Fairness opinions are a fact of life in transactions involving public companies. There is a general 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 is a fairness opinion needed by privately held companies?
Private companies are becoming increasingly complex in regards to equity structure. We find ownership interests of companies 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 equity interests that must be taken into consideration regarding a 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 companies, while comfortable accessing advisors typically limit advice to attorneys and accountants. 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 transaction. The litigation environment is causing private owners to accept the cost of a fairness opinion as “insurance” to interested parties challenging the transaction.
There are several circumstances in which controlling shareholders and boards of directors of privately held businesses are increasingly in need of fairness opinions:
Multiple Classes of Stock. Many privately held businesses 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 with respect to the financial implications as they relate to those divergent interests.
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.
Families. 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.
Lack of Outside Board Members. Few privately held companies have boards of directors comprised of many, if any, outside, independent board members. In addition, management depth and expertise are rarely sufficient to provide expertise needed in evaluating the fairness of a transaction.
All of these issues deserve consideration when entering into a sale or merger transaction, or virtually any transaction involving a change of ownership control. In order 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 disasters by recommending that the company obtain an outside independent fairness opinion. In addition, it is important to help find a financial advisor who will meet the highest standards in their preparation of a fairness opinion. At a minimum, the issuer of a fairness opinion should:
• Collect historical company data, asset information, and legal documents
• Conduct management interviews and site visits
• Analyze historical financial statements and trends
• Analyze economic and industry data and trends
• Compare the company’s performance to industry standards
• Identify and select appropriate valuation methodologies
• Properly apply appropriate valuation methodologies
• Prepare a well-reasoned analysis and presentation
Once an advisor has recommended the use of outside financial expertise in assessing the fairness of a transaction in a way that addresses all of the above considerations, that advisor should rest well, knowing that he has done all he can. Why get a fairness opinion for a private company? The best reason is whichever one lets you and your client sleep better at night.