Valuation Services Bulletin: Q1 2021
In This Issue:
- RVNB Class Action Alleging Breach of Fiduciary Duty by ESOP Trustee Hurtles Toward Final Settlement
- Court Finds Valuation of Debtor Entity Must Account for COVID-19 Effect on Industry
- Expert’s Goodwill Calculation Based on Rule of Thumb Sinks Under Appellate Scrutiny
- In Fair Value Determination, Court Says SSVS Discourages Use of Post-Valuation-Date Data
ESOP litigation watchers can add one more case to the number of actions that recently have been resolved. This case, Casey v. Reliance Trust Company, involves a proposed class action in which the plaintiffs sued the trustee, Reliance, alleging ERISA violations related to a 2012 transaction, including breach of fiduciary duty by causing the plan to overpay for company stock. The plaintiffs recently asked the court for final approval of settlement.
Disagreement on damages: The case involved RVNB Holdings Inc., a company providing moving and storage services throughout the U.S. In October 2012, RVNB formed an ESOP to acquire the common stock of RVNB. RVNB retained Reliance as ESOP trustee. An independent appraiser performed the underlying valuations. The purchase price was $85 million. In June 2017, RVNB’s board of directors approved the termination of the ESOP and all participants’ interests became immediately fully vested. In fall 2017, RVNB was sold to a private equity firm.
In June 2018, the plaintiffs filed a class action in which they alleged the plan overpaid for RVNB stock by approximately $42.5 million. Reliance engaged in a prohibited transaction, as defined under ERISA, causing the plan to buy the RVNB shares and to borrow money from RVNB for the purchase. Further, Reliance acted for the benefit of RVNB and the selling shareholders by approving a purchase price that was more than fair market value.
In their recent motion for final approval of the settlement, the plaintiffs state that, as part of the litigation, both sides engaged in extensive “fact discovery and expert discovery.” Further, both parties retained high-caliber valuation and damages experts. The parties also “vigorously engaged in the mediation process.”
The motion notes that Reliance denied the allegations and the facts on which the plaintiffs’ liability allegations rested. The contested facts include “the accuracy of RVNB’s projections, whether the valuation methods employed by Reliance Trust and its advisors were proper, and whether there were negative facts that were ignored by or not sufficiently investigated by Reliance Trust during the due diligence and negotiation process.”
The motion notes that Reliance has maintained the plan and its participants suffered no harm at all from the 2012 transaction. In negotiating a resolution, the parties exchanged “position papers supporting their differing views of what a proper measure of damages should be and presented their theories extensively in the mediation.” However, they were unable to resolve this “core dispute” by the time they reached a settlement in January 2020.
In asking for approval of the final settlement, the plaintiffs’ motion notes the settlement “provides significant relief and constitutes an excellent result for the Class.” Under the agreement, Reliance will pay $6.25 million. Each class member will obtain about $5,300 (before court-approved deductions), which is “well above the range for similar cases.” The named plaintiffs each will receive a $25,000 “case contribution award.” In exchange, the court will dismiss the case against Reliance on the merits. The plaintiffs’ motion says the settlement agreement is “fair, reasonable, and adequate,” as required under the applicable law.
The case, which is litigated in federal court, eastern district of Texas, is Casey v. Reliance Trust Company, Case No.: 4:18-cv-000424-ALM.
In re Body Transit, 2020 Bankr. LEXIS 2111 (Aug. 7, 2020)
A recent Chapter 11 bankruptcy ruling on the creditor’s election to have its claim treated as fully secured turned on valuation issues. On a basic level, the question was how to value a fitness club in the context of COVID-19 and the resulting economic uncertainty. The parties’ valuation experts disagreed about the extent to which they considered the effects of COVID-19. The court found the creditor’s expert failed to properly account for the present health and market conditions and produced a valuation that was not entirely credible. At the same time, the court rejected the position the debtor’s expert took, which was valuing the company based on the liquidation value of its tangible assets. The court performed its own valuation, providing an informative, timely analysis.
Section 1111(b) election. The debtor owned three fitness clubs in various locations in Pennsylvania. On Jan. 2, 2020, it filed for Chapter 11 bankruptcy and later asked the court to proceed under the Small Business Reorganization Act (SBRA). The court granted the motion.
In response to the bankruptcy filing, First Bank filed claims to position itself as a secured creditor. The unpaid balance of its prepetition claims was about $970,000.
