Valuation Services Bulletin: Q2 2019
In This Issue:
In re Marriage of Preston, 2018 Ill. App. Unpub. LEXIS 1281 (Aug. 1, 2018)
One of the key questions in an Illinois divorce case was how to allocate goodwill between enterprise and personal goodwill. One expert used the “with-and-without” method; the other used the MUM approach in a simplified version. The latter prevailed. Although the appellate court’s opinion is unpublished, valuators should take note because the court’s discussion of the dispute over the validity of MUM reflects an ongoing debate in the valuation community.
At issue was the value of a company offering design assistance and engineering services as well as machining and molding assembly. The husband was the sole shareholder and, by the wife’s admission, the “key guy” at the company. Both sides retained seasoned, credentialed business appraisers who used a similar methodology to value the company, weighting the results of the income and market approach. But the analyses diverged in a number of respects, including the approach for determining the value of goodwill attributable to the husband—a value that was not marital property and therefore excludable from the company’s overall value.
The wife’s expert used the “with-and-without method,” comparing the company’s projected cash flow over five years under two scenarios: if the husband left the company having signed a noncompete and if he left without signing a noncompete agreement. The expert valued personal goodwill at nearly $1.1 million.
The husband’s expert used the multiattribute utility model (MUM) for which he selected 10 attributes that he scored in a binary manner, i.e., the attribute either existed or did not exist. (The traditional MUM method uses an elaborate scoring system, but the expert used a simplified version.) He determined that two-thirds of the total goodwill value, $2.1 million, represented personal goodwill and one-third was enterprise goodwill.
The wife’s expert acknowledged that MUM was an accepted goodwill allocation method but criticized it for being “subjective” in terms of selecting the attributes and the binary scoring. The “with-and-without” methodology was able to eliminate subjectivity, the wife’s expert said.
The trial court adopted the value determination the husband’s expert proposed, awarding the wife half of it. In appealing the trial court’s valuation decision, the wife attacked the opposing expert’s personal goodwill determination as “far too subjective, and far too suspect, to be accepted by the court.” MUM, the wife argued, allowed for “cherry-picking” and for skewing the results. The appellate court was not persuaded. It found the trial court faced conflicting valuation testimony, considered the weakness in each expert’s opinion, and noted that both goodwill methods were accepted in the profession. Under the applicable standard of review, the appellate court said it was required to give deference to the trial court as fact finder.
Extra: Goodwill is just one of the many topics on the agenda of the upcoming AAML/BVR National Divorce Conference, which will take place in Las Vegas, May 8-10. In addition, the conference offers attendees a great opportunity to explore a host of other legal and valuation-related topics and interact with peers.
Noven Pharmaceuticals v Novartis Pharmaceuticals, 2018 N.Y. Mis. LEXIS 5133 (Nov. 9, 2018)
When it comes to document discovery, the “why and “when” matter greatly, as a recent New York ruling centering on a valuation report makes clear. The issue was whether a valuation the defendant had commissioned months before the plaintiff filed suit was privileged or protected by the work-product doctrine.
No protection: In 2012, two pharmaceutical companies made an agreement to end a joint venture. Years later, they were still at odds as to whether the agreement required a valuation of noncash assets to effect the distribution of capital contributions. The plaintiff believed a fair market valuation of products was necessary, whereas the defendant initially disagreed. In spring 2015, the defendant changed course and began to pursue its own valuation, which, it then said, the parties “could use as a starting point.” Contemporaneous communication between the parties showed that, at the time, the parties were in negotiations.
In fall 2015, the defendant’s in-house counsel decided the plaintiff’s position as to the valuation was “antithetical” to the agreement. The disagreement, he believed, “could lead to litigation.” At the same time, in the ongoing discussions with the plaintiff, the defendant did not mention anything about a valuation. The defendant eventually hired a law firm that formally retained an appraiser, saying an estimate of the value of the products would help the firm “assess the case.” The appraiser’s final report from February 2016 said it was “privileged and confidential.” The valuation was assisting with “the provision of services for corporate planning purposes.” The appraiser’s services were solely for internal use “to assist with … litigation due diligence.”
In March 2016, the parties again met to settle their dispute. The defendant used the valuation to prepare for the meeting. The parties did not achieve a resolution, and, six months later, the plaintiff sued.
The plaintiff asked for the defendant’s valuation. The court found it was discoverable. When the defendant continued to refuse producing the report, the plaintiff filed a motion to compel, which the court granted.
