The title of this post notwithstanding, the judge’s decision in the recent, high-stakes stock valuation case I’m about to describe, featuring a clash of business appraiser titans whose conclusions of value differed by almost 400%, did not refer to them as “hired guns.”
But the judge did not mince her words in expressing the view that, while “unquestionably qualified to testify on the issue of valuation,” the two experts, whose “zealous advocacy” for their respective clients “compromised their reliability,” offered “wildly disparate” values that were “tailored to suit the party who is paying for them.” Ouch!
The 54-page decision by a Minnesota state court judge in Lund v Lund, Decision, Order & Judgment, No. 27-CV-14-20058 [Minn. Dist. Ct. Hennepin Cnty. June 2, 2017], rejected both experts’ values — $80 million according to the expert for the selling shareholder and $21 million according to the expert for the purchasing company — in arriving at the court’s own value of $45 million for a 25% interest in a chain of 26 upscale grocery stores in the Twin Cities area known as Lunds & Byerlys together with affiliated management and real estate holding companies.
The plaintiff in Lund is one of four siblings, each of whom inherited 25% ownership of the family-owned grocery business founded by their grandfather. The plaintiff, who was not actively involved in the business operations, sued for judicial dissolution based on the majority’s “unfairly prejudicial” conduct in failing to structure an exit strategy. The court agreed and ordered the company to purchase her interest for fair value.
The valuation hearing centered on the appraisal reports and testimony of the two expert appraisers, Roger Grabowski for the company and Robert Reilly for the plaintiff, each of whom ranks among the country’s best known, most highly respected, and most widely published business appraisers.
The court’s decision offers a detailed recitation of the company’s history, structure, financial condition, and competitive environment, followed by a thorough summary and analysis of the appraisers’ contentions and methodology, and the court’s independent assessment. Valuation junkies will want to study the decision carefully. For the rest of you, here are some of the highlights:
- In its discussion of burdens of proof under Minnesota’s fair-value standard, the judge wrote that “when expert witnesses offer conflicting opinions, both of which have a reasonable basis in fact, ‘the trier of fact must decide who is right’. In some circumstances, neither expert is right.” She then added in a footnote, “The Court’s obligation to determine the fair value of the Lund Entities is met in this instance despite rather than because of the expert opinions provided at trial” (italics in original).
- Both experts used the income and market approaches. For the income approach, both used a discounted cash flow (DCF) analysis. For the market approach, plaintiff’s expert used a guideline public company analysis and a merged and acquired company analysis while the company’s expert only used the guideline public company analysis.
- The court agreed that the DCF method was the “most appropriate technique” for valuing the operating companies, but rejected both experts’ market approaches because, she found, “the companies considered by the parties’ experts are definitively not comparable” (italics in original), consisting of a “random array of grocery-related businesses.”
- The judge, in announcing that the court would make “its own independent judgment of the companies’ fair value,” noted that the two experts “disagree as to essentially every input and assumption contemplated in their DCF calculations,” that they “tailored” their valuations to suit their clients, and that “this cold fact cuts against both experts’ credibility in equal measure.”
- According to the judge, plaintiff’s expert “inflates the value of the companies by taking an overly optimistic view” of their future growth by minimizing the impact of local competition, whereas the companies’ expert “undervalues” the companies by “improperly considering” certain tax and pension obligations in calculating future cash flows and by applying a marketability discount “which is, as a matter of law in Minnesota, inappropriate in this case.” As the judge summed up, “Both experts’ approaches are laden with internal inconsistencies, and together they offer apples and oranges for the Court to compare.”
- The court accepted a terminal growth rate of 3% as proposed by the companies’ expert, finding that the plaintiff’s expert’s 4% rate suffered from a “disconnect” with his understated capital expenditure forecast.
- For his discount rate, plaintiff’s expert computed a WACC of 9% compared to 10% computed by the companies’ expert — the difference derived mainly from their different assumptions concerning capital structure. Plaintiff’s expert assumed 75% equity and 25% debt based on industry standards. The companies’ expert assumed 100% equity and 0% debt based on the companies’ actual capital structure. The different assumptions produced a $100 million swing in value. The court took guidance from the competing views of case law from Delaware and Nevada, and chose to follow the latter in arriving at 90% equity/10% debt structure that reduced the swing to $45 million.
- The court followed Minnesota case law, which, like a number of other states (but not New York), generally prohibits a marketability discount except in “extraordinary circumstances” involving “wrongdoing on the part of the minority shareholder that has caused a reduction in the value of the corporation” or an “unfair transfer of wealth” — neither of which the court found applicable to the plaintiff. “The proper way to grant the equitable relief to which [plaintiff] is entitled in a manner that is fair and equitable to all parties,” the court wrote, “is in setting the terms and conditions of the buyout, not in applying a discount for lack of marketability.”
