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Delaware Chancery Relies on Deal Proposal Valuation in Adjudicating Buyout Dispute

Smith v. Promontory Financial Group, LLC, 2019 Del. Ch. LEXIS 148 (April 30, 2019)

In a buyout dispute centering on a company with an unusual business model and an “improvised operating agreement” (court’s words), one of the two equal partners withdrew and sued in the Delaware Court of Chancery for the value of his interest. In determining the company’s going concern value, the parties’ experts used the discounted cash flow method (plaintiff) and asset accumulation method (defendants). The court found both approaches were entirely unsuited for the circumstances. Instead, the court looked to a deal proposal that the parties negotiated just prior to the plaintiff’s departure. Although they never concluded the deal, they agreed on a company value for purposes of the negotiations, the court noted.

Letter of intent’s withdrawal language. The plaintiff and the defendant formed Promontory Growth and Innovation LLC (PGI), a management consulting firm that aimed to help clients to increase their profits. The plaintiff had expertise in the profit-improvement field, whereas the defendant once had been the U.S. Comptroller of the Currency. The defendant would serve as PGI’s rainmaker; as he knew the CEOs of many financial service companies personally, he marketed PGI’s service whenever possible. The plaintiff was in charge of PGI’s day-to-day operations. The defendant served as nonexecutive chairman.

The plaintiff and the defendant only negotiated a letter of intent (LOI) but never agreed to a full operating agreement. Instead, they agreed in writing that the LOI (signed in May 2009) would function as PGI’s operating agreement. Both parties also assigned their equal interests in PGI to their respective LLCs.

The LOI provided that the defendant’s LLC (Promontory) would provide PGI with working capital, which PGI was supposed to pay back. Once PGI had done so and also covered operating costs, it could make distributions to the two members.

The LOI provided that, if the plaintiff voluntarily withdrew after “three years from the date [PGI] commences its first engagement,” he was entitled to half of the going-concern value of the company minus his services, “the value to be decided between the parties at the time thereof.” The LOI was silent as to who would pay plaintiff’s share. The buyout formula applicable in case a member left because of death or incapacity was different.

PGI’s business model was unusual in that it did not envision repeat customers. Basically, the company’s services were intended for certain-size businesses that wanted to improve their profit performance. Once that goal was achieved, PGI’s work was over. Finding clients was difficult; it required being in the right place at the right time. The plaintiff likened it to “finding the needle in a haystack.” PGI worked on a contingency fee basis.

In 2009, the company had no clients. In 2010, it had two projects, one resulting in total revenue of $278,000 and the other one in total revenue of $5.8 million. A third project with the plaintiff as CEO started in May 2011 and ended in April 2012. Total revenue was $137.5 million, and total profit to PGI was $120 million. It seems that, inadvertently, the company distributed all of its profits to the two members. At the same time, the company’s debt to the defendant’s LLC, Promontory, kept increasing as PGI needed money to keep operations going and also to market the plaintiff’s book.

In early 2013, when asked to pay back half of PGI’s debt to Promontory, the plaintiff demurred. He suggested that new assignments would produce more revenue that could be used to repay the loans. But no new engagements materialized during his tenure.

‘Shelved’ debt/equity deal. In May 2013, the plaintiff said he had “a strong idiosyncratic aversion” to reinvest the money PGI had distributed to him in PGI. He also claimed he had liquidity problems. The parties began to work on a “debt/equity deal” that the plaintiff had proposed. It envisioned that Promontory would write off the debt PGI owed it, PGI would fund working capital until it ran out of money, and, in exchange for the loan write-off, the plaintiff’s interest in PGI would be reduced from 50% to 30%.

