Case Study: What’s My Business Worth – Sullivan Homes Ltd.

Harry is not happy. His partner, Jim, has a serious health issue and wants to sell their construction business. However, there is no shareholders’ agreement to guide them through the process, and there are unresolved grievances. Can they find a solution that secures Jim’s retirement while ensuring the company’s continued success? Has Jim, the majority shareholder, been paying himself too high a salary, trampling on Harry’s shareholder rights? Will their disputes have to be resolved in the courtroom? And finally, could it all have been avoided?

Introduction

Sullivan Homes Ltd. has a strong reputation for building high-quality custom homes. Last year, it generated approximately $3.78 million in sales, with an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of around $460,000.

Jim, the company’s President, owns 75% of the common shares, while Harry, the Construction Manager, holds the remaining 25%. Jim, now 62, is considering retirement due to health concerns—he typically works over 60 hours a week, and his blood pressure is off the scale.

The company operates out of a 600-square-foot space. It is too small, but the lease has four years to run. Equipment and inventory are stored on Harry’s acreage property.

The company employs around 15 full-time workers, including Jim’s nephew, Craig, a project manager.

The two shareholders have discussed Jim’s desire to sell the company, and Harry expressed interest in buying Jim’s shares.

Possible Selling Price Range

A business broker has advised that the company should sell for at least $1.5 million and potentially as much as $2.0 million. The broker believes buyers would be attracted by the company’s solid reputation, profitability, strong balance sheet, and an expected additional $350,000 in profits from uncompleted contracts.

Jim’s Concerns

Jim has several concerns:

1. To finance his retirement, Jim’s financial advisor has determined that the net proceeds from the sale of his 75% shareholding must be at least $1.2 million. He is worried that if the company sells for $1.5 million, his 75% share of the proceeds will not be enough.

2. Jim hopes to use the Lifetime Capital Gains Exemption to shelter most of the sale proceeds from taxes. For this to work, he would have to sell his shares. An asset sale would not qualify for the exemption.

3. Jim is concerned about Harry’s ability to run the company independently and worries that he will have to continue managing the business long after the sale has gone through. Also, since Harry’s assets are limited, Jim would need to provide at least $1 million in vendor financing. Consequently, Jim would prefer a “clean” sale of shares to a third party.

4. Jim feels that Harry owes him—he brought Harry into the company, promoted him, and sold him 25% of the business at a below-market price, and he has always worked longer hours than Harry.

Harry’s Concerns

Harry has conflicting concerns and grievances:

1. He worries about his job security if the company is sold, as his share of the sale proceeds would not be enough to fund his early retirement. At 46, he would still need to work for another 10 to 15 years.

2. Harry feels confident that he can run the company himself. Although Jim has been his mentor, Harry believes he is now ready to step out of Jim’s shadow.

3. A particular annoyance is that he receives no compensation for allowing the company to store equipment on his acreage property. He also noted that the business broker suggested that Jim’s salary is on the high side. When he discussed this with his lawyer, he mentioned something called “minority shareholder oppression.”

4. He is uncertain that the business broker’s valuation is realistic. Was the broker given all relevant information? All Harry has seen is a two-page letter.

5. The company has not been prepared for sale. For example, Jim’s nephew, Craig, has been with the company for two years but has made several costly mistakes that have impacted the bottom line. However, Jim is unwilling to fire him and is reluctant to discuss the issue.

6. Harry is concerned about the business broker’s fee, which could be close to 10% of the selling price, amounting to $150,000 or more. He wonders how the brokers can justify such a fee.

7. Before Jim’s health issues arose, they had discussed expanding the business and selling it in about five years, when the sale proceeds would be sufficient for both to retire. Harry is frustrated that Jim’s health problems are now affecting Harry’s plans for the future.

8. The company must distribute its investment portfolio as a dividend to qualify for the Enhanced Capital Gains Exemption. Harry is reluctant to agree to the dividend distribution, as it would be taxable. He questions why he must pay additional taxes to reduce Jim’s tax liability.

Mapping a Path Forward

Shareholder dispute litigation is extremely costly and must be avoided at all costs, as the legal fees can run into the hundreds of thousands of dollars. Jim and Harry have significant disagreements over their contributions to the company, when and how to sell, how to prepare it for sale, and its value. To move forward, they should:

1. Seek legal advice to fully understand their respective positions. Can Jim force Harry to sell his shares? If not, can he push through an asset sale instead of a share sale? What would the company's severance obligations be if the business is sold and Harry loses his job?

2. To facilitate productive negotiations, they must understand their respective tax positions, including the steps necessary to utilize the Lifetime Capital Gains Exemption. Are there any strategies that would make the transaction more tax-efficient? They also need to obtain estimates of the proceeds they will receive in each scenario—a sale of shares or an asset sale.

3. Obtain an accurate valuation of the business that both parties trust. They should consider hiring a business valuator jointly to avoid competing valuations and further discord. The valuator can also advise on steps they could take to prepare the company for sale and enhance the selling price.

4. They should determine how the business broker’s fees are calculated and exactly what services the broker will and will not provide. They should also obtain an estimate of their lawyer and tax advisors’ fees.

5. Perhaps the sale agreement could include a provision guaranteeing Harry’s job. A Human Resources consultant could advise on whether Jim’s salary is excessive and how to deal with Craig’s performance issues.

6. Lastly, if they cannot resolve issues, such as Jim’s concerns about Harry’s ability to run the company and Craig’s performance, they should consider hiring a commercial mediator.

Their best chance of resolving these issues involves open and constructive dialogue, with both shareholders having a complete understanding of the tax, legal and valuation issues.

Importance of a Shareholders’ Agreement

Many of Jim and Harry’s problems might have been avoided if they had a shareholders’ agreement. In my book, Maximizing Business Value Construction Companies, I outline some of the issues that may need to be addressed in a shareholders’ agreement, including:

1. The circumstances where one shareholder can buy out the interest of another shareholder.

2. Whether a sale of a share interest to a third party requires the consent of the remaining shareholders.

3. Will the remaining shareholders have a right of first refusal in the event a shareholder wishes to sell to a third party?

4. How will the price be determined if the company or the remaining shareholders purchase another shareholder’s interest?

5. What percentage of the shareholders are needed to approve a sale of the entire company?

6. Will the company employ the shareholders and/or family members? If so, what will be the terms of their employment?

Some of the questions and issues shareholders should pay carefully attention to when reviewing a draft agreement include:

1. Does the agreement impede their ability to liquidate their shares at fair market value?

2. Will it allow the other shareholders to purchase their shares at less than fair market value.

3. Does the agreement give the other shareholders a right of first refusal to purchase your shares? Potential purchasers may be reluctant to make a serious offer if they know that the other shareholders may pre-empt them.

Finally, when negotiating a shareholders’ agreement excellent legal advice is critical.

This case study uses hypothetical facts that may not apply to actual facts and circumstances. It also reflect laws and practices, which are subject to change and should not be relied upon as a substitute for specialized advice in connection with a particular matter. The author does not accept any legal responsibility for its contents or for any consequences arising from using or misusing the information provided. If legal, tax, accounting or other expert assistance is required, the services of a competent professional person must be sought.