January 11, 2024

We have discussed this topic in the past. Still, I think it's worth revisiting to remind companies of their fiduciary obligations to minority shareholders, especially considering the recent number of mergers & acquisitions in the architecture, engineering, and environmental consulting industry over the past few years. According to government statistics, over the next seven years, 10,000 Americans per day will be retiring which totals more than 25 million people. This shift increases 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 challenging to avoid. 

Fairness opinions can greatly reduce your risk 

What if over the last two years, your company's revenues decreased by 35%, profit margins are about one-third of what they were before, your workforce is half of what it used to be, and your employees are anxious because their employment future, while better than last year, remains a little uncertain. Then, one day, out of the blue, a firm makes an inquiry to acquire your company's assets. 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 and give your remaining employees a more stable employment future. Still, it 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 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. They 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 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 recommend whether or not to pursue the deal.

In evaluating the fairness of a transaction, appraisal experts consider the broader concept of fairness involving potential conflicts of interest. Thus, the fairness test requires the consideration of procedural fairness and substantive fairness.

Procedural Fairness

Procedural fairness requires that no individual or group of individuals can use their control or management influence to direct a transaction's outcome such that the transaction's benefits 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 transaction's approval is obtained from shareholders. In a transaction, questionable dealings include but are not limited to, overreaching, hurried transactions, lack of arm's length negotiation, fraud, and withholding pertinent information. In some states, in a transaction that appears to be a conflict of interest, the burden of proof will initially rest on the party with the conflict. It is critically important to document each step of the transaction process, from initial discussion to closing, to ensure that the board took appropriate steps and care to mitigate any appearance of conflicts of interest. 

Substantive Fairness

Substantive fairness considers the economics of a proposed transaction, including, but not limited to, economic considerations such as employment agreements, earn-outs, seller financing, retention compensation, and 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 considerations to be received by different transaction beneficiaries are 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. However, you must also consider 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 in the combined companies. The expert must investigate how the acquiring company values its common stock and 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 only accrues to the principal shareholders, a non-principal shareholder could argue that the principals received greater consideration in the transaction.

As for the question of whether a company could give a bonus to certain shareholders who are locking in their losses, it was an actual situation of a distressed transaction in which I was an advisor. In this instance, the CEO shared with me how he would allocate the proceeds from the sale of the company's assets. Since he was the largest shareholder, he felt it would be beneficial to minimize the losses of those 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 unfair because, in his generosity, he was taking the rightful economic value away from other minority shareholders to benefit those who 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.

Michael will be speaking more on this and other valuation related topics at the 2024 Growth & Ownership Strategies Conference November 6-8, 2024.