The court’s concise opinion pays close attention to the purpose of the valuation and the timing. The court found the attorney-client privilege did not apply because the valuation was not prepared by an attorney “acting as such,” and it did not reflect an attorney’s thinking and professional skills. The work-product doctrine did not apply because the valuation was not “created solely and exclusively in anticipation of litigation.” The court noted that, before the defendant contemplated litigation, its business people chose an appraiser to prepare the valuation for business purposes. Even if the defendant shortly afterwards contemplated the possibility of litigation, the defendant could not show that “the actual scope or nature of the retention changed in any material way.” After the valuation was completed, the parties were still in business discussions to resolve their disagreement. “Under the circumstances, a mixed purpose cannot be ruled out,” the court said.
Persaud v. Goad, 2018 Md. App. LEXIS 1076 (Nov. 19, 2018) (unreported opinion)
This Maryland divorce case, which features a combination of real estate and business assets, raised several noteworthy valuation questions. One concerned the trial court’s decision to assign a negative value to one company where case law says marital property cannot have a negative value. The appeals court sought to affirm this principle while also upholding the trial court’s overall analysis. A second issue was the valuation of the spouses’ catering company that operated out of a space the spouses’ real estate company owned. The parties’ experts relied on different sets of financials—one was based on cash-basis accounting, and the other on accrual-basis accounting. Moreover, one expert argued that the catering business formed a single unit with the real estate holding company, which meant both companies had to be valued as one business. The opposing expert rejected this proposition, as did the trial court. Ultimately, the trial court declined to adopt either expert’s opinion and came up with its own valuation. The appeals court, noting the trial court’s discretion, affirmed.
A mix of marital assets. The spouses acquired real estate (residential and nonresidential) and a catering business in a “unique and historic building” in Baltimore that used to be a luxury hotel but was converted into a condominium with commercial and residential units. At the time of divorce, the spouses owned about 45% of the building’s square footage and a majority of seats on the board of the condominium association. The board had the authority to impose use restrictions and “special assessments.” However, in their proposed valuations, the parties’ experts did not quantify the value of control over the board, the appeals court later observed.
Because the husband had a judgment against him, the wife came to hold title to the companies. At the time of divorce, she managed the real estate holdings and operated the catering business.
Valuation issues dominated the divorce proceedings, prompting the trial court to comment that, even though “this is a divorce case … effectively, this is a business dissolution matter.” The parties’ expert appraisals were $5 million apart. In a nutshell, the husband’s expert claimed the holding company for the nonresidential properties was worth slightly over $1.9 million and the operating company for the catering business was worth slightly less than $1.2 million. In contrast, the wife’s expert contended both of those entities should be considered a single entity worth -$1.76 million.
The trial court found the total value of the marital property that was in the wife’s name (the real estate and business holdings) was about $2.8 million. The property to which the husband held title was worth about $750,000 (his retirement assets). The court awarded the businesses to the wife, and it awarded the husband half of the total value of the wife’s property, offset by half of the total value of the husband’s property in the form of a monetary award.
Initially, the trial court decided that it was important to account for the cost of selling the assets. If the wife were to sell her real estate, she “most likely would incur sales costs,” including a 7% realtor fee and a 1% fee to cover closing costs, the court found. Therefore, in calculating the monetary award to the husband, the court included 46% of the value of the wife’s real property and business holdings and 50% of the value of the wife’s other holdings. The husband objected to this and other findings and asked the court for an amended order. In response, the trial court took away the deduction for costs of sale, which increased the monetary award to the husband from $650,000 to approximately $760,000.
Negative value controversy. The husband unsuccessfully raised other challenges in a post-judgment motion and later made the same arguments on appeal with the state Court of Appeals.
A major point of contention was the valuation of one business entity, Truffles LLC. Truffles owned two units (R1 and R2) in the building, both of which were underground. The R1 unit used to be a “bottle club” where people held parties fueled by alcohol that frequently resulted in fights and police presence, as well as unfavorable coverage in the local paper. The husband said he had bought this space to shut down the operation because it had negative effects on the catering business in the building. R2 was a space that was unusable because of water damage. The husband said owning both of these spaces did increase voting power on the condominium board,
The husband’s real estate expert said the value of the two units was zero. “Any value attributed to these spaces would be offset by the liability of the cost to correct the space, the condominium fees and taxes,” the expert explained. The wife’s real estate expert also arrived at a zero value. He said R1 and R2 were “in poor condition and could not be rented.” At the same time, the units “still incur the fixed condominium fees” of almost $78,300 as well as “combined real estate taxes” of over $19,600. Therefore, the annual expenses related to the two spaces were almost $97,900.
The wife’s business valuation expert said Truffles, as the holding company for R1 and R2, had a value of -$118,200. He pointed out the units were vacant and did not generate any income, while leaving the owner with sizable yearly expenses in condo fees and taxes.