In his proposal, the plaintiff wrote: “You are writing off around $3.25 mm of my debt for 20% of PGI, which puts a value of PGI of just $16.25 mm with me still in place.” The plaintiff conditioned his final agreement to the deal on the defendant’s consent and the plaintiff’s obtaining advice from his tax advisor. Although the defendant agreed to the deal and the defendant LLC’s tax counsel conferred with the plaintiff’s tax accountant, the plaintiff ultimately decided to “shelve” the deal. He said he would repay 50% of PGI’s debt once “our next deal hits.” In August 2013, the plaintiff resigned as CEO. He said he wanted to exercise his option, “under our agreement,” to receive 50% of the current going-concern value of PGI minus his services.

From May 2012 until the plaintiff’s resignation, in August 2013, PGI did not land any new engagements. After the plaintiff had left, PGI obtained an engagement in 2014 and one in 2015, which together brought in over $12 million in revenue. In mid-2016, PGI ceased operations.

The plaintiff filed a complaint for the value of his interest in PGI with the Delaware Court of Chancery. The defendant and Promontory counterclaimed. When an attempt to resolve the case through mediation failed, the case went to trial.

Questionable projections. In 2012, Promontory asked the plaintiff to provide guidance for long-term projections for PGI. The plaintiff said it was hard to make long-term predictions for the company. Nevertheless, he assumed PGI could expect to generate three deals in 2013, five in 2014, and PGI then would increase the number of deals by one for the following years, until 2016. Accordingly, by then, PGI would have seven deals. The plaintiff assumed each deal would generate $10 million based on his experience working for other companies. The assumed number of deals conflicted with PGI’s statements in its marketing materials that PGI would not perform more than three deals per year.

Although PGI did not do another deal after April 2012, and therefore did not realize the plaintiff’s 2012 projections, Promontory used the plaintiff’s forecast going forward by shifting the expected deals and revenue out one year. The deals and revenue that were to occur in 2013 were shifted to 2014, and the numbers forecast for 2014 were shifted to 2015.

Contrasting valuation approaches. At trial, both parties presented valuations from experts who used different methodologies and arrived at markedly different results.

The plaintiff’s expert used Promontory’s long-term projections for his discounted cash flow analysis. This approach yielded a value of PGI without the plaintiff of $37.5 million. Alternatively, this expert developed a valuation based on a modified version of the debt/equity deal, which he said, served as a reality check on the DCF analysis.

In contrast, the defense expert valued the company under the asset accumulation method and arrived at a value of zero at the date the plaintiff left the company. The defense argued that the debt/equity deal reduced the plaintiff’s interest to 30%. At the same time, the defense said, the interest percentage did not matter because there was no value in PGI.

The defense expert said he tried to value the company’s intangible assets (workforce and goodwill) and found only the workforce had any value. However, the fair market value of the company’s liabilities exceeded the value of the company’s tangible and intangible assets. Therefore, the company’s value was zero, the defense expert concluded.

Controlling corporate document. The parties disagreed over how to determine how much the plaintiff was entitled to. The plaintiff asked the court to look to the LOI, which provided for a valuation based on the going-concern value of PGI minus the plaintiff’s services. The defense argued both parties in fact had accepted the debt/equity deal. As this was the controlling corporate document, the plaintiff only had a claim to 30% of the value of PGI without the plaintiff’s services.

The court found that the debt/equity deal was never finalized. The parties did not make a binding contract. Even though the defendant promptly accepted the plaintiff’s proposal, the plaintiff never said he wished to proceed or agreed to be bound by the terms of his proposal, the court said. It noted the defendant’s behavior suggested an awareness that the plaintiff would not agree to the deal. Based on the LOI, the plaintiff retained a 50% interest in PGI before his withdrawal, the court said.

‘Spurious projections of cash flows.’ The court rejected both experts’ methods. The asset accumulation approach was inappropriate where, as here, the company’s sole business was providing professional services and the company naturally had few tangible assets, the court said. “An asset approach for a viable services business, like PGI, would tend to undervalue such a business.” It explained how this method was inadequate to valuing PGI’s prospects, noting that valuing PGI just before the company ended up securing its lucrative third engagement would produce a close-to-zero value because the company then had more debt than it had assets. But such a valuation “would have missed the $120 million in profits received by PGI over the following twelve months,” the court said. Accordingly, the asset accumulation method was not a helpful tool for valuing the subject company.

