2011 kicked off the next huge demographic shift in the U.S. – Baby Boomers entering retirement age (65). Over the next 19 years, according to government statistics, on average, 10,000 Americans per day will be retiring for a total of more than 69 million people. This shift is increasing ownership transition activities among architecture, engineering, and environmental consulting firms. As firms explore ways to buy out retiring shareholders, care must be given to the process of executing a transaction, whether it’s with a third party, select employees, and/or an ESOP.
Whatever approach your company takes to monetize the ownership interests of its shareholders, the board of directors and senior management acting on behalf of minority shareholders must take great care to avoid or mitigate conflicts of interest. Since most, if not all, architecture, engineering, and environmental consulting firms are owned by employees, the appearance of conflicts of interest or self-dealing can be difficult to avoid. The use of fairness opinions can reduce your risk of minority shareholder litigation.
What if over the last two years your company’s revenues decreased by 35%, profit margins are about one-third than what they were before, your work force is half of what it used to be, and your employees are anxious because their employment future, while better than last year, still remain a little uncertain. Then, one day out of the blue, a firm makes an inquiry to acquire the assets of your company. The cultures are a perfect match and the combined companies will likely create better opportunities for your services. Additionally, this acquisition will monetize the shareholders’ investment, give a more stable employment future for your remaining employees, but will lock in the losses on the recent investments made by certain shareholders. In this transaction, you have decided to take some of the cash proceeds and issue bonuses to those shareholders who are locking in their losses as this will make them feel better about the transaction. Is this fair? We will answer this question near the end of this Perspective.
In 1985, in the case of Smith v Van Gorkum, the board of directors was held personally liable for breaching their fiduciary duty of care by approving a merger – even though the premium received in the transaction was substantial. In this particular instance, the board of directors of Trans Union approved the sale of the company to Jay Pritzker, a corporate takeover specialist, at $55 per share by relying upon the opinions and the transaction process being carried out by a few senior managers – namely the CEO and CFO. In its ruling, the Court set a precedent that board members should protect themselves by obtaining a fairness opinion from a qualified, third-party valuation expert.
Fairness opinions are designed to assist directors in making reasonable business judgments that require the board to: (a) exercise due care in the process of making that decision; (b) act independently and objectively; (c) act in good faith; and (d) exercise full discretion in making their decision. Fairness opinions do not express an opinion value or even a range of values, and should not be confused with a valuation report or appraisal. A fairness opinion is an opinion as to whether a proposed transaction is fair from a financial point of view. It examines the value of the interests to be received in a transaction (cash, notes, earn-outs, employment bonuses, etc.) compared to the value of the interests given up. Fairness opinions are usually issued on behalf of either the buyer or the seller in a proposed transaction and do not make a recommendation as to whether or not to pursue the deal.
In evaluating the fairness of a transaction, appraisal experts take into account the broader concept of fairness involving potential conflicts of interest. Thus, the test for fairness requires the consideration of procedural fairness and substantive fairness.
Procedural fairness requires that no one individual or group of individuals can use their control or management influence to direct the outcome of a transaction such that the benefits of the transaction inure to select individual(s) without regard for the rights of minority shareholder(s). Courts have ruled that fair dealing includes matters such as how the transaction is timed, initiated, structured, negotiated, and disclosed to directors as well as how the approval of the transaction is obtained from shareholders. In a transaction, questionable dealings include, but are not limited to, overreaching, hurried transaction, lack of arm’s length negotiation, fraud, and withholding of pertinent information. In some states, in a transaction that has an appearance of a conflict of interest, the burden of proof will initially rest on the party with the conflict.
Substantive fairness considers the economics of a proposed transaction, including, but not limited to the types of economic considerations such as employment agreements, earn-outs, seller financing, retention compensation, rental agreements on seller-principal owned buildings, among other factors. Substantive fairness does not consider whether a higher price or more favorable structure could be achieved.
A subset of substantive fairness, but not always a requirement, is the issue of relative fairness. Relative fairness tests whether the different consideration to be received by different beneficiaries of transaction is also fair. Personally, I have opined on transactions in which principal shareholders received cash and stock and non-principal shareholders received cash only. At first glance, it might appear that the non-principals in such a transaction were better off as they received better liquidity and less risk in the transaction. However, you must also take into account the loss of economic benefits to the non-principal shareholders through the lack of ownership of the combined companies. In such a case the expert must evaluate the benefits of the consideration to be received by the principal shareholders through their ownership interest of the combined companies. The expert must investigate how the acquiring company values its common stock as well as the additional benefits of being a shareholder including perquisites such as company cars, unique retirement plans, and the like. Most importantly, the expert must assess the value accretion created by the combined companies. If this accretion were to only accrue to the principal shareholders, a non-principal shareholder could argue that the principals actually received greater consideration in the transaction.
As for the question of whether a company could give a bonus to certain shareholders that are locking in their losses was an actual situation of a distressed transaction in which I was an advisor. In this particular instance, the CEO shared with me how he was going to allocate the proceeds from the sale of the company’s assets. Since he was the largest shareholder, he felt that it would be beneficial to minimize the losses of those shareholders who are locking in their losses when they sell the company. I found this to be very generous of him, but very risky. This act makes the transaction not fair because in his generosity, he was taking the rightful economic value away from other minority shareholders for the benefit of those shareholders that were locking in losses.
Since fair dealing and fair price are examined as a whole, your financial expert should be informed of all material facts and circumstances of the transaction, even if the opinion does not directly address the aspect of fair dealing.