The debtor closed two of its locations but sought to reorganize by operating in one remaining location. For this purpose, in April 2020, the debtor filed a proposed Chapter 11 reorganization plan, which is awaiting court confirmation.
In response, the bank filed a § 1111(b) election. As the court says, section 1111(b) of the Bankruptcy Code is a complex statutory provision “with a number of moving parts that interact with other Code provisions.” In essence, § 1111(b) “permits an undersecured creditor to elect to have its claim treated as fully secured for certain purposes in a chapter 11 reorganization.”
Here, the debtor objected to the election. Under the debtor’s reorganization strategy, it offered to treat the bank as a secured creditor, but only up to about $317,000. In repaying this amount, in monthly installments, it proposed to pay about $29,000 in interest. The reminder of the bank’s allowed claim would be treated as unsecured components and repaid under the same standard that applies to unsecured creditors holding allowed claims.
In objecting to the bank’s § 1111(b) election, the debtor argued the bank’s interest in the property of the bankruptcy estate is of “inconsequential value,” as contemplated (but not defined) in the Bankruptcy Code. The Code in essence provides that a § 1111(b) election is not available to a creditor where the latter’s interest is “inconsequential.”
First Bank countered this objection by arguing that it was undisputed that First Bank had a security interest in the debtor’s property, which had value. “Inconsequential value,” according to First Bank, meant no value whatsoever. Alternatively, First Bank argued it held a first position lien and the value of its lien was not inconsequential when compared to the value of the creditor’s collateral.
Regarding the second argument, the debtor argued that the correct method is to compare the value of the creditor’s lien to the total amount of the creditor’s claim.
The court, in an earlier ruling and in this ruling, found that “inconsequential value” did not mean zero value and that the determination of whether the creditor’s interest was inconsequential required comparison of the value of the creditor’s lien position (value of its interest in the debtor’s property) to the total amount of the creditor’s claim.
Solid, but not fully convincing, valuation testimony. The Bankruptcy Court had to decide whether or not to approve the bank’s § 1111(b) election. To make the decision, the court first had to determine the value of the bank’s secured position on the debtor’s assets.
As the court noted, both parties offered testimony from “knowledgeable witnesses, with solid credentials, each of whom has offered an opinion supported by a considered rationale.” As the court also found, “no single opinion offered at the [evidentiary] hearing was fully convincing.”
Debtor’s valuation testimony. The debtor offered testimony from two witnesses. One was the managing partner of a business that advised companies in the fitness industry regarding the sale or acquisition of fitness and sports-related businesses and equipment. The court noted, although the witness was not qualified as an expert, there was no objection to his offering an opinion on the value of the debtor’s entity.
The witness’s report said that, due to the COVID-19 pandemic, the industry was such that the debtor could not sell its business as a going concern. If the debtor could survive the current climate, it could have value in the future. At present, its only value was its liquidation value, the witness said.
The witness acknowledged that he had not done a valuation in accordance with the standards of the American Society of Appraisers (ASA). He said his opinion was based on his view of the state of the fitness industry as it currently was. He said that a traditional business valuation (particularly one based on the discounted cash flow analysis) would not offer an accurate picture of the value of a fitness business. According to the witness, historical data had lost its predictive power in light of the dramatic changes in the industry resulting from the pandemic.
He noted that most fitness clubs would reopen with half capacity compared to 2019 and would need sufficient reserves to fund the significant operating losses for the first six to nine months following reopening. Moreover, fitness clubs that planned to reopen would need additional capital to pay for extra marketing and membership acquisition programs. The witness said it could take two years before the fitness industry settled into a “new normal.”
The debtor presented testimony from a second witness, a fitness equipment broker, who had inspected the debtor’s equipment and initially found the latter was worth between $28,000 and $30,000. Testifying at the hearing, this witness said there currently was a glut of equipment, resulting from the COVID-19 shutdown, which meant the equipment was worth about 10% less than he had stated in his earlier report.
This valuation also was not based on the ASA’s standards.
Creditor’s valuation testimony. First Bank also offered testimony from two valuation witnesses.
The first witness was president of a well-known auctioneer and appraisal company in Philadelphia. He was a member of ASA and qualified as an expert in the valuation of equipment when liquidated in place. His two valuation reports were admitted into evidence.