The court found the plaintiff’s reliance on the DCF was similarly misplaced. The company’s business model (“boom or bust economics”) did not lend itself to this analysis. Also, the plaintiff’s expert “relied on spurious projections of cash flows,” which were based on the plaintiff’s guidance where the plaintiff had had no experience creating long-term projections, the court noted. The projections actually exceeded the number of deals per year the company said it would do. Worse, even though the initial projections proved to be unreliable, Promontory used them later by pushing them out for another year. According to the court, this is a methodology “that is as remarkable for its simplicity as it is dubious.”

The court said the debt/equity deal proposal was the best indicator of the company’s value with the plaintiff in place. Both, the plaintiff and the defendant, agreed with the plaintiff’s written statement in the proposal that PGI, with the plaintiff there, was worth $16.25 million. Also, this proposal was nearly contemporaneous with the plaintiff’s withdrawal, the court pointed out.

Based on the formula in the LOI, the court decided that the value of the company without the plaintiff was $8.125 million. The plaintiff was entitled to 50% of that amount, the court decided.

The court dismissed defense arguments that the plaintiff in effect was more important to the success of the business than the defendant and that his departure would drive the value for the company without the plaintiff below 50%. The court observed that the company had continued following the plaintiff’s departure and obtained some engagements. Therefore, the company retained half of its value after the plaintiff’s departure, the court concluded.

Based on the withdrawal provision in the LOI and the value stated in the plaintiff’s debt/equity deal proposal, the court awarded the plaintiff about $4 million, noting that this amount would be reduced by the plaintiff’s obligation to pay half of PGI’s debt to the defendant’s LLC, Promontory. The debt amount was $3.1 million.

Court Says Expulsion Price Determination in Louisiana Buyout Dispute Is Triable Issue

Complete Logistical Services, LLC v. Rulh, 2019 U.S. Dist. LEXIS 95701 (June 6, 2019)

Although a Louisiana LLC had in place an operating agreement that dealt with the expulsion of an “offending member,” litigation ensued. The court found that, while the agreement was a binding contract, it gave little guidance “on the issue of how to undergo a valuation of an expelled member’s expulsion price.” The court, ruling on the parties’ summary judgment motions, found neither the state’s revised statute nor case law offered a solution to the ambiguity in the contract on calculating the expulsion price. Therefore, the court ordered trial on this issue (and a number of other issues). The parties’ valuation disagreements revolved around the use of discounts. The court’s decision also includes an analysis of the parties’ respective Daubert challenges to opposing expert testimony.

Backstory. The plaintiff, a limited liability company, provided contract personnel for clients in the maritime industry, including vessels, drilling rigs, production platforms, and port facilities. At the time of the dispute, the LLC had four members. One of them was the defendant, who owned a 33.33% interest.

Three of the four members alleged that the defendant member had engaged in “egregious” conduct that harmed the company and, pursuant to an existing operating agreement, took steps to expel the defendant. The remaining members first revoked the defendant’s authority to manage the business or act unilaterally on the company’s behalf. They then agreed to obtain a “financial evaluation of the offending member’s interest” before progressing to the expulsion. An expert valuation concluded the expulsion price for the defendant was -$173,000.

The operating agreement provided that, during the expulsion process, the defendant may request “computer generated financial reports so that he may have an independent evaluation at his own cost if he so chooses.” The defendant did not ask for these documents. The operating agreement also provided that, if the defendant wanted to introduce his own valuation, he had to request that the remaining members consider it. The defendant’s attorney, in a letter, said the defendant would offer his own valuation as prepared by the defendant’s expert. The defendant claimed the “fair and proper evaluation” of his interest in the company was $7.4 million. But, at a subsequent meeting with the other members, the defendant said this was “not an official valuation” and that he needed more information. The defendant and his attorney then left the meeting.

