Case Law Patterns for Lack of Marketability Discounts

Transcription

1 Case Law Patterns for Lack of Marketability Discounts

2 Speaker Biography For 20 years, Robert Reilly has been a managing director of Willamette Management Associates. Willamette provides valuation consulting, economic analysis, and financial advisory services for transaction, financing, taxation, bankruptcy, litigation, and planning purposes. For over 30 years, Robert has focused on business and securities valuation, intangible asset and intellectual property analyses, and on lost profits and economic damages analyses. Robert holds a BA in economics and an MBA in finance, both from Columbia University. He is a certified public accountant, accredited in business valuation, and certified in financial forensics. He is a chartered financial analyst, certified management accountant, and certified business appraiser.

3 Valuation Adjustments are Influenced by the Type of Business Divorce Litigation There are various types of litigation claims that could be categorized as a business divorce. The type of litigation claim could influence (1) the valuation analyst s assignment and (2) the application of various types of valuation adjustments.

4 Valuation Adjustments are Influenced by the Type of Business Divorce Litigation (cont.) Some of the common types of business divorce litigation claims include: dissenting shareholder appraisal rights minority shareholder freeze-out shareholder oppression request for corporate dissolution without oppression partnership, LLC dissolution joint venture agreement dissolution breach of contract breach of noncompete agreement buy/sell agreement interpretations/violations shareholder derivative actions

5 Valuation Adjustments are Influenced by the Type of Business Divorce Litigation (cont.) The valuation analyst should have a clear understanding of the type of business divorce that is the subject of the pending or threatened litigation. In addition, the valuation analyst should develop a clear understanding of how the type of business divorce will affect (1) the analyst s assignment, (2) the valuation analysis purpose and objective, (3) the judicially acceptable valuation approaches and methods, (4) the types of valuation adjustments that are/are not judicially allowed, and (5) the format of the valuation report.

6 Valuation Analyst s Assignment The valuation analyst should obtain clear instructions from the client s legal counsel with regard to the valuation and/or economic damages implications of the subject type of business divorce. These instructions from the clients legal counsel are legal instructions that may (1) affect the analyst s assignment and (2) direct the analyst s actions. The valuation analyst typically prefers to receive these legal instructions in writing. These legal instructions, of course, are based on the lawyer s interpretation of the jurisdiction-appropriate statutory authority and judicial precedent.

7 Valuation Analyst s Assignment (cont.) The lawyer s legal instructions may cite or include the appropriate statutory authority and judicial precedent. And, the analyst may read these legal authorities as a layperson. However, the analyst is not a lawyer. The analyst should not inadvertently attempt to practice law. That is, the analyst should not attempt to develop a legal interpretation of the appropriate legal authority. The analyst should rely on the client s legal counsel for any and all legal interpretations to any and all legal authorities.

8 Defining the Valuation Analyst s Assignment The client s legal counsel will typically define the following principal elements of the analyst s assignment: will the analyst value the entire subject company as is? will the analyst value the entire subject company to the control owner? will the analyst value the entire subject company to the market? will the analyst value the subject equity securities as is? will the analyst value the subject equity securities to the control owner? will the analyst value the subject equity securities to the market? will the analyst estimate historical lost profits to the plaintiff? will the analyst estimate expected future lost profits to the plaintiff? will the analyst estimate historical unjust enrichment to the defendant? will the analyst estimate expected future unjust enrichment to the defendant?

9 Defining the Valuation Analyst s Assignment (cont.) The client s legal counsel will typically define the following specific elements of the analyst s assignment? valuation as of date(s) damages period (e.g., event, mitigation) dates standard of value value to who? legal definition of value fair value, fair market value, etc. plaintiff s specific ownership interest period that plaintiff owned the interest legal rights/limitations of plaintiff ownership interest all other shareholders ownership interests ownership levels for various control events under state statute legally-determined level of value for the assignment

10 Defining the Valuation Analyst s Assignment (cont.) The client s legal counsel should also indicate to the analyst if the plaintiff s interest is subject to: buy/sell agreement other shareholder agreements put/call options unusual shareholder rights/obligations other contractual terms or conditions