He offered a “Desktop Appraisal,” which he defined as “an expert’s opinion of value based on limited information and assumptions … and a limited appraisal of market conditions.” The appraiser did not inspect the equipment but relied on information First Bank provided.
The expert report said the market approach was the most useful approach for valuing fitness equipment. The report provided a list of the pieces of equipment and their value at the location that was to stay open. The total value of the equipment was about $130,000.
The court noted the report referenced research data but nowhere discussed the analysis of the data. The court also said the testimony of this expert “was relatively brief and conclusory.”
First Bank’s second witness was a highly experienced business valuator and member of ASA who was retained to value the debtor’s intangible assets.
This expert reviewed the debtor’s 2018 tax return, the most recent version of the debtor’s reorganization plan, the report of the other appraiser the creditor retained, and the debtor’s disposable income projections submitted to the court in April 2020.
The business valuation expert used a market approach to conclude the value of the debtor was $170,000. Accepting the other appraiser’s $130,000 value determination for tangible assets, the business appraiser concluded the value of the intangible assets was about $40,000.
The market approach, he explained, examines “the relationship between prices that buyers have been willing to pay for stock in companies that provide a reasonable basis for comparison to the relevant characteristics of the company being valued and various quantifiable facts,” after which “derived ratios are applied to the subject company in order to establish value.”
The analysis considered two rules of thumb applicable to fitness centers (from an accepted commercial guide). One posits that value equals 70% to 100% of annual revenue, plus inventory. The other posits that value is 2 to 3.5 times the seller’s discretionary earnings (SDE), plus inventory.
He said he looked at sales of about 30 fitness and yoga businesses occurring between January 2019 and March 2020. He found the median value was 60% of net sales and this value was about double the SDE.
The business valuator looked at projected revenue in the first year following plan confirmation and in the third year after plan confirmation. He assigned great weight to the SDE derived from historical data. As these data preceded COVID-19 and its effect on the economy, the expert explained that COVID-19 did have an impact on value but that the stock markets were able to recover most of the losses posted early in the pandemic. Further, regardless of uncertainty, there was optimism about the recovery, the expert proclaimed.
The analysis of the first-year projections resulted in a value of $165,000. He said he reduced his multiples (estimated value/sales and estimated value/SDE) to account for COVID-19’s impact.
In analyzing the third year post-confirmation, the expert did not reduce the multipliers but applied pre-COVID-19 multipliers. However, he gave more weight to the SDE benchmark. He arrived at a fair market value of $395,000 based on Year 3 revenue. He then discounted the value to account for the uncertainty of the company’s achieving this level of performance (as the court noted, “presumably due to COVID-19”). He used a 30% discount rate, assuming an investor buying a company today would expect a 30% return. Under this analysis, the business valuation expert arrived at a present value of almost $180,000.
Given the two close values his analysis achieved, First Bank’s business valuation expert determined the present-day value of the business was $170,000.
Enterprise value as starting point. At the outset of its analysis, the court explained a value determination had to consider the purpose of the valuation and the proposed disposition or use of the property. Considering the debtor intended to use its assets to reorganize as a going concern, the court said it could not accept the debtor’s premise that value consisted of the liquidation value of the tangible assets.
The court further noted, in determining whether First Bank should be permitted to make a § 1111(b) election, it was important to consider the debtor’s future revenue stream and the potential increase in value of the creditor’s collateral based on anticipated increase in the revenue stream. The appropriate starting point was the determination of the debtor’s enterprise value, rather than a liquidation analysis of tangible assets, the court said.
Although this starting point might support the approach First Bank’s business valuation expert proposed, the court found the expert’s analysis wanting. He had not fully considered the present economic conditions in the fitness industry resulting from COVID-19 and his degree of optimism was unwarranted, the court said. It also said it could not see a “valid nexus between the state of the stock market over the past few months and the state of the fitness industry or the Debtor’s potential reorganization prospects.”
The court said it tended to agree with the opposing industry witness who commented on the state of the industry and who found the debtor’s projections overly optimistic. The court noted, “[I]t is not presently possible to project when public health and market conditions will support the growth of business revenues the Debtor posits as the foundation of its reorganization.” Further, the court said, the debtor seemed to recognize the uncertainty. The court noted (in a footnote) the proposed reorganization plan did not predict when there would be sufficient revenue to perform its plan obligations. The underlying projections were generic (i.e., running from Month 1 to Month 60) rather than starting on a specific date in the future.