The remaining members resolved to expel the defendant. Notwithstanding the expert valuation they had procured, the remaining members decided to buy the defendant’s interest in the company for $3,333.

The company filed a complaint against the defendant alleging a series of violations under state law, as well as unfair enrichment, breach of fiduciary duties, conversion, conspiracy, and fraud. Further, the company asked the court for a declaration that the expulsion was proper and that the defendant was no longer a member of the company. The claims were based on company allegations that the defendant had stolen confidential information from the company, including client lists, financial statements, and sales records, allegedly in connection with plans to start a competing business. The company also claimed the defendant had taken a sizable amount of money from the company’s bank account without authorization. As a consequence, the company was unable to pay its employees holiday bonuses and, in turn, lost a key employee in its diving division because that employee did not receive a bonus.

The defendant counterclaimed and asked the court for a declaratory judgment that the price the company offered in connection with the defendant’s expulsion did not comply with the company’s operating agreement. The defendant stipulated that he would not try to overturn his expulsion but did not concede that his behavior was “egregious” or caused “direct harm” to the company.

Rivaling expert valuations. The expulsion price of the defendant’s 33.33% ownership interest was a flashpoint in the litigation. Both sides offered expert valuations and filed Daubert motions to exclude the rival expert’s testimony. They also filed summary judgment motions on the issue of whether the expulsion price complied with the operating agreement.

The company’s expert, who had done the earlier value determination, explained that he calculated the value of the company as a whole under the asset, income, and market approaches. He said his analysis included “pre-incident” and “post-incident” metrics and values. The incident apparently was the defendant’s alleged taking of money from the company and the company’s subsequent loss of the employee in the diving division. The company’s expert applied discounts for lack of marketability and control to the company’s post-incident value. From the 100% “post-incident non-marketable, non-controlling interest value,” the expert extrapolated the value of the defendant’s interest.

Under the terms of the operating agreement, the expulsion price “shall take into account all losses caused by the offending member whether actual or speculative.” Therefore, the company’s expert reduced the calculated value for the defendant’s interest for diminution of value losses to the company and for out-of-pocket costs. Based on all of these factors, the company’s expert arrived at a value of -$173,000.

The defendant’s expert used a discounted cash flow analysis, the guideline transaction method, and the guideline public company method to value the company. He then extrapolated the value of the defendant’s interest. The expert did not use discounts for lack of marketability or control. He also did not adjust the achieved value for losses to the company’s value resulting from the defendant’s alleged misconduct, explaining that nothing in his analysis indicated that the defendant has caused the company any losses—actual or speculative. Ultimately, the defense expert arrived at an expulsion price of $6.4 million.

Daubert motions. The defendant’s main argument for exclusion of the company’s expert was that the expert used the incorrect standard of value: fair market value (FMV) as opposed to fair value (FV). Further, the expert applied the wrong section of the operating agreement when valuing the company, used an “inapplicable valuation methodology,” and, acting on bias, intentionally undervalued the company.

For its part, the company argued the defendant’s expert “misapplies valuation techniques, deviates from accepted valuation principles and professional standards, applies data sources erroneously and inconsistently, and selects biased data that inflates the value of [the defendant’s] interest.” Moreover, the expert made impermissible conclusions of law, the company contended.

The court decided that, under Rule 702 of the Federal Rules of Evidence and Daubert and its progeny, both experts were qualified to testify and most of their testimony was admissible.

Applicable law. Rule 702 allows a witness who is qualified as an expert by “knowledge, skill, experience, training or education” and whose testimony “will assist the trier of fact” to testify if: (1) the testimony is based on sufficient facts or data; (2) the testimony is the product of reliable principles and methods; and (3) the witness has applied principles and methods reliably to the facts of the case.

Daubert and related cases require that the testimony be reliable and relevant. Under Daubert, the trial court functions as a “gatekeeper” to ensure the testimony is reliable and relevant. In assessing reliability, the court must focus “solely on principles and methodology, not on the conclusions that they generate.”