11 Defining the Assignment Levels of Value After consideration of state statutes and relevant judicial precedent, the client s legal counsel should instruct the analyst as to the assignment level of value: value the entity or security - as if marketable - as if nonmarketable value the entity or security - as if a controlling ownership interest - as if a noncontrolling ownership interest

12 Defining the Assignment Levels of Value (cont.) The client s legal counsel should instruct the analyst whether or not to consider the value implications of: the corporate event to which the plaintiff objects the economic benefits of a proposed merger or other transaction the general acquisition premium (above a control only premium) that M&A transaction prices may include any jurisdiction-specific definitions of marketability, control, or other valuation terms The client s legal counsel should not place the valuation analyst in the position of (1) legally determining the appropriate level of value or (2) concluding what is fair to the litigants.

13 Common Normalization Adjustments The valuation analyst will typically make financial statement normalization adjustments in a business or security valuation performed (1) for any purpose and (2) at any level of value.

14 Common Normalization Adjustments (cont.) Some of these typical financial statement normalization adjustments include: effects of changes in accounting principles effects of adoption of new accounting principles effects of results of discontinued operations effects of extraordinary events effects of nonrecurring debits or credits - litigation settlements - insurance settlements - environmental expense/reimbursement - income/other tax disputes - purchase/sale nonoperating assets

15 Common Normalization Adjustments (cont.) The valuation analyst should note that these normalization adjustments may affect the subject company income statement, cash flow statement, and balance sheet. When using any market approach valuation methods, the valuation analyst should normalize the guideline company financial statements, as well as the subject company financial statements.

16 Common Level of Value Valuation Adjustments The valuation analyst will commonly make the following type of financial statement normalization adjustments when valuing the subject company/security on a controlling ownership interest level of value: 1. excess compensation expense to industry average levels 2. excess variable operating expense to industry average levels, over time 3. excess variable SG&A expense to industry average levels, over time 4. excess net working capital (especially cash balances) to industry average levels, over time 5. unusual debt/equity ratio to industry average levels, in the discount rate analysis

17 Common Level of Value Valuation Adjustments (cont.) 6. deferred/inadequate capital expenditures to industry average levels 7. unusual depreciation policy to industry normal policy 8. excessive cost of capital components to industry normal costs 9. excess non-operating assets are liquidated 10. dividend policy is adjusted to industry normal distribution level (after considering the subject company cash needs) The analyst should note that these control level of value adjustments may affect the subject company income statement, cash flow statement, and balance sheet.

18 Common Shareholder Oppression Valuation Adjustments In addition to the typical control level normalization adjustments, the valuation analyst may investigate and consider the following shareholder oppression type of normalization adjustments in the business/security valuation: 1. unproductive/ghost friend or relative employees on payroll 2. company payment for personal-use automobile and other forms of travel or for personal vacations and other nonbusiness travel 3. company payment for personal household expenditures or for housing capital expenditures of control owner or of friends and relatives 4. company payment of personal income tax liability of control owner or others

19 Common Shareholder Oppression Valuation Adjustments (cont.) 5. company payment of personal hobby expenditures of control owner or others 6. company payment of personal loans or credit cards of control owner or others 7. company payment of expenses/capital expenditures of another business owned separately by control owner or redirection of company sales/receipts to another business owned directly by control owner 8. company rental of real estate or other assets owned by control owner 9. reserves for uncollectible accounts, allowance for inventory shrinkage, or other contra-asset expense accounts that can be directly controlled by control owner 10. expensing of capital expenditures or excessively rapid depreciation expense that can be controlled by control owner

20 Common Shareholder Oppression Valuation Adjustments (cont.) The analyst should note that these valuation adjustments can affect the subject company income statement, cash flow statement, and balance sheet. The analyst should note that these valuation adjustments can affect the results of all income approach, market approach, and asset-based approach business/security valuation methods. The analyst should also note that these valuation analysts not only affect subject company/security value. They may also affect the plaintiff economic damages analysis. And, they may also affect the subject company s historical, current, and expected future ability to pay dividends or other owner distributions.

