By statute in New York and many other states, including Delaware, the standard of value used in dissenting shareholder appraisals and buy-outs in corporate dissolution proceedings brought by minority shareholders is “fair value.” Fair value is to be distinguished from its better known cousin, “fair market value,” which is the standard applied in federal estate and gift tax proceedings and in matrimonial cases. In one of the first posts I wrote for this blog over three years ago, I quoted Shannon Pratt’s leading treatise’s definition of fair value — “a legally created standard of value that applies to certain specific transactions” (Valuing a Business, p. 45 [5th ed. 2008]) — which I in turn translated as meaning “whatever the courts say it means.”
Leave it to Chris Mercer, one of America’s leading authorities on business appraisal and author of countless books and articles, to tackle the elusive subject of fair value in a series of posts for his new blog called ValuationSpeak. Chris’s posts are must reading certainly for any attorney or business appraiser who handles a valuation proceeding applying the statutory fair value standard. I also commend the articles to any business owner who wants to get a handle on what a fair value appraisal entails, and what discounts will or won’t be taken, to help them make more informed decisions about commencing or defending a judicial valuation proceeding. Here’s an overview of the six posts written to date:
Part 1: Introduction. Calling himself an “agnostic” on the subject, Chris begins his series with the fundamental observation that “fair value is ultimately a legal concept” as to which the appraiser must take guidance from legal counsel “regarding their legal interpretation of fair value in each jurisdiction.” He then highlights the Delaware appraisal statute’s definition of fair value, which he says gives “little effective guidance” and merely requires consideration of “all relevant factors” akin to the criteria found in IRS Revenue Ruling 59-60 applicable to fair market value determinations. (Note: New York’s fair value jurisprudence, beginning with the seminal Blake case, likewise invites consideration of the factors identified in Revenue Ruling 59-60.) Chris contrasts the willing buyer/willing seller, “objective” standard of fair market value versus the willing buyer/unwilling seller “equitable” standard of fair value, leading him to conclude that “fair value is intertwined with concepts of fair market value and equity, which can be highly confusing for participants in fair value proceedings and for business appraisers as well.”
Part 2: Discounted Cash Flow Method. Chris’s second post offers a somewhat technical primer on the basic models or methods used within the income approach to value (the other approaches being the asset and market approaches), including the Discounted Cash Flow (DCF) method, the Gordon Model, and a “two-stage” DCF model that combines elements of the first two. The basic DCF method determines the net present value of future cash flows projected in perpetuity, whereas the Gordon Model uses a single-period income capitalization method. Chris also discusses the market approach in which the appraiser compares certain valuation metrics of the subject company with similar metrics of “guideline” public companies. According to Chris, the DCF method “is a commonly used valuation method, particularly when valuing sizeable companies where management routinely prepares forecasts of future financial performance” and is the “favored valuation method” in the Delaware Court of Chancery.
Part 3: Traditional Levels of Value Chart. Third in the series is an explanation of the traditional levels of value chart that Chris says is “at the heart of every valuation decision made in statutory fair value determinations, either judicially or by appraisers.” Here’s what the chart looks like:
The middle level, Marketable Minority Interest Basis, is the “benchmark” level representing, for a closely held company, the equity value of the enterprise as if there were a free and active public market for the shares. Above this benchmark is the Controlling Interest Basis representing pricing as if the entire company (or a controlling interest in it) is sold. A control premium is added when moving up from the benchmark to the control level of value, while a minority discount is applied when moving in the opposite direction. The lowest level is Nonmarketable Minority Interest Basis representing the value of an illiquid minority interest in a closely held company. Movement from the middle, benchmark level to the lower level is achieved by applying a marketability discount a/k/a discount for lack of marketability (DLOM) usually based on restricted stock and pre-IPO studies. Chris closes his post with the intriguing comment, “Appraisers and courts have used and misused these studies for years. The misuse of available evidence has contributed to confusion in the statutory fair value arena.”
Part 4: Proportionate Interest in a Going Concern. Chris’s next post addresses a central theme pervading fair value case law, i.e., that the minority or dissenting shareholder whose interest is being bought out is entitled to be paid his or her “proportionate interest in a going concern” also sometimes expressed as the “intrinsic value” of the shares. Chris points out that the Controlling Interest Basis and the Marketable Minority Interest Basis levels in the chart both are enterprise concepts and reflect going concern value, leading to confusion for appraisers and courts in statutory fair value determinations. “The crux of the problem with the term ‘proportionate interest in a going concern,'” he continues, “is that it can mean different things to different people.” Appraisers either should request a specific legal interpretation from counsel or provide indications of value at both levels, Chris recommends.
Part 5: The Implicit Minority Discount. Fifth in the series is a discussion of the Implicit Minority Discount (IMD) which took root in Delaware case law based on works by Messrs. Pratt and Mercer in the 1990s. The IMD posits that all publicly traded shares trade at a substantial discount relative to their proportionate share of the corporation and that, accordingly, when using the Guideline Public Company Method to value shares in a non-public company there must be a substantial upward adjustment to correct the IMD. Chris explains that both he and Pratt have modified their positions on the use of control premiums when using the Guideline Public Company Method as reflected in the updated, four-levels of value chart shown on the right side below:
In other words, whereas an upward adjustment would be required if consideration were to be given to a strategic buyer of a public company based on cash flow-driven differences, the same is not necessarily true for a financial buyer.
Part 6: Applicability of Marketability Discounts in New York. The last of Chris’s six posts so far on statutory fair value addresses an issue closer to home, namely, the doctrinal and evidentiary bases for the marketability discount in New York case law. Chris’s discussion begins with a summary of New York law concerning marketability discount that I prepared for a post several months ago featuring the Cole v. Macklowe case which he then relates to the levels of value chart. Chris pulls no punches in stating that, while “the issue may be well-settled, it is also well-debated in New York statutory fair value cases because the logic is simply incorrect.” The problem, he says, is that “[i]t is incorrect, both theoretically and practically, to apply a marketability discount to a controlling interest in a business” and that “[t]here are no studies that provide market evidence of a lack of marketability for controlling interests in companies.” Chris questions the current validity of the authorities relied upon in the 1985 Blake ruling that cemented the marketability discount in New York fair value case law. He also illustrates his point using a hypothetical real estate holding company, suggesting that no marketability discount ought to be imposed on top of the “time to market” assumption built into the underlying real estate appraisal. Reminding readers of his “agnostic” stance on “what courts in any jurisdiction call fair value,” he closes with a plea to the judiciary:
What I am concerned about, however, is the fact that courts provide valuation guidance in the process of making their statutory fair value determinations. If that valuation guidance is unclear, or if it is based on inadequate or inappropriate market evidence, then the stage is set for future disputes in fair value determinations.
I’ll close simply by re-urging my interested readers to take the time to study each of Chris’s posts on this important, timely and complex subject.
Note to Chris: Keep ‘em coming!