Prolink’s overall damages accordingly. Prolink appealed to the DivisionalCourt, which concluded the judge had applied the wrong approach to the calculations. It sent the matter back to the same judge for rehearing and redetermination, after giving specific instructions on the proper method for recalculating the share value.

At that rehearing, the judge scrutinized the respective valuations submitted by the experts for Prolinkand the agent, noting they were “radically different”.

Prolink’s expert had decided that MIB should be valued as a going concern. He used the earnings capitalization method (which involves calculating the earnings capacity and then applies a multiple that reflects what an investor would pay) and the market multiple method (which determines MIB’s value by comparing it to other comparable brokerages that have recently sold on the market, andanalyzing the sale price in relation to MIB’s gross commission income).

In contrast, the agent’s expert had also used two different approaches: The first was the income/cash flow approach (which ascribes a value to MIB based on its ability to earn a reasonable return on investment); the second was the market approach (which involves estimating MIB’s fair marketvalue based on the analysis of comparable market transactions or values).
The judge noted with approval that both experts had used a combination of two different approaches in arriving at their differing results, which was reasonable and appropriate in the circumstances. The judge then examined the specific share valuation results derived from these differing methodologies.

Prolink’s expert had concluded that the value of the 25 shares in MIB was between $111,625 to $125,375, based on MIB being assessed as a going concern, with a book of business consisting ofabout 600 customers. Using an earnings capitalization approach, he calculated MIB’s overall worth was between $411,000 to $592,000 – with a midpoint of $501,500. Based on that midpoint, those 25 shares (representing one-quarter of the 100 available) were worth $125,375 at the high end. On the lower end, and using the market multiple method, he estimated MIB’s fair market value was between $405,690 and $486,828. Using the midpoint between the two, the value of Prolink’s 25% share wouldbe $111,625.In contrast, the agent’s expert arrived at a figure of between $16,000 to $23,000 for those same 25minority shares. The lower-end figure was based on cash flow approach, setting MIB’s overall valuebetween $73,000 and $86,000 and applying a 20% minority discount to the $79,500 midpoint. The $23,000.00 figure was based on the market approach, with an overall value for MIB of between $74,000 and $104,000.

The judge began by noting that both experts were knowledgeable and experienced, and both had combined the income/cash flow method and some variation the market method to arrive at a valuation. Their vastly-differing outcomes were simply caused by differences in their root assumptions. Thejudge added that where those assumptions were at odds, he preferred the evidence of the agent’sexpert.
Importantly, the judge also clarified that while he was obliged to make his own evaluation guided by the experts, he was not bound by their conclusions in any way.

In embarking on a detailed scrutiny of the evidence, the judge was particularly critical of Prolink’sexpert in two respects. First, he had failed to disclose that the accounting firm at which he worked had an ongoing connection with Prolink – one of his partners was Prolink’s accountant. Although this non- disclosure did not mandate the total disregard of his evidence – since it fell short of being tainted withactual bias – it prompted the judge to approach his evidence “with some caution”. The judge added that experts still have a duty to give fair, objective and non-partisan evidence; in this case the undisclosed pre-existing relationship merely impacted the weight of the opinion, not its admissibility.

Secondly, the judge sharply criticized the refusal by Prolink’s expert to acknowledge in his valuationthat the financial crisis of 2008-2009 had any effect on the value of MIB. As the court put it, “I thinkthat any Canadian or American who was not living under a rock in the fall of 2008 and the spring of 2009 was aware that there was a major crisis in world financial markets. Investment banks (such as Lehman Brothers) collapsed and all major Western governments were forced to provide liquidity totheir financial systems.” To put forward the position that the insurance industry was completely unaffected by the major financial crisis, as Prolink’s expert did, was simply unrealistic.
Disclaimer: The content in this article is provided for general information purposes only. It does not constitute legal advice. All rights are reserved.

In making its ultimate ruling as to the correct approach to assessing the fair market value of MIB’s minority shares, the judge also rejected the contention by the agent’s expert that the company shouldbe valued as a risky start-up business, justifying the use of a cash flow multiple of 4-5 times earnings. In fact, the judge found that MIB was an affiliate of a well-established major insurer, which the agent left after taking an existing book of business with him. On the other hand, the judge also ruled that the 8-10 times multiple suggested by Prolink’s expert was too high. The judge settled on a reasonable mid-point of 6-7 times earnings to reflect the fact that there were still risks associated with MIB as a business.

Otherwise, however, the judge accepted the approach taken by the agent’s expert, and ordered him torecalculate the income/cash flow valuation figures for MIB using those set multiples, and to take the midpoint. The market method calculation was to stay the same.
In other words, the fair market value of 100 percent of the shares was to be calculated as the mid-point between two spots:
1) The midpoint of the (now-recalculated) income/cashflow valuation, and
2) The midpoint of the market method valuation.

Prolink’s damages after the agent’s breach were therefore quantified at one-quarter of that 100-sharevalue, representing the fair market value of 25 of MIB’s issued and outstanding shares. This meant the correct and final valuation would be closer to the $23,000 originally estimated by the agent’s expert.

This recent case is just one of many in which experienced expert valuators provided plausible – yet staggeringly different – fair market value figures for minority corporate shares. It illustrates some of the numerous factors that can be relevant, and some of the diverse conceptual approaches to that can be taken – all with unsurprisingly differing outcomes.
As the decision in Prolink Broker Network Inc. v. Jaitley suggests, sometimes a combined approach is the most fair, appropriate, and reasonable one.

Disclaimer: The content in this article is provided for general information purposes only. It does not constitute legal advice. All rights are reserved.