The trial court noted there was “uncontroverted testimony” that the units had “little or no commercial use or value to the food service businesses, but were purchased so [t]he [p]arties could strengthen their position on … [the] condominium board.” The court also found that, given “the unusually high carrying costs … and the fact that they do not generate income,” valuing them at zero () “undercuts the negative impact they have on the total value of the other units.” The court said it was difficult to see how one could sell the “valuable” commercial properties in the building “while keeping units with $97,000 in annual … carrying costs with no income.” Accordingly, the trial court decided Truffles, as the owner of the units, had a value of -$118,200, crediting the wife’s expert. As a consequence, the trial court reduced the husband’s monetary award by half of that amount.
In his post-judgment motion, the husband argued that, under the applicable law, it was error to assign a negative value to Truffles. The wife conceded that “in most cases the court cannot attribute a negative value to marital property in granting a marital award.” At the same time, the wife maintained it was appropriate for the court to consider the “financial drain” resulting from the units. She requested that the trial court “adjust the overall marital award” to account for this negative effect on the marital property held in the building.
The trial court let stand its finding, emphasizing it had decided the units “negatively impact[ed] the value of all of the marital property associated with [the building].” According to the trial court, it was of “no moment” that the court had “expressed this impact as a negative value” in its original opinion.
Focus on fairness. In reviewing the trial court’s ruling, the appeals court explained that, pursuant to Maryland law, the trial court must follow a three-step process in making an equitable distribution of property. Step 1 is to determine which property is marital property. Step 2 requires determining the value of all marital property. Step 3 asks the court to “evaluate whether ‘the division of marital property according to title will be unfair; if so, the court may make an award to rectify the inequality.’” If the trial court decides in favor of a monetary award, it must consider the factors set forth in the applicable statute (FL § 8-205(b)) to calculate the amount of the award.
The appeals court agreed with the husband that the trial court, in its original order, erred. But the reviewing court found a reason to uphold the trial court’s findings. The Court of Appeals acknowledged that the controlling case law requires the court to value each item of marital property separately. “There is no authority for the deduction of the loss incurred by a spouse in a bad investment from the value of the other marital property titled in his name.” The value of the bad investment would be zero. See Green v. Green, 64 Md. App. 122 (1985).
However, the Court of Appeals explained that, under case law, a trial court need not “ignore economic reality where the liabilities associated with a marital asset greatly exceed whatever money an owner could hope to extract from the asset.” See Randolph v. Randolph, 67 Md. App. 577 (1986). For example, in Randolph, the court allowed that debt associated with the husband’s partnership interests was “a factor to be considered in granting a monetary award but not in determining the value of any marital property other than” that asset.
The Court of Appeals found that the trial court, in its amended opinion, had “re-characterized” its arguably improper original decision to make it clear the reduction of the monetary award to the husband was based on the negative impact that asset had on all of the marital property. The trial court “unmistakably signaled” it was concerned about “fairness and not simply about finances” when it emphasized that it would be “inequitable for [the husband] to receive the benefit of the ‘good’ property, but not receive a portion of the burden of the ‘bad’ property,” the appeals court said.
And, considering the trial court’s later reasoning, requiring that court to revisit this issue would be unreasonable. Further, the trial court’s valuation of Truffles was not prejudicial because the error ultimately did not affect the outcome. The trial court would have made this deduction anyway, whether it did so when valuing the various marital assets or when considering the parties’ economic circumstances, the Court of Appeals found.
Disputed catering business valuation. The husband also attacked the trial court’s zero valuation of the catering business, which the husband’s expert had valued at $1.2 million. The record “constrained the court to assign a positive value” to the catering business, the husband contended.
In 2009, when the husband bought the catering business as part of a larger transaction, he paid almost $4.3 million for the real estate in the building but a mere $10,000 for the food-service businesses. The husband later admitted that he and the seller had not obtained an appraisal but had “picked a number of $10,000.” The catering businesses at that time had liabilities of several hundred thousand dollars.
Trial testimony showed the business model for the catering business was unusual in that the business operated inside the building and did not offer off-site catering. Sales were tied to events taking place inside the building’s other spaces. Because the spouses owned the real estate, they did not charge the catering company market rent but only charged enough to cover costs.
The catering business required customers to pay upfront (usually one year in advance) 25% of the price for catering an event. The customer would pay the remainder in 25% increments before the event. When the husband managed the companies, he would redirect funds from the catering business’s account to other investments in the building.