Trial courts generally have broad discretion in deciding whether or not expert testimony is admissible.

Qualifications. The court here first found that both experts were qualified. They both had “sufficient training and experience in the field of business valuations” to provide opinions on the value of the company “as well as the proper membership and expulsion price” for the defendant. The court concluded the experts’ specialized knowledge would assist the trier of fact.

Methodology. The court noted that questions as to the reliability of an expert’s methodology went toward the weight to give the expert’s opinion rather than admissibility. These were issues for the trier of fact.

The court said neither expert’s testimony was “wholly unreliable.”

Legal opinions. In response to the company’s claim that the defense expert report included improper opinions on legal issues related to the interpretation of the controlling operating agreement, the court ruled that neither expert would be allowed to give legal opinions as to contract interpretation related to the operating agreement.

Summary judgment motions. In ruling on the parties’ summary judgment motions, the court first reviewed the provisions of the operating agreement as to expulsion of a member and found the agreement said little about the method that should be used to calculate the offending member’s expulsion price. The contract merely specified that a majority of members had to vote to expel the offending member and “agree on a price to pay the expelled member for his interest.” The agreement said: “This price shall take into account all losses caused by the offending member whether actual or speculative.”

The sticking point was whether, under the terms of the agreement, discounts were permissible. The company said there was no prohibition against applying discounts, as the company’s expert had done. Moreover, the company said, discounts are appropriate “under generally accepted accounting and evaluation standards.”

The defendant maintained the price should have been determined under the fair value standard, as opposed to the fair market value standard the company’s expert had used. Applying discounts violated Louisiana law as well as the operating agreement, the defendant argued.

State law. To support his argument against the use of discounts, the defendant cited to Cannon v. Bertrand, in which the state Supreme Court had cautioned that minority and lack of marketability discounts should be used “sparingly” and only when the facts of the case supported the application of discounts. See Cannon v. Bertrand (Cannon II), 2008-1073 (La. 1/21/09) (available at BVLaw).

However, the company countered that Cannon was not controlling here because it dealt with a limited liability partnership, not with a limited liability company. LLPs are subject to different legal provisions than LLCs, the company noted. Further, Cannon dealt with the voluntary withdrawal of a partner, not with the expulsion of the departing member.

The court agreed with the company’s position. The court also referenced another case, Wall v. Bryan, in which the Louisiana Court of Appeal dealt with valuing the interest of a withdrawing member of an LLC. In Wall, the court found that, under the applicable statutory provision, the use of discounts was proper. See Wall v. Bryan, 251 So. 3d 650 (La. App. 2 Cir. 6/27/18) (available at BVLaw).

The court in the instant case concluded that “the holding in Wall makes plain that the application of marketability and minority discounts in valuating a withdrawing LLC member’s interest is not contrary to law.” Accordingly, the court denied the defendant’s summary judgment on the basis that Louisiana law prohibited the use of discounts.

Operating agreement. Next, the court considered the provisions of the operating agreement on the issue of discounts.

The court emphasized that, while the agreement was binding on the parties, it was “silent as to how the expulsion price must be calculated.” The court dismissed the company’s claim that this silence meant the remaining members could use any amount as the expulsion price as long as they agreed on it. According to the court, this interpretation of the agreement would be “absurd,” as it would allow the remaining members to arbitrarily set an expulsion price and possibly realize a windfall at the expense of the expelled member.

Because the contract was ambiguous, the court tried to “fill in the gap” by considering section 1325(C) of the revised state statute (La. R.S. 12:1325(C)), which provides for the use of the fair market value in valuing a withdrawing or resigning member’s interest where the written operating agreement does not specify the standard of value.

The court in the instant case pointed out that this statutory provision, however, does not address expulsion. Further, the court said, “There is no civil code article or revised statute that specifically addresses this situation.” The court said that, even though “it would not do violence to the statute to interpret it as including involuntary withdrawals,” it was unable to find case law that had applied the statute to an expulsion.

