Section 2000 Valuations

Disagreements in the governance of a corporation - whether due to mishandling of corporate assets, opinions on strategy, unfairness, fraud, illegality, malfeasance, or even personality conflicts - are not uncommon. California law allows minority shareholders to file for involuntary dissolution under Section 2000 of the California Corporations Code on certain grounds. 

Section 2000  provides that, in an action for involuntary dissolution, the corporation or, if it does not elect, the shareholders holding 50% or more of the voting power, may avoid dissolution of the corporation by purchasing for cash the shares owned by the plaintiffs at their fair value.

Shareholders can protect the corporation from Section 2000 actions by entering into Shareholder Agreements or Buy-Sell Agreements which would govern the exit process of a dissenting shareholder. Absent one of these agreements, however, Section 2000 of the Corporations Code will govern.

The Standard of Value Under Section 2000

If the non-moving parties elect to avoid dissolution by purchasing the interest, and the parties cannot agree on a value, the court is to appoint three disinterested appraisers to determine the fair value of the moving shareholder’s interest. Fair value is defined in Section 2000(a) as:

"The fair value shall be determined on the basis of the liquidation value as of the valuation date but taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation."

This definition of value contemplates two standards: "liquidation value" and "going concern in liquidation." Reconciling these standards can be difficult. Liquidation value assumes "that the business is terminated and the assets are sold piecemeal." (International Glossary of Business Valuation Terms, 2022.) Going concern in liquidation assumes the corporation is sold as operated. The assumptions underlying these standards may yield different values.

Legislative intent helps to sort this out. The purpose of Section 2000 is to provide a path whereby the purchasers can continue to operate the corporation by acquiring the dissenting shareholder's shares at a price equal to what they would have received had their dissolution action been allowed to continue to a successful conclusion. This was addressed in Brown v. Allied Corrugated Box Co. (1979) 91 Cal.App.3d 477: the "statutes suggest that a minority shareholder who brings an action for the involuntary dissolution of a corporation should not... receive less than he would have received had the dissolution been allowed to proceed." (Brown, p. 487.) 

The goal of the analyst is to arrive at a representation of value to the shareholder interest applicable if the corporation had liquidated or sold. "Under the statute, the appraisers are not only entitled, but are required, to consider the manner in which the parties to such a hypothetical sale are most likely to maximize their return." (Abrams v. Abrams-Rubaloff and Associates Incorporated (1980) 114 Cal.App.3d 240, p. 249.) The liquidation value should contemplate the value of the assets assuming they are sold piecemeal and all goodwill in the business is forfeited. On the other hand, the potential of a sale on a going concern basis, without the sacrifice of the goodwill value, should also be considered. (See Brown at p. 490.)

Considerations to Meet this Standard

Does a minority discount apply?

In Goles v. Sawhney (2016) 5 Cal.App.5th 1014, the California Court of Appeals held that a discount for lack of control does not apply. In Goles, plaintiffs brought an involuntary dissolution alleging that the shareholder/directors “looted” the corporation by taking unauthorized loans, employing family members, using corporate funds to pay personal expenses, and neglecting corporate governance. (Goles, pp. 1018-1019.)

Three appraisers were appointed by the trial court and two of them applied lack of control discounts. The trial court averaged the values provided by the three appraiser, despite the differences in the levels of value.

The Court held that Section 2000 “does not permit a lack-of-control discount when determining the fair value of a minority shareholder interest” since this discount makes little sense when the shares are being purchased by someone who already has control of the corporation. (Goles, p. 1019.) 

This rule was well put in Brown: if liquidation occurred, "each of the shareholders would have been entitled to the exact same amount per share, with no consideration being given to whether the shares had been controlling or noncontrolling." (Brown, p. 486.)

Should costs for liquidation be considered?

The costs associated with the liquidation of the corporation should be considered. These costs may include attorneys fees, accountant fees, legal costs, brokerage fees, sales costs, and taxes. The magnitude of the costs will vary depending on whether a piecemeal sale is contemplated or the corporation is sold as a going concern in liquidation. 

Does a marketability discount apply?

Marketability is the ability to quickly convert property to cash at minimal cost. It's safe to assume that marketability discounts don't apply to Section 2000 valuations. Although there is no guidance on this issue from California courts, this seems to be the consensus among lawyers and valuation experts in the state.

A majority of states that have ruled on this issue have not allowed marketability discounts. See, e.g., Delaware in Cavalier Oil Corp. v. Harnett 564 A.2d 1137, Nebraska in Rigel Corp. v. Cutchall 245 Neb. 118, and Colorado in Pueblo Bancorporation v. Lindoe 63 P.3d 353. Although there is precedent for a marketability discount from an Oregon appellate court - see Columbia Management Co. v. Wyss 94 Or.App. 195. 

Since a Section 2000 valuation assumes liquidation, there is no theoretical basis for a marketability discount. Any impairment due to the liquidation process should be considered a liquidation cost.

Should the value of a derivative suit be considered?

Section 2000 dissolutions are often accompanied by derivative suits. A derivative suit is an action brought by shareholders on behalf of the corporation. Since the gains, if any, from a derivative suit accrue to the benefit of the corporation, not the shareholders, the lawsuit represents a contingent asset to the corporation. “A derivative claim (or other claim that may yield a potential recovery for the corporation) is a corporate asset that must be considered when determining ‘fair value.” (Friedman et al., Cal. Practice Guide: Corporation. The Rutter Group. 2016.) “If successful, a derivative claim will accrue to the direct benefit of the corporation and not to the stockholder who litigated it.” (Grosset v. Wenaas (2008) 42 Cal.4th 1100, 1114.)

Capturing the value of a derivative suit may, or may not, be a complicated matter. The expert should consider the relief prayed for in the complaint and the likelihood of prevailing on such relief, at some other level of relief, or not prevailing at all. If a complaint prays for injunctive relief that doesn’t necessarily mean that there is no monetary value to the corporation for that relief. However, determining the value to the corporation of such relief would be a highly subjective analysis. It is suspect whether such an analysis should be taken at all and, if it is, whether it would hold up in court. 

Assumption that the selling shareholder enters into a non-compete agreement.

A final point is that the selling shareholder is assumed to enter into a non-compete with the corporation regardless of whether an agreement is actually contemplated. Thus, the selling shareholder's intent to enter the market and compete with the corporation does effect the valuation under this section. (See Abrams, p. 249.) 

Conclusion

The unique standard of value under Section 2000 creates valuation issues you're unlikely to encounter elsewhere. This coupled with the litigated setting can lead to complex, drawn out legal proceedings. Appraisers are encouraged to keep their logic and assumptions grounded so that they reach reasonable conclusions of value.

 

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