21 Valuation Analyst s Conclusions and Opinions The business divorce valuation involves analyses that are not always performed in a business/security valuation prepared for many other purposes. In addition to capital market analysis and financial analysis, the valuation analyst may also perform the following tasks in a business divorce assignment: forensic and investigative accounting, financial accounting and financial statement preparation, forensic IT analysis, fraud investigation, general ledger and accounting system analysis, internal control investigation, etc.

22 Valuation Analyst s Conclusions and Opinions (cont.) The valuation analyst should clearly understand the scope of the business divorce valuation assignment. The valuation analyst should clearly understand the quality and quantity of the subject company financial statements, accounting systems, and actual transaction documentation that will be available for analysis. And, the valuation analyst should clearly understand the scope of the valuation and/or economic damages and/or forensic accounting opinions that the assignment calls for.

23 Valuation Analyst s Conclusions and Opinions (cont.) These assignment understandings should be agreed to between the analyst, the client, and the client s legal counsel. In addition, the analyst s report should clearly describe (1) the scope of the analyst s assignment and (2) the analyst s business/security valuation conclusion, plaintiff economic damages conclusion, and/or subject company forensic accounting/internal control opinion.

24 The Economics of Fairness A Simplified Illustrative Example Five years ago, Andy Alpha and Ben Beta started a company that they called Alpha Beta Corporation. Andy owns 60% of the common stock of the corporation, and Ben owns the remaining 40% of the common stock of the corporation. After five years of successful operations, Andy and Ben can no longer agree on the management direction of Alpha Beta Corporation. To eliminate their interpersonal conflict, Andy wants to buy out Ben, and Ben wants to sell out to Andy.

25 The Economics of Fairness A Simplified Illustrative Example (cont.) Andy and Ben agree that if they sold 100% of Alpha Beta Corporation, say to a competitor, the total company stock would sell for $10,000,000. There are 100,000 shares of Alpha Beta Corporation stock outstanding. As an aside, Andy and Ben both work full time for the company, and they both earn generous salaries and bonuses. The company does not pay dividends on its common stock.

26 The Economics of Fairness A Simplified Illustrative Example (cont.) Assuming a $10,000,000 total company equity value, Ben expects that Andy will buy him out as follows: Alpha Beta Corporation total equity value $10,000,000 total number of common shares outstanding 100,000 = pro rata total equity value per share $100 number of shares owned by Ben 40,000 (i.e., 100,000 shares outstanding 40% ownership) = pro rata equity value of Ben s shares $4,000,000

27 The Economics of Fairness A Simplified Illustrative Example (cont.) In other words, Ben believes that the fair value of his Alpha Beta Corporation ownership interest is $4,000,000. Assuming the $10,000,000 total equity value is correct, a valuation analyst would conclude that the value of the Alpha Beta Corporation stock, on a marketable, controlling ownership interest basis, is $100 per share.

28 The Economics of Fairness A Simplified Illustrative Example (cont.) However, based on a $10,000,000 total company equity value, Andy offers to buy out Ben as follows: Alpha Beta Corporation total equity value $10,000,000 total number of common shares outstanding 100,000 = pro rata total equity value per share $100 (i.e., value of common stock on a marketable, controlling interest basis) discount for lack of 25% - $25 = value of common stock on a marketable, noncontrolling interest basis $75 discount for lack of 33% - $25 = value of common stock on a nonmarketable, noncontrolling interest basis $50 number of shares owned by Ben 40,000 (i.e., 100,000 shares outstanding 40% ownership) = fair market value of Ben s shares $2,000,000

29 The Economics of Fairness A Simplified Illustrative Example (cont.) In other words, Andy believes that the fair market value of Ben s Alpha Beta Corporation ownership interest is $2,000,000. Assuming the $10,000,000 total equity value is correct, a valuation analyst would conclude that the value of the Alpha Beta Corporation stock, on a nonmarketable, noncontrolling ownership interest basis, is $50 per share.

30 The Economics of Fairness The Disputed Transaction At first, Andy and Ben can t agree on the share price at which Andy will buy out Ben s 40% ownership interest in Alpha Beta Corporation. Ben concludes that the $50 per share offer from Andy is not a fair price. Ben asserts that the stock is clearly worth $100 per share to Andy. This is because Andy could sell the entire company for $100 per share. Andy believes that no other buyer would pay Ben more than $50 per share for Ben s Alpha Beta stock. Andy believes that $50 per share price is the market price for Ben s stock to any third party investor in the company.