There was a genuine issue of material fact as to how to calculate the value of the expelled member’s interest in the company in light of the operating agreement that should be left for the jury, the court said. Accordingly, it denied the parties’ summary judgment motions on this issue.

In addition, the court found the defendant had not waived his right to challenge the expulsion price.

Moreover, the court denied the defendant’s summary judgment motion as to the company’s trade secrets act violation claims. However, it found the company failed to provide evidence that it suffered damages as a result of the defendant’s alleged conversion, fraud, breach of fiduciary duties, or violations under the state uniform trade secrets act (LUTSA). Accordingly, it granted the defendant’s summary judgment motion as to those claims.

In conclusion, the court decided the issue of how to value the expelled member’s interest in the subject LLC pursuant to the company’s operating agreement and state law should go to trial and could not be resolved on summary judgment.

In Florida Divorce, Expert’s ‘With-and-Without’ Valuation Withstands Appeal

Muszynski v. Muszynski, Case No. 2013-DR-18828-O, Final Judgment of Dissolution of Marriage, Circuit Court of the Ninth Circuit, Orange County, Fla. (Oct. 4, 2017), Bob Leblanc (Circuit Judge), aff’d per curiam Muszynski v. Muszynski, 2019 Fla. App. LEXIS 9913 (June 25, 2019)

In a nasty Florida divorce case, an appellate court recently upheld the trial court’s valuation findings concerning the husband’s 50% interest in a successful company that operates in the waste disposal industry. The trial court adopted the valuation of the wife’s expert, which included the value of certain intangibles belonging to the company but excluded the value of the husband’s personal goodwill. In Florida, enterprise goodwill is a marital asset, but personal goodwill is not.

Separating out personal goodwill: During the marriage, the husband set up a business, soon selling a 50% ownership interest to a third party. The husband had sole ownership over the remaining 50%. The company facilitated waste removal in that it had relationships with companies that generated waste and those that hauled it away. Apparently, the company did not, itself, remove the waste.

A few years before filing for divorce, the husband sold a 45% interest (nonvoting stock) to a trust but retained a 5% interest that represented 50% of the total voting rights in the company. Ostensibly, he did so for estate planning purposes. But the trial court noted that, at that time, the parties’ marriage was breaking down and that the wife was not properly informed of the sale and its implications.

The trial court first determined that the totality of circumstances suggested the sale “did not serve a valid marital purpose and was unconscionable.” The transaction was the husband’s “unilateral decision” and did not change the classification of the husband’s interest from a marital asset to a nonmarital asset. The value, for purposes of equitable distribution, was the full 50% of the company’s stock (not the retained 5% interest), the trial court decided.

The parties’ experts prepared fair market value determinations but disagreed on how to value the husband’s interest. The husband’s expert proposed a net asset valuation, noting, however, that the company had no significant assets as it didn’t produce anything or own much. According to this expert, all intangible value was linked to the husband’s (and his business partner’s) client relationships and therefore was not a marital asset. This value represented nothing more than the husband’s future earning capacity, which must not be considered in dividing marital property in a divorce proceeding, the expert said.

The wife’s expert valued the company’s assets and teased out the value of all identifiable intangibles which, he explained, belonged to the enterprise (including workforce, trade name, employees’ noncompetes, and customer relations). Proceeding from the premise that a buyer would not buy the company without having a noncompete for the husband in place, which evidences personal goodwill, he used the with-and-without method to determine the value of the husband’s noncompete and subtracted this value from the overall valuation.

In crediting this expert’s testimony, the court emphasized that the valuation did not include any personal goodwill of the husband. The court said it accepted the wife’s expert’s “methodologies for separating out any value related to Husband’s personal goodwill.” A state court of appeal recently affirmed the trial court’s decision per curiam, without issuing an opinion.


Dan Rosio Partner, Valuation Services
Andy Manchir Partner, Business Valuation & ESOP Services

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