Under the husband’s management, beginning in 2013, the company’s accountant was ordered to switch from accrual-basis accounting to cash-basis accounting. The husband later claimed this method gave a more accurate picture of the company’s profits. The wife, in contrast, argued this approach allowed the husband to show higher profits than there actually were, in an effort to impress lenders.
When the wife took over management and operations, she hired another accountant who returned to accrual-basis accounting for 2015 and the first three quarters of 2016. Testifying at trial, this accountant said cash-basis accounting was “very misleading” where the company collected deposits long in advance of events. Cash-basis financials “would overstate the net worth” of the company as this information “underestimated liabilities.” By way of example, at the end of 2015, the company had $850,000 in “deferred revenue” but only $173,000 in cash. By mid-2016, it had $1.6 million in “deferred revenue” against $427,000 in the bank. The deficiency at the end of 2016 was even greater, the accountant testified. He characterized the catering company as “definitely insolvent.”
The husband’s business valuation expert, valuing the company at $1.2 million as of December 2015 (the agreed-upon valuation date was June 2016), relied on the former accountant’s financial records prepared under the cash-basis accounting method. The expert did not consider the data the testifying account had prepared.
The wife’s expert argued the holding companies for the nonresidential real estate and the catering company should be valued as a single entity. They were “wholly dependent” on each other. He noted that customers signed up for the catering and the use of the event space simultaneously. In a hypothetical transaction, a willing buyer and a willing seller would only agree to a transaction involving both companies at the same time, the expert said. Relying on data from the testifying accountant that was based on accrual-basis accounting, this expert concluded the fair market value of the catering business and the real estate holding company together, as of June 2016, was -$1.76 million.
The husband’s expert objected to the single valuation, noting a “real estate appraisal is different from the appraisal of an operating entity.” Moreover, it was conceivable that the catering company would allow other caterers to service events and charge those companies a facility fee, the expert claimed.
The trial court found that all of the real estate was worth about $4.6 million, but it had encumbrances of $3.7 million. Therefore, the net value of the properties was about $930,000. Concerning the catering company valuation, the trial court found the “accrual-basis accounting system more accurately reflects the finances of the business.” But the court rejected the proposition by the wife’s expert to treat the companies as a single entity. Doing so “masks the true value of each LLC,” the trial court said. It assigned this asset a value of zero “[g]iven its dependence on [the real estate holding company] for rent ‘at cost.’”
The court noted that, if a third party demanded market rent from the catering business, the latter would cease to exist, “given the competitive market for catering services.” The court noted the $10,000 sales price, which “considered the lack of working capital in [the company’s] possession.” In fact, at the time of sale, the business had collected nearly $330,000 in customer deposits that required performance at future events, but the company did not have the cash to put on the events. The seller agreed to credit the husband dollar for dollar when purchasing the real estate if the husband agreed to take the catering business off the seller’s hands.
The trial court affirmed its finding in its amended order, saying the catering business “has no value absent ownership of the real estate.” The value of the catering business was “inextricably tied to the value of the real estate used by it,” the court said, adding the original sale made this obvious.
The Court of Appeals noted the husband failed to cite to case law that required the trial court to adopt the valuation the husband’s expert proposed. The trial court had given specific reasons why it discounted that expert’s opinion, including the expert’s use of the wrong valuation date and his reliance on cash-basis accounting data. Although the expert explained his use of that data, there was countervailing expert testimony, the appeals court found.
Further, the husband’s attack on the opposing expert was “immaterial” because the trial court had not adopted the opposing expert’s opinion. There also was no merit to the argument that assigning the catering business zero value “simply defies logic.” There was testimony, including from an accountant for the company, that said redirecting customer deposits into illiquid real estate investments for other entities had a “negative impact on [the catering company’s] ability to meet its obligations as they become due,” the appeals court said. It noted the husband’s expert agreed that a third-party buyer would lower the sales price to account for the company’s working capital deficiency,” even though the expert did not think the reduction would be dollar for dollar.
The husband’s various arguments against the trial court’s valuation “cannot overcome the deferential standard of review,” the Court of Appeals said. While a different fact-finder might have come to a different conclusion than the trial court, the latter’s valuation was not clearly erroneous, the appeals court concluded.
“The [trial] court here was even-handed in its decisions and transparent in its reasoning,” the Court of Appeals said. It upheld the trial court’s value determinations and the amount of the monetary award to the husband.