The court said it was unlikely that an investor would buy the debtor’s business as a going concern, except at a substantial discount. However, this did not mean there was no value in the debtor’s business.
The court noted that the owner of the debtor entity wanted to retain the business, expecting potential future growth. This meant there was value independent of the liquidation value of its assets. The plan also projected that, even considering the debtor’s financial obligations, the entity still would be able to pay the owner an amount that increased from $48,000 per year to $108,000 per year.
Neither side’s valuation was fully satisfactory, the court said. However, as the court was required to make a value determination before it could decide whether the creditor’s interest was of “inconsequential value,” the court decided that an “entrepreneur-purchaser” would be willing to pay a premium of $50,000 over the $30,000 value of tangible assets to buy the debtor’s entity as a going concern. This low premium accounted for the high degree of risk in purchasing a fitness club “in the present environment,” the court said. (It used a 60% risk factor.)
Although possible, there simply was no guarantee that the debtor would be able to survive the economic challenges facing the industry and then generate enough revenue to pay the entrepreneur-purchaser any salary at all, much less the amount assumed in the debtor’s “optimistic projections,” the court said.
The court found the creditor’s interest in the debtor’s assets was worth $80,000, which qualified as inconsequential in relation to the creditor’s total claim of $970,000. Therefore, the court said First Bank was precluded from making a § 1111(b) election.
The court noted that the debtor’s financial problems, starting in January 2020 with its Chapter 11 filing and continuing through the COVID-19 crisis that began in March 2020, caused a “precipitous decline in the value of the Debtor’s business and First Bank’s lien position.” If the business can survive at all, the evidence suggests the value of the business will not increase in the foreseeable future, the court noted.
In closing remarks, the court noted that, while the debtor won on this particular issue, there was a real question as to whether plan confirmation was feasible. The court said it credited the debtor’s industry witness who testified to the current dismal state of the fitness industry. This testimony raised questions as to whether the debtor would be able to reorganize in the absence of some cash infusion, the court said.
“Perhaps there is a ‘Goldilocks zone,’ a narrow path that a debtor can navigate between inconsequential value left in the business and feasibility of a proposed Chapter 11 plan; perhaps not,” the court said.
Stowe v. Stowe, 2020 N.C. App. LEXIS 498; 2020 WL 3697735 (July 7, 2020)
A North Carolina appeals court opinion shows that, for purposes of presenting a credible valuation, industry experience matters as does accreditation as a business valuator. The focus of this divorce case was the value of an insurance agency the husband ran. The trial court’s value determination relied on testimony from the wife’s expert, which, the appeals court found, did not adequately account for differences in insurance agencies and was not based on an acceptable methodology, particularly regarding the value of goodwill. The appeals court upheld the trial court’s decision not to admit the husband’s expert, a CPA, as a business valuation expert because the witness lacked BV credentials and experience. He could only testify as expert in certified public accounting matters, the trial court found.
Independent insurance agency. Initially, the husband owned an Allstate captive insurance agency. This meant the company only sold Allstate insurance policies. Eventually, the husband and wife decided it was preferable to own an independent insurance agency as it could generate more revenue, having access to more policies and vendors. The new, independent, agency sold policies of about 30 different insurers. However, Allstate was the primary vendor and accounted for about one-third of the policies written.
The evidence showed that the spouses bought the business by using a multiplier of 2x gross revenue in valuing the agency. Eventually, the husband bought another agency that was folded into the existing business. The business had tangible personal property, intangible assets, accounts receivable, renewable contracts, and liabilities, including loans and credit card debt.
The spouses separated in September 2017. The main issue during the divorce proceedings was the value of the insurance agency, which was marital property.
The husband testified that the business value was “nominal,” considering the business had operated at a loss for years. The husband also tried to offer business valuation expert testimony from a CPA who said he had significant experience in the insurance business as he had owned an independent agency for 10 years.
The trial court found the husband was unable to offer competent evidence as to the value of the business because he lacked the qualifications of an expert in business valuation and did not present a methodology that was appropriate for determining the fair market value of the business. In terms of credibility, the court noted the husband, in June 2017 (three months prior to separation), listed the value of the business at $400,000 (about 2x the gross revenue of the business) in a financial statement.