- The court concluded a value of approximately $45 million for the plaintiff’s shares in the companies — about $5 million less than the midway point between the experts’ appraisals — which it ordered paid 5% cash within 90 days after entry of a final, non-appealable order and the balance in subordinated, unsecured notes payable over 20 years, along with other terms addressing various future economic circumstances.
The Appraiser’s Duty of Non-Advocacy
There’s nothing new about the phenomenon in contested stock valuation proceedings of judges being confronted with competing appraisals light-years apart, even when substantially the same financial data are being utilized by two qualified appraisers.
I’ve featured on this blog a number of New York stock valuation cases in which the opposing experts offered hugely disparate appraisals, such as the La Verghetta case (enterprise value of $162 million vs. $6.4 million), the AriZona Iced Tea case (enterprise value of $3.2 billion vs. $426 million), and the Zelouf case ($3.8 million vs. $1.3 million for the petitioner’s shares). There’s a well-known passage from a 1997 Delaware Chancery Court valuation case, which I’ve quoted before, in which the court expressed its frustration with this phenomenon by quipping that “one report is submitted by Dr. Pangloss, and the other by Mr. Scrooge.”
Accredited business appraisers are required to maintain professional independence and objectivity in their appraisal analyses and in litigation support roles. For example:
- The Professional Standards promulgated by the National Association of Certified Valuation Analysts (Preamble 1.2.a) state that a member “shall remain objective, apply professional integrity, shall not knowingly misrepresent facts, or subrogate judgment to others.”
- Section 1.4 of Standard One of the Business Appraisal Standards promulgated by The Institute of Business Appraisers states that “Non-advocacy is considered to be a mandatory standard of appraisal.”
- PG-1 of the Procedural Guidelines (“Role of the Independent Financial Expert”), Part II.H, promulgated by the American Society of Appraisers, states that “The expert witness . . . should maintain integrity, objectivity and independence.”
Does that mean that, whenever two appraisers offer widely disparate appraisals in a contested valuation proceeding, one or both of them, in the words of the judge in Lund, have tailored their appraisals to suit their paying client?
Obviously I can’t answer that question as it pertains to Lund or any other case in which I’ve had no involvement. Before anyone jumps to the conclusion that appraisals must be “cooked to order” when they’re so far apart, I highly recommend you read a recent post by prominent business appraiser Chris Mercer responding to the Lund decision, entitled Differing Expert Witness Valuation Conclusions, in which he writes:
Unfortunately for courts and for business valuation experts, the issue quite often is not nearly so neat and simple. Consider these possibilities:
- The appraiser with the lower conclusion is reasonable, and the other appraiser has a much higher conclusion.
- The appraiser with the higher conclusion is reasonable, and the other appraiser has a much lower conclusion.
Because of the large difference between the two appraisers in both instances, courts may assume that both are being advocative. This simply may not be the case. It would be better if all courts would look at the valuation process in its entirety before prejudging that all appraisers are advocates.
Chris’s post then highlights six sources of differences in expert opinions that are consistent with the appraiser’s duty to maintain objectivity and non-advocacy, but nonetheless can contribute to significant gaps in proffered values in contested proceedings:
- Differences in legal guidance and related assumptions, e.g., concerning the applicability of valuation discounts.
- Differences in information made available in the course of pretrial discovery, resulting in the expert for the non-company side not obtaining the same, full financial information made available to the company’s expert.
- Differences in access to management, which as Chris puts it, “can cause differences in valuation assumptions that can be interpreted by courts as advocative by one appraiser or the other.”
- Differences in valuation approaches or methods which, according to Chris, require “appraiser judgment” and “should not be considered a source of bias unless the appraiser cannot convincingly explain why they have used (or not) particular methods.”
- Differences in appraiser assumptions and judgments concerning a host of valuation techniques such as forecast assumptions for DCF, weights assigned to methods in correlating conclusions, and treatment of non-operating assets.
- “Mistakes” which “are embarrassing, but they happen,” says Chris.
Where the heck did you find it? Last but not least, whenever I’m asked where I find recent valuation cases decided outside New York, my answer almost invariably is one or the other of my two favorite resources for keeping up with developments in the world of business valuation: BVWire (which is where I learned of the Lund case) and Business Valuation Update, both published by Business Valuation Resources. BVWire is a weekly e-newsletter that usually is the first to report on interesting new cases from across the country, along with other news of interest to valuation professionals. BV Update is a monthly publication featuring in-depth articles on valuation issues and detailed summaries of noteworthy valuation cases. If business valuation is your thing, you need to subscribe to both.