31 The Economics of Fairness The Disputed Transaction (cont.) In response to Ben s suggestion that they both sell the entire company, Andy indicates to Ben that he has no current interest in selling Alpha Beta Corporation. Several months pass, and no stock purchase/sale transaction occurs between Andy and Ben. Then, Ben s family develops serious health problems and other liquidity needs. Ben urgently needs cash for his wife s operation, his son s education, his daughter s wedding, and his brother-in-law s gambling debts. Desperate for cash, Ben sells his Alpha Beta Corporation stock to Andy for $2,000,000, or $50 per share.

32 The Economics of Fairness The Disputed Transaction (cont.) Three weeks later, Andy sells 100% of the Alpha Beta Corporation stock to a competitor for $10,000,000, or $100 per share. Upon hearing of Andy s sale of the entire company, Ben sues Andy. Ben claims that he did not receive fair value for his 40,000 shares of Alpha Beta Corporation stock that he sold to Andy.

33 The Economics of Fairness What is Fair? Unquestionably, Andy sold 100% of the Alpha Beta Corporation stock for $10,000,000, or $100 per share. Also, unquestionably, weeks earlier, Andy bought Ben s 40% block of Alpha Beta Corporation stock for $2,000,000, or $50 per share.

34 The Economics of Fairness What is Fair? (cont.) If Ben still owned the 40% block of Alpha Beta Corporation stock when Andy sold the entire company, then the allocation of the Alpha Beta Corporation stock sale proceeds would have been as follows: Proceeds Proceeds Allocation Allocation To Andy to Ben Total share ownership % 60% 40% Total number of shares 60,000 40,000 Total sale proceeds, $10,000,000 $6,000,000 $4,000,000 Total sale proceeds per share $100 $100

35 The Economics of Fairness What is Fair? (cont.) However, Ben had already sold his Alpha Beta Corporation stock to Andy by the time that Andy sold the entire company to the competitor. So, Ben only received $2,000,000 for his stock from Andy, instead of $4,000,000 for his stock from the competitor. Therefore, Ben will claim that he lost out on $2,000,000 of fair value (i.e., the $4,000,000 allocated company sale price the $2,000,000 stock sale price actually received from Andy).

36 The Economics of Fairness What is Fair? (cont.) Andy received the entire $10,000,000 sale proceeds for 100% of the company stock from the competitor, instead of the $6,000,000 sale price allocation he would have received if Ben still owned 40% of the company stock. Ben will claim that Andy was unjustly enriched by the amount of $2,000,000 (i.e., the $10,000,000 total equity price the $6,000,000 that Andy would have received for his 60% interest the $2,000,000 that Andy actually paid to Ben for Ben s 40% interest).

37 The Economics of Fairness What is Fair Value? The question that the judicial finder of fact may have to answer is: Is the fair value of the Alpha Beta Corporation stock to Ben $50 per share at the same time that Andy can turn around and sell the Alpha Beta Corporation stock for $100 per share? Or, is the fair value of Alpha Beta Corporation stock the same value per share to all shareholders (e.g., pro rata $10,000,000 total equity value) (1) to all shareholders (2) regardless of how many shares that shareholder owns (i.e., controls)?

38 The Economics of Fairness What is Fair Value? (cont.) In other words, is fair value a conclusion that is the same for all shares of a corporation, regardless of the relative ownership interests of the various corporate shareholders? Alternative, is fair value per share different from fair market value per share, in that fair market value considers (1) the size/liquidity of the subject block of stock relative to 92) the size/liquidity of other blocks of stock in the subject company?

39 The Economics of Fairness What is Fair Value? (cont.) Lastly, is fair value an equity-derived concept? Is fair value intended to be a figure that is equally fair, equitable, just, etc. to all parties to the dispute? In contrast, is fair market value a market-derived concept? Is fair market value a figure that willing market participants would pay/accept for the subject interest? and, is the market sometimes not fair, equitable, or just?