As for the husband’s expert, on cross-examination, the witness acknowledged he was not accredited by the AICPA or NACVA as a business valuator. The plaintiff objected to his admission as a BV expert. The court decided to admit the expert only as an expert in certified public accounting. The court’s ruling said the expert had “minimal business valuation experience, maintained minimal continuing education in business valuation methodologies, has not prepared business valuations for insurance agencies more than twice in the preceding 30 years and … these were for the purposes of assisting a client in the purchase of an agency.”
The court admitted the wife’s proffered expert as an expert in business valuation, forensic accounting, and certified public accounting. He presented two conclusions of value, one dated July 2018 and one dated November 2018. The values were about $20,000 apart and both estimates were based on the income approach. The July value estimate was $531,400 and the November estimate was $511,200.
The expert explained that the records on which his conclusions of value were based were “incomplete, at best.” He said he considered four factors, including cash assets verified by QuickBooks software, a note receivable, a loan owed by the business, and goodwill. The expert said he had access to the 2017 tax returns, most of the bank statements, and a summary book. He did not have access to the balance sheet.
Scanty goodwill determination. As for calculating the goodwill/intangible value related to the business, the wife’s expert explained he used the agency’s 2016 revenues and multiplied them by 2.45. The multiplier, he said, came from an article the plaintiff had provided, titled “First Quarter 2018 Allstate Agency Value Index,” which the head of a lending company for Allstate Insurance agencies had written. It contained a chart that detailed “Allstate Agency Price to New/Renewal Commission Ratio (National Average)” for the fourth quarter of 2016, all of 2017, and the first quarter of 2018.
On cross-examination, when asked specifically about the 2.45 multiplier, the wife’s expert said he recognized the difference between an independent agency and an Allstate captive agency. But, he said, he relied on the chart because “[it] was a document that stated what the market rates were in terms of the revenue multiple.”
The opposing attorney then produced another article by the same author and lending company that said Allstate captive agencies were unique in that they had available to them resources independent agencies did not have. One advantage they had was a buyback provision for a prospective seller. This article also included a chart that indicated a higher multiple for Allstate captive agencies than independent agencies. Specifically, the author valued Allstate captive agencies at 2.5x annual commissions and independent agencies at 1.5x annual commissions.
The trial court adopted the lower valuation the wife’s expert proposed, $511,200. Regarding the 2.45 multiple to determine the goodwill/intangible value of the business, the court, in its equitable distribution order, said the wife’s expert had considered industry standards “and also considered multipliers used by Allstate Insurance in valuing agencies considering the size, volume and sales.” The court noted the wife’s expert had interviewed professionals in the industry to determine the appropriate multipliers. “Based upon all sources and consideration, and consistent with industry standard, [the expert] applied a multiplier of 2.45 times gross sales to determine the goodwill of the business. The Court finds this to be reasonable and credible.”
Incompetent valuation evidence. The husband appealed various aspects of the trial court’s ruling. One argument said the trial court erred by basing its value determination on incompetent evidence. Specifically, the expert on whose valuation the court relied used an improper valuation method that did not approximate the fair market value of the insurance agency and its goodwill.
The Court of Appeals noted that, in a nonjury trial, the standard of review was
“whether there is competent evidence to support the trial court’s findings of fact and whether the findings support the conclusions of law and ensuing judgment.” See Peltzer v. Peltzer, 222 N.C. App. 784 (2012) (available at BVLaw).
Also, under case law, a trial court should make “specific findings as to the value of a spouse’s professional practice and the existence and value of its goodwill, and should clearly indicate the evidence on which its valuations are based, preferably noting the valuation method or methods on which it relied.” See Patton v. Patton, 318 N.C. 404 (1986) (available at BVLaw).
The appeals court noted that a key element of the prevailing valuation was the 2.45 multiple the wife’s expert used to calculate goodwill value. The court observed the multiple was based on an article by an author whose background and qualifications as to valuing insurance agencies were never provided.
The Court of Appeals also noted the author of the article and his lending agency only financed Allstate captive agencies, not independent agencies such as the subject insurance company. The reviewing court rejected the trial court’s comment that Allstate policies accounted for one-third of the sales of the subject company was unsound. The trial court’s valuation failed to consider “resources and advantages that a captive Allstate agency has, such as a buyback provision for a prospective seller and other resources to justify and warrant the higher revenue multiples over that applied to independent insurance agencies.”