Saltzer v. Rolka, 2018 Pa. Super. Unpub. LEXIS 4044 (Oct. 30, 2018)
Although unpublished, this Pennsylvania appellate ruling in a buyout dispute merits attention as it shows how the trial court tried to reconcile the contrasting expert valuations in determining fair value. Here, as is often the case, the members of a company executed an operating agreement but did not include a buyout provision for valuing a departing member’s shares. This omission later became a liability when two members tried to force the third member out by devising their own buyback formula. Litigation ensued, leading to a trial and ultimately to an appeal because neither side was satisfied with the trial court’s value determination. The court’s valuation was substantially higher than the proposed buyout price, but the court, agreeing with the defendants’ expert, found it was appropriate to apply a company-specific risk discount. The treatment of goodwill became another sticking point.
Forced sale. Three members created a closely held limited liability company that offered consulting services to state public utility commissions and the federal government. The company’s main source of income was one contract that was structured as five contracts generating about $300,000 in profits per year. All three members worked for the company, receiving regular salaries. One served as the company’s president and manager, and the other worked on the consulting side of the business. The third member, the plaintiff, was the specialist in information technology and served as VP of operations. As owners of the company, the members also periodically received profit disbursements in proportion to the size of their interests.
In April 2007, the members made an operating agreement under which the defendants (remaining members) each owned 400 units of the company and the plaintiff (departing member) owned 200 units. The operating agreement did not address a member’s departure (by death or otherwise). In the next few years, the members talked about amending the agreement to include a buyout provision, but they took no action.
In May 2013, the defendant members fired the plaintiff. But the latter remained an owner and as such continued to share in the company’s profits.
In June 2014, the defendant members decided to force the plaintiff out. As they together owned a majority interest in the company, they decided they could amend the operating agreement by devising a formula for determining the buyout price. The record later showed that the defendants arrived at the purchase price ($63,400) by “arbitrarily plugging numbers into their self-created formula.” The appellate court later noted that the defendants “had no factual basis for the valuation.”
To add insult to injury, the defendants gave the plaintiff a check for only 20% of the purchase price and two promissory notes for the remaining obligation. As the appellate court noted, in essence, the defendants made the forced-out member finance the buyback of his ownership interest. The plaintiff sued.
At trial, the parties presented valuation expert testimony. (However, the appellate court does not discuss the testimony in great detail.) The defendants’ expert said that it was appropriate to discount the value of the company by 24% to account for the uncertainty around the valuation date as to whether the key contract would be renewed. The final (fifth year) portion of the contract was to expire in June 2016. However, by the time this case went to trial, the contract had been extended to December 2016. The defense expert also argued in favor of excluding the value of personal goodwill attributable to the two remaining members from the valuation.
In contrast, the plaintiff’s expert rejected a personal goodwill deduction as well as a risk-based discount related to the company’s largest customer because the contract in fact continued into the following years.
Date of valuation matters. The trial court found the remaining members had breached their fiduciary duty to the plaintiff and had acted in an oppressive manner when they forced a sale on their terms. The court said the plaintiff’s expert was more credible and adopted her valuation. Therefore, the court did not deduct the value of personal goodwill from the company valuation.
However, the court agreed with the defense expert that a risk discount was appropriate under the facts of the case. Fair value was “the value on the date of dissociation,” i.e., the value in 2014 when a renewal of the contract was not a certainty. The trial court valued the plaintiff’s share in the company at $294,000. It declined to award the plaintiff punitive damages even though it recognized that the defendants’ conduct vis-à-vis the plaintiff was close to outrageous conduct, as defined by law.
Both parties appealed the trial court’s findings with the Superior Court of Pennsylvania (appellate court). The plaintiff challenged the application of risk discount, and the defendants attacked the trial court’s decision not to allow a personal goodwill deduction. In addition, the plaintiff claimed it was entitled to punitive damages, considering the defendants’ “recklessly indifferent” conduct.
The Superior Court affirmed. It agreed with the trial court that the existing operating agreement did not allow for an amendment by a majority of votes. Under the applicable state Limited Liability Company Act (LLCA), which governed here, the modification of the operating agreement required the unanimous vote of all members, not simply a majority of votes, the reviewing court found.
The appellate court rejected the plaintiff’s argument that no evidence at trial “even remotely suggested that the stream of income from the … contract would end,” obviating the need for a risk-based discount. The valuation date was the date of dissociation, the appellate court affirmed. The plaintiff’s expert improperly relied on information after the plaintiff had been made to leave. Also, the appellate court noted, the valuation findings were credibility determinations that were “well” within the trial court’s discretion and with which the appellate court could not interfere. Likewise, the trial court, in balancing the circumstances accompanying the forced buyout, did not abuse its discretion in finding that punitive damages were not appropriate in the instant case.
The appellate court upheld the $294,000 valuation of the plaintiff’s ownership interest.
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