Fairness opinions are a fact of life in transactions involving public companies. There is a consensus that the fairness opinion is a powerful tool in protecting boards of directors from liability related to a transaction. For a public company, a board of directors’ careful consideration of an independent fairness opinion can be the strongest protection against accusations of, and liability for, fiduciary failure. But, why do privately held companies need a fairness opinion?
Private companies are becoming increasingly complex with regards to their ownership structure. We find that ownership interests of companies are no longer concentrated in one or two shareholders. With the advent of private equity funds, mezzanine funds, numerous estate, and trust structures, there are now many more investors in private companies who must demonstrate that they are acting in the best interest of their own shareholders or trust beneficiaries regarding a proposed transaction.
Companies, both publicly traded and privately held, routinely depend on key advisors to help avoid and manage risk. However, public companies have understood that the engagement of independent advisors is necessary. Private company owners with a controlling interest have historically not found it necessary to hire outside financial advisors to provide a fairness opinion on a proposed transaction. Given the current litigation environment, privately held companies are increasingly willing to accept the cost of a fairness opinion as “insurance” to help protect against potential deal-related litigation.
Ten Reasons to Consider Engaging a Third-Party for a Fairness Opinion
There are several circumstances in which controlling shareholders and boards of directors of privately held businesses are increasingly in need of fairness opinions.
1. Multiple Classes of Stock
Many privately held companies have multiple classes of stock, each with rights different from the others (e.g., preferred vs. common), resulting in very different and often divergent interests. In contemplating a transaction, controlling shareholders and boards of directors must be careful to be fair to all parties concerning the financial implications as they relate to those divergent interests.
2. Passive Shareholders
Many privately held companies have a large number of passive shareholders (e.g., not active in the operations or management of the business). These passive shareholders will not have the same understanding of the company’s business, operations, or value as the controlling shareholder or board of directors. The reassurance of an outside, independent advisor could avoid or mitigate risk substantially.
3. A Trust as a shareholder
Many companies have shares owned by a trust. The trustee faces many fiduciary challenges in sales transactions. There is a heavy responsibility of the trustee to protect the financial interests of the trust beneficiaries.
Trustees are fiduciaries, similar to directors of corporations. While a fairness opinion is not specifically codified, in nearly every instance, a trustee will require a fairness opinion that serves to protect the company and the ESOP from potential future claims.
Many privately held companies are owned by family groups. Others are controlled by family groups but have additional family shareholders outside the control group. Disputes between family members are common, especially when not all of the family members have an equal voice in the management of the company.
6. Lack of Outside Board Members
Few privately held companies have boards of directors comprised of independent board members. In addition, management depth and expertise are rarely sufficient to provide the knowledge needed in evaluating the fairness of a transaction.
7. Transactions with Multiple Bids
Selling companies that receive multiple bids with varying forms of consideration (stock, notes, cash, etc.) need to understand the exact terms and how each of these offers compare with one another. The correct interpretation is essential in understanding which offer is best for all shareholders.
8. Divergent Interest Between Directors and Shareholders
While directors have a fiduciary responsibility to the shareholders and are expected to act in good faith in supervising the affairs of a business, they may not hold the same opinion as shareholders as to what is best. If a transaction is consummated by one party, much to the dismay of the other, there is an increased risk of litigation. When a proposed transaction has these parties at odds, the reassurance of an outside, independent advisor could help avoid or mitigate risk.
In a recapitalization where rights and preferences of equity classes change, directors and shareholders need to understand the pricing, terms and structure thoroughly. If not meticulously reviewed, minority shareholders could find that their ownership interest will become diluted further upon certain future events. An opinion from an independent advisor often serves as the first line of defense that the transaction was not in the best interest of all shareholders.
10. Divestitures, Spin-offs
In some instances, companies may look to restructure and improve operations through the sale or spin-off of a portion of a business. That transaction often involves a sale to existing management or related parties. An independent objective analysis of the proposed deal can serve to protect the interests of directors, shareholders, investors and other parties with any fiduciary responsibility.
All of these issues deserve consideration when entering into a sale or merger, or virtually any transaction involving a change of ownership control. To manage the risk associated with these types of transactions, the surrogate boards of directors for private companies (the companies’ outside advisors – attorneys, accountants, and others) should help their clients make informed decisions and avoid future complications by recommending that the company obtain an outside independent fairness opinion.
Our team of accredited business valuation experts provides a wide range of valuation services. Whether you need a fairness opinion or a full valuation, please give us a call to schedule a complimentary consultation.