The Court of Appeals observed that the trial court found the business owner’s testimony as to the value of his company was not credible as he was not a business valuation expert. At the same time, the appeals court noted, the trial court referenced the owner’s testimony that he used a 2.0 multiple of sales when buying the agency as support for the 2.45 multiple.
The Court of Appeals added that, under case law, an owner may offer a lay opinion as to the value of the asset if he or she can show knowledge of the property and some basis for his or her opinion.
The Court of Appeals concluded the evidence and findings here did not support the trial court’s conclusion on valuation.
In terms of valuation methodology, the Court of Appeals noted the Internal Revenue Service’s Ruling 59-60, which provides factors that are fundamental to any value analysis.
Further, relevant case law requires the trial court “to value goodwill with great care, for the individual practitioner will be forced to pay the ex-spouse tangible dollars for an intangible asset at a value concededly arrived at on the basis of some uncertain elements.” See Poore v. Poore, 75 N.C. App.414 (1985) (available at BVLaw). In addition, the court should examine “the age, health, and professional reputation of the practitioner, the nature of the practice, the length of time the practice has been in existence, its past profits, its comparative professional success, and the value of its other assets.” Id.
The Court of Appeals found the trial court neither used the IRS Rev. Rul. 59-60 factors nor the framework of Poore in finding and valuing goodwill. “It simply addressed the amount of goodwill by concluding [the subject agency] ‘had certain goodwill.’” The Court of Appeals found this was a conclusory statement. All the trial court considered was a multiplier “even though this multiplier was derived from a non-analogous source applying un-adjusted factors.”
Moreover, the appeals court found the trial court’s value determination was not based on an appropriate methodology. “While there may ultimately be goodwill or other intangible assets to include, the trial court did not conduct any further analysis to support the conclusion of value of goodwill.
The Court of Appeals reversed the valuation portions of the trial court’s order and remanded for additional findings and calculations of the business’s value “to support its conclusion.”
Admission of expert testimony. The defendant also challenged the trial court’s exclusion of his expert as an expert in business valuation under North Carolina Rule of Evidence 702(a), governing admission of expert testimony. See N.C. Gen. Stat. § 8C-1, Rule 702 (2019).
The Court of Appeals used an abuse of discretion standard to review this issue. In objecting to the exclusion of his expert at trial, the husband argued that the expert had the requisite specialized (business valuation) knowledge and his testimony would assist the court’s understanding of some of the issues in the case. Therefore, this was not a matter of admissibility but of the weight given to his testimony. The parties then argued over the importance of having credentials as a business valuation specialist.
The Court of Appeals noted that, interpreting Rule 702(a), the state Supreme Court has said regarding a witness’s qualification that the question is always the same: “Does the witness have enough expertise to be in a better position than the trier of fact to have an opinion on the subject?” The high court noted that expertise did not always require a particular degree or certification or practicing a particular profession. “But this does not mean that the trial court cannot screen the evidence based on the expert’s qualifications. In some cases, degrees or certifications may play a role in determining the witness’s qualifications.” See State v. McGrady, 368 N.C. 880 (2016).
Under the applicable case law, the qualifications of the husband’s expert went toward admissibility and not just weight, the Court of Appeals noted. It concluded the trial court did not abuse its discretion when it did not admit the husband’s expert in the field of business valuations.
In sum, the reviewing court overturned the trial court’s value findings and conclusion but upheld the trial court’s decision to exclude the husband’s expert as an expert on business valuation, finding he lacked the necessary qualifications.
The IRS Rev. Rul. 59-60 factors are:
- The nature of the business and the history of the enterprise from its inception;
- The economic outlook in general and the condition and outlook of the specific industry in particular;
- The book value of the stock and the financial condition of the business;
- The earning capacity of the company;
- The dividend-paying capacity;
- Whether or not the enterprise has goodwill or other intangible value;
- Sales of the stock and the size of the block of stock to be valued; and
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter.
