Shareholder Agreements and Valuation | Fair Value vs Market Value | Maclarens Lawyers, Merrylands

Shareholder Agreements and Valuation:  Fair Value vs Market Value

Shareholder agreements often govern how equity transactions are handled and the application of fair value vs market value can make a significant difference to the outcome.  In our latest article, Senior Partner and commercial lawyer Jessica Diep explains the importance of understanding the difference between these valuation methods. 

A shareholder’s agreement is a contract between shareholders of a company who agree to each vote their shares in a particular way on defined matters and resolutions. These matters usually include appointments to the board, the dividend policy of the company and the procedures and mechanisms for effecting both standard and special transactions.  More sophisticated shareholder agreements may also go one step further and agree to regulate or control how a shareholder holds, transfers or disposes of its shares.

The clauses in shareholder agreements that have the most impact on an intending share sale are the pre-emptive rights, first rights of refusal, tag along or drag along rights, and the powers and procedures provisions.

Often the shareholders have agreed, since the first execution of the shareholder’s agreement, that when these provisions are activated, the share sale price will be determined by a mechanism covering a future (possibly distant) transaction instead of permitting the transferring shareholder to dictate or nominate a sale price.

Shareholder agreement valuation mechanisms will incorporate a formula for ‘fair value vs market value’. Although these terms may not seem important when initially entering into the agreement, it can be of great and sometimes dramatic importance when an actual sale transaction arises.

Potential Impact of Valuation in a Shareholder Agreement

The case of Toll (FHL) Pty Ltd v Prixcar Services Pty Ltd & Ors 2007 ABSB ¶95-474 illustrates the issue of ‘fair value vs market value’, particularly with reference to a sale by a minority interest to the majority shareholders. It also illustrates the problem with shareholder agreements and valuation when the criteria for expert determinations of value are not specified accurately and in detail.

Toll was one of four shareholders and owned 33.33% of the shares in Prixcar Services Pty Ltd. Its shareholder’s agreement contained pre-emptive rights requiring Toll to first offer to transfer its shares at Fair Value to the remaining shareholders before it became entitled to sell its shares to any third-party buyer.

In the 2007 Toll case, the appointed valuer erroneously discounted the value of Toll's minority interest. Firstly, in applying a discounted cash flow analysis to determine value, the valuer applied a discount rate to reflect Toll's minority shareholding, which should not have been done. Secondly, the valuer failed to apply a control premium to reflect the fact that the other shareholders may have been prepared to pay an amount in excess of market value because of the special, strategic significance the shares may have had to those shareholders. The Court held that the minority interest was said to have “special value” for the majority shareholders. Fair value had to take into account the special value to the purchaser of acquiring 100% of the company and was not the same as market value. Therefore, the fair value exceeded the market value.

This decision shows that it is difficult to successfully set aside an expert determination of value, including of shares, even if it is contended to be erroneous.

As reliance is placed on the opinion of a single expert, that expert can get it wrong and it is recommended that the determination of value mechanisms in a shareholders agreement should include some appeal (or dispute) mechanism which may be relied on by either party. Of course, this has the consequences of extra costs and further delay in finalising the determination.

The concept of ‘fair value vs market value’ is also important to shareholders when an applicant shareholder seeks a court order under section 233(1)(d) of the Corporations Act for the compulsory purchase of shares under a strict set of circumstances such as oppressive conduct. The basic requirement is that the valuation must be fair on the facts of the particular case. However the court may satisfy itself in any way it wishes as to what the true value of the shares are and usually requires each party to provide an expert opinion report determining a value before coming to a decision.

In Holt v Cox (1994) 15 ACSR 313 (upheld on appeal: (1997) 23 ACSR 590), Santow J set out a number of relevant principles concerning the meaning that should be given to the word “fair” when it is an express contractual criterion. Those principles are as follows:

“(1) A distinction must be drawn between ‘fair value and market value’. This emphasises the significance of the word “fair” when used in conjunction with words such as price, value or market value. It is a mistake to automatically equate “market value”, as distinct from fair market value, with the “real value” which this test is designed to ascertain.

(2) When the criterion of fairness appears in connection with price or value, the price or value arrived at must be “fair, just and equitable in the circumstances”.

(3) At least where the valuation is required in circumstances of compulsory acquisition or expropriation, the requirement of fairness means that a “liberal” estimate of value should be given.”

Experience has exposed many examples of minority shareholders being forced to sell their shares under a number of different circumstances. Best practice suggests that valuation in shareholder agreements should be thoroughly considered, including the issue of ‘fair value vs market value’, and agreed to at the outset to circumvent the need for costly litigation.

For more information on shareholder agreements and valuation, contact Jessica Diep from our Commercial Law team at Maclarens Lawyers on 02 9682 3777.