Buyouts are one of the most important topics small businesses must consider. It should be a topic discussed, negotiated, and decided upon pursuant to a shareholder or LLC operating agreement. However, it often is not.
For corporations, the Illinois Business Corporation Act (BCA) allows a buyout if a minority shareholder has alleged fraud, oppression, illegality, waste, or failure of corporate purpose in an action against the majority shareholder. 805 ILCS 5/12.56(a)(3).
For LLCs, the Illinois Limited Liability Company Act (LLC Act) permits a buyout to be ordered when a member should be dissociated from the LLC. One member can sue to force the dissociation of another member when it is no longer practicable to do business with the member. This may occur when some wrongful act was committed. 805 ILCS 180/35-45(6). In one recent case, an arbitration panel ruled that a member was permitted by the operating agreement to compete with the LLC, but that by doing so he had made it impracticable to continue in business with the LLC and therefore should be dissociated.
Valuation of small businesses for a buyout can be hotly contested. It is not an exact science, but it masquerades as such. Fights center around how profit is calculated (e.g., excessive salaries and personal expenses must be subtracted.) Adjustments are also required for non-recurrent, helpful and hurtful events to recent revenues.
After profits are determined, the court must determine their stability to capitalize them. In a stable business (an apartment building, for example), annual profits of $100,000 could lead to a cap rate of 10 or more and a value of $1,000,000 or more, whereas in an unstable business (used cars, for example), profits of $100,000 might yield a cap rate of only 1 or 3, for a value of $100,000 to $300,000.
After a value is determined, some valuators discount a minority shareholder’s pro rata share of value (a 20% shareholder would have a right to $200,000 of a business valued at $1,000,000 pro rata) because they lack the right to control the business, meaning that a fair value of $200,000 would be discounted because it does not provide majority control. An article in Business Law Today argued that a minority shareholder’s shares were not worth anything without a shareholder’s agreement because the majority shareholder could effectively deny any compensation to the minority shareholder. Most states, such as Illinois, have statutes that, under a statutory buyout, require a minority shareholder to be bought out for the fair value (no lack of initial discount) rather than fair market value of his or her shares. 805 ILCS 5/12.56(b)(11).
Some valuators will also apply a marketability discount for small corporations or LLCs. The theory that there is no market for the shares of small or privately held businesses. One question in these cases is whether the marketability discount would apply to the sale of the whole business or just a portion of the shares. If for the whole business, then all shareholders bear this discount equally, but if for a minority shareholder’s shares only, then the valuation produces a discount for the minority shareholder that is not borne equally by the majority shareholders and should not be considered the fair market value.
Restrictive covenants may also be an issue. If the business’s revenues depend on key employees, for example, and if they are free to leave the business after the buyout, the business value would immediately diminish if they left. The statutes permit the court to order that the seller of the shares be prohibited from competing for a period after the buyout. 805 ILCS 5/12.56(e)(iii).
In this space it is impossible to list all the factors that go into a buyout. We do so much of this litigation that we have purchased and regularly consult the leading valuation textbooks and have worked with and against many different valuators. This helps us prepare them to testify when they are working with us and helps us cross-examine those who are working against us.
To speak to one of our lawyers, get in touch with us at (312) 223-1699 or email Thomas E. Patterson at firstname.lastname@example.org for more advice and information.