Biton v. Kreinis, 2020 Va. Cir. LEXIS 94 (July 10, 2020)
In buyout litigation involving the two owners of a company that oversaw two retail stores, the issue was the fair value of the departing owner’s shares. Both experts used a capitalization of earnings approach, but their value conclusions were very different. The experts disagreed over key inputs including what annual revenue to use. Related to this question was what facts were known and knowable on the applicable valuation date and whether there was an argument for using post-valuation-date revenue. The court said no. Another issue was the use of a key-person discount to account for the loss of the selling shareholder’s expertise going forward. The court performed its own analysis, achieving a value that was close to the value the selling shareholder’s expert proposed. The court’s technical discussion is informative.
Two mall locations. The plaintiff (selling shareholder) and the defendant (buying shareholder) met when the plaintiff did training for the defendant’s store employees. The defendant was so impressed by the plaintiff that he asked her to go into business with him.
In September 2017, the two agreed to jointly operate two retail stores selling high-end cosmetics. The stores would be in two different malls. The parties formed a corporate entity for most administrative functions related to the two stores, including payroll and accounting. According to the agreement, the plaintiff and the defendant would each own 50% of the shares of the corporation. They also were the corporation’s only directors. Both shareholders agreed to receive a monthly salary of $3,500 and a commission of 35% of any sales for which they were the sales representative.
At that time, the defendant’s store was in operation. The second store, to be run by the plaintiff, initially was expected to open in January 2018 but did not open until May 2018. (This delay mattered for valuation purposes.)
For 2018, the corporation in tax reports showed total revenue of about $3 million and a net income of almost $552,000. During that year, both shareholders received $98,000 in salary and about $395,000 in shareholder distributions. They agreed not to take commissions.
In June 2019, relations between the owners broke down. At trial, both parties noted there was “significant corporate dysfunction” that resulted in a significant drop in revenue. Total corporate revenue for 2019 based on the company’s QuickBooks account was about $2.4 million.
In August 2019, the plaintiff asked the court for dissolution of the company. A few days later, under the applicable statutory provision, the defendant elected to purchase the plaintiff’s shares in lieu of dissolution.
The issue at trial was the fair value of the plaintiff’s shares in August 2019 (the day before the plaintiff filed her petition). Both parties offered expert testimony.
Capitalization of earnings method favored by all. Both experts valued the company under an income approach, using the capitalization of earnings method. The court approved of this approach. The court’s discussion set forth the method’s key components, the experts’ positions on the various elements, and the court’s resolution of the various disagreements.
The court explained the method this way:
The methodology relies on a representative historical cash flow and assumes that future cash flows will grow at a slow, steady pace into perpetuity. The calculated estimated annual cash flow is divided by a capitalization rate to determine the overall value of the corporation. This method assumes that all corporate assets, tangible and intangible, are indistinguishable parts of the business.
Representative annual revenue. To calculate future cash flow, the plaintiff’s (selling shareholder’s) expert used the company’s 2018 revenue. He explained that 2018 was “the last available year an accountant had filed a corporate tax return.” Also, this was the last complete year before the owners’ business relations broke down irreparably. The expert also said, at that time, there was no reason to believe the company would not continue as it did in 2018.
Because the second store did not open until May 2018, this expert “filled in” the missing months (January through April) by calculating an average 2018 monthly income per location and seasonal adjustment. The 2018 adjusted total revenue was almost $3.5 million and ongoing cash flow was about $838,000, the expert concluded.
In contrast, the defendant’s (buying shareholder’s) expert used the 2019 revenue, based on QuickBooks data, as representative annual cash flow. While the valuation date was August 2019 and revenue from September through December was not known, the expert said, “[T]he parties knew the business was not going to produce the same level of revenues the last four months of 2019 as in 2018.” In testimony, the expert admitted it was not common to use post-valuation-date revenue.
The court disapproved of the use of the 2019 QuickBooks revenue. First, the court said with emphasis, these data included five months of revenue after the August 2019 valuation date. “Using data after the valuation date is discouraged by the Statement on Standards for Valuation Services [SSVS], which states that, [‘g]enerally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date.’”
The court pointed out that, in the first half of 2019, the company experienced considerable dysfunction that’s led to a substantial decrease in revenue. The court said, “[P]rojecting this anomalous revenue stream into perpetuity, however, is not indicative of future performance.”
Further, the court said the 2019 financial data were not reliable. The QuickBooks data were suspect as became clear from the fact that the 2018 QuickBooks data were more than 12% higher than the 2018 tax-reported revenue, “a fact that neither expert could explain.” Also, the QuickBooks profit-and-loss statements for the same period (August through December 2019) were “markedly different.” The court observed there also were a number of “unusual ledger entries after the defendant elected to purchase the plaintiff’s interest in 2019 that involved significant payments to the defendant.”
