California Partition Law Blog
When business entities become subject to internal dissension, it’s not uncommon for several members to approach the court system and seek to dissolve the entity. Often, this is in the best interest of all involved.
Sometimes, however, the other members, shareholders, or partners, do not want to let the business go. They feel it can continue to operate. As such, they may invoke a special mandatory buyout to keep the business running. The buyout allows those who want the business to continue to purchase the interests or stocks of those who wish to leave.
For LLCs and Partnerships, the buyout price is determined by the same standard: Fair Market Value. Corporations, on the other hand, conduct buyouts based on “Fair Value.” While this difference may seem minimal, they are ultimately quite different from each other.
What is Dissolution and Winding Up?
California’s Corporation Code has several sets of distinct statutes that apply based upon the type of business entity they govern. Corporations, Partnerships (including limited partnerships), and LLCs all have their own sets of rules and regulations. That said, all of these entities share similar regulatory provisions when it comes to one process: “dissolution” and “winding up.”
Dissolution is the beginning of the end for business entities. If dissolution is sought in the court, the court needs to determine whether or not to dissolve the business. If the court ultimately concludes dissolution is warranted, the business formally begins to “wind up,” meaning its sole function is to pay off creditors, shareholders, partners, etc.
As stated under California’s Corporations Code, this process is very similar for LLC’s, Limited and General Partnerships, and for Corporations as well. (Corp. Code §§ 2000 et seq., 17701.01 et seq., 15900 et seq., 16801 et seq.)
Can Dissolution be avoided?
Yes. As noted above, the end of a business has two stages – dissolution comes first, and winding up comes second. In order to prevent the court from rendering a judgment of dissolution, certain parties are entitled to commence a “mandatory buyout.”
As will be explained, this process involves the LLC members or corporate shareholders who wish to prevent dissolution, binding together to purchase the shares or membership interests from those who want the entity to be dissolved. (Corp. Code §§ 2000, 17707.03.)
This is because California has an “interest in preserving the corporate enterprise as a going concern if desired by the majority or by the other 50% owners,” and providing a “meaningful alternative” to termination. (Mart v. Severson (2002) 95 Cal.App.4th 521, 524.)
How does the buyout work for LLCs and Corporations?
The LLC buyout is governed by Corporations Code section 17707.03. Under that section, in any lawsuit for judicial dissolution, “the other members may avoid the dissolution of the [LLC] by purchasing for cash the membership interests [owned by the initiating parties] at their fair market value.”
For Corporations, the buyout is governed by Corporations Code section 2000. The process is a little more complex than with LLC’s. First, the corporation itself is the one with the power to initiate the buyout. But if the corporation does not wish to proceed, then 50% or more of the voting power of the corporation can exercise the buyout right.
This is an important difference between LLC and Corporation dissolution actions. With LLC’s, it wouldn’t matter if 60 or 70% of the membership interests wanted to dissolve the company. The other members can still attempt the buyout. With corporations, however, if more than 50% of the voting interests want the corporation dissolved, the other shareholders are out of luck. (Severson, 95 Cal.App.4th at 524.)
Returning to the buy-out process, the statute provides that the corporation or applicable voting shares may prevent dissolution by purchasing for cash the shares owned by the plaintiffs at their “fair value.” (Corp. Code § 2000.)
At first glance, there appears to be little difference between the statutes. However, the buyout standards are actually very different. LLC buyouts occur on the “fair market value” of member interests. Corporate buyouts use “fair value.” These standards are not the same.
What’s the difference between fair value and fair market value?
This question was addressed directly two years ago by the Second District Court of Appeal. In Cheng v. Coastal L.B. Associations, LLC (2021) 69 Cal.App.5th 112, four siblings equally owned 25% interests in the LLC. (Id. at 116.) One siblings initiated dissolution proceedings, and the other three siblings invoked the mandatory buyout. The court set the buyout price, and the sibling appealed, claiming the court used the wrong standard.
On appeal, the court disagreed. The court explained that “fair market value” is “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell.” (Rappaport v. Gelfand (2011) 197 Cal.App.4th 1213, 1228.) Thus, fair market value includes discounts reflected in the “market” at large.
“Fair value,” on the other hand, is “the liquidation value as of the valuation date, but taking into account the possibility, if any, of sale of the entire business as a going concern.” (Corp. Code § 2000.) Unlike fair market value, fair value does not consider market-related factors that could affect the value of the stock.
The Court finished by noting, “had the Legislature intended to apply a ‘fair value’ standard to purchases of membership interests [for LLCs], it would have done so expressly.” (Cheng, 69 Cal.App.5th at 124.) As such, the buyout standard for LLCs is fundamentally different than that for Corporations.
How the Lawyers at Underwood Law Firm Can Help
Winding up a business can prove to be a difficult task. Some members/ shareholders/ partners will inevitably wish for the relationship to continue, while others may only be looking out for themselves. In these situations, the right attorney can make all the difference.
As each case is unique, business owners would be well-served to seek experienced counsel familiar with pass-through entities and the winding up procedure. At the Underwood Law Firm, our knowledgeable attorneys are here to help. If you are trying to begin dissolution, wondering whether you can fight one off, or if you just have questions, please do not hesitate to contact our office.