The court said the 2018 revenue information the plaintiff’s expert used “appears reliable.” The court also approved of the expert’s approach to adjust the 2018 revenue to factor into the calculation the “missing” months. Accordingly, the court used the 2018 revenue as adjusted by the plaintiff’s expert as representative annual revenue.
Key-person discount. The plaintiff’s expert claimed the loss of the plaintiff would not affect corporate earnings. Her sales expertise could be replaced, he maintained.
On the other hand, the defendant’s expert said the plaintiff added considerable value to the company and it would cost the company between $350,000 and $400,000 to replace her.
The court found the plaintiff was not easily replaceable. For valuation purposes, corporate revenue should be discounted by 10%, it decided. The court noted the defendant initially was so impressed with the plaintiff’s unique value as a salesperson that he offered to go into business with her. The plaintiff set up the second mall location, and, during the first eight months of operations, this location generated 57% of the company’s revenue. “[I]n the first two-thirds of a year, while operating a new store, [the plaintiff’s] location was 33% more productive than [the defendant’s] location,” the court emphasized. It continued: “[T]his means that [the company] arguably was more than 16% more profitable with [the plaintiff] than it would have been if [the plaintiff]—or someone else—had been responsible for the same revenue as [the defendant].”
Discounting the 2018 revenue as determined by the plaintiff’s expert (approximately $3.5 million), the court found the company’s representative annual revenue for the purpose of valuation was about $3.1 million.
The court agreed with the plaintiff’s expert that there needed to be adjustments to account for one-time opening expenses of the second mall and charitable contributions.
Another issue was reasonable compensation for a general manager who would manage both stores. The plaintiff’s expert, using salary data related to this location from the Bureau of Labor Statistics, found the annual mean salary for general and operations managers was $125,000.
The defendant’s expert said the 2019 market rate was $118,000 per year but did not cite to any sources to support the claim.
The court used the $125,000 annual salary. This figure meant a $71,000 savings compared to the 2018 combined officer salaries of $196,000. The court found the net income margin was 24.13%. Using this rate and the representative annual revenue of $3.1 million, the court found the proper estimate of ongoing pretax cash flows was $754,000.
Capitalization rate considerations. The plaintiff’s expert used an 18.60% capitalization rate. The defendant’s expert calculated a 24.38% rate.
The court noted that both experts agreed on some of the components of the discount rate used to calculate the capitalization rate. Both experts used a 2.31% risk-free rate of return, a 6.91% equity risk premium, and a 5.22% small stock risk premium.
They had a different approach to calculating the company-specific risk premium (CSRP), the court said. The plaintiff’s expert assumed a 3.25% industry risk premium and an 8.00% CSRP; the defendant’s expert assumed a 12% CSRP without using an industry risk premium.
The court found 12% was the appropriate CSRP. This resulted in a 26.44% net cash flow discount rate.
The experts also disagreed over the long-term growth rate. The defendant’s expert, who had a dim view of the company’s prospects and considered average historical increases in GDP and future prospects for retail sales, especially in malls, thought a 2% rate was appropriate.
The plaintiff’s expert applied a 4% annual growth rate. He said the 10-year consensus forecast of the nominal GDP average annual growth rate was around 4.5% to 5.5%. The 10-year projected inflation rate was 2.3%, he said.
The court used a 2.5% long-term growth rate, pointing to the totality of the evidence and the company’s “current circumstances.”
The court arrived at a 23.36% capitalization rate.
Applying this rate to after-tax cash flow and adjusting for nonoperating liabilities (related to pending lawsuits for past sales commissions), the court arrived at a “final corporate valuation” of about $2 million. Accordingly, the fair value of the plaintiff’s 50% stake in the company was just over $1 million.
Pursuant to the applicable statute, the court allowed payment of the purchase price in installments. The court pointed to the company’s current financial condition and specifically “the reduced operational status of the [company’s] stores due to the ongoing pandemic.” It required an initial payment of $150,000 within 60 days and monthly payments of $30,000 afterward until the total purchase price was paid to the plaintiff. Providing the plaintiff with security, in the form of a first-priority perfected lien on the company’s current and future assets and all its corporate stock, was appropriate, the court decided.
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