The following testimony was given by an accredited business appraiser, testifying on behalf of the purchasing majority shareholders in a buy-out valuation proceeding under Section 1118 of the Business Corporation Law, to determine the “fair value” of the petitioner’s 45% interest in two related companies:
Q: . . . I see that for the [first] appraisal there was no separate marketability discount analysis, but there is one for the [second] appraisal. Could you explain the basis of that?
A: After the issuance of both reports, . . . we were asked to come up with a value on a fully enterprise, the value of both entities. After the second report, [the majority shareholders’ lawyer] asked me to address it because the case had become a 1118 case, and in that case the definition of value is fair value, and under that definition of value for the minority interest, what other considerations would one take into consideration, and I said, well, you would address the marketability discount of that specific block of stock under that statute. And he asked me then could I quantify what the marketability discount would be applicable to the stock.
Q. Applicable to the minority interest?
A. To the block of stock, the 45 percent interest.
The same expert, in a written report, wrote that “[a] minority equity holder of [the two companies] owns an equity interest for which no market exists. . . . It is our opinion that no less than a 30%-to-35% discount for lack of marketability is appropriate for the equity interest in [the two companies] to derive the fair value of the specific fractional interest in each company . . ..”
The judge in that case rejected the expert’s position and refused to apply the proposed discount. Can you guess why?
The answer, according to the judge, is that in actuality the expert was applying a minority discount a/k/a discount for lack of control (DLOC) dressed up as a discount for lack of marketability (DLOM). Why does it matter? Because New York case law holds that under the “fair value” standard applicable in valuation proceedings under Section 1118, as well as under the statute governing dissenting shareholder appraisals (BCL 623), application of a minority discount is prohibited.
The International Glossary of Business Valuation Terms gives the following definitions for DLOC and DLOM:
Discount for Lack of Control–an amount or percentage deducted
from the pro rata share of value of 100% of an equity interest in
a business to reflect the absence of some or all of the powers of
Discount for Lack of Marketability–an amount or percentage
deducted from the value of an ownership interest to reflect the relative
absence of marketability.
DLOM is deducted from the value of the entity as a whole, i.e., it applies to all shares, not just the minority stake being valued, to reflect the relative illiquidity of the shares compared to those of publicly traded companies. DLOC is deducted from the proportionate share of the value of the minority stake being valued, to reflect the affect on cash flows of the absence of control attributes.
Leading valuation expert Shannon Pratt, at page 69 of his standard reference book, “Valuing a Business” (5th Ed.), writes that “[l]ack of control is reflected in the projected cash flows; that is, whether or not control adjustments have been made to the cash flows.” In contrast, he writes, “[m]arketability, or lack thereof, is the ability to sell the interest and obtain cash quickly without loss of value.”
The seminal New York case upholding the use of DLOM and rejecting DLOC under the fair value standard is Matter of Blake decided in 1985 by the Appellate Division, Second Department (107 AD2d 139, 486 NYS2d 341). The Blake court reasoned that the oppressed minority shareholder statute was enacted for the protection of minority shareholders, and that “the corporation should not receive a windfall in the form of a discount because it elected to purchase the minority interest pursuant to [BCL ] 1118.” The New York Court of Appeals (New York’s highest court) in Matter of Penepent Corp., 96 NY2d 186 (2001), offered a somewhat different rationale for the prohibition:
To impose upon petitioning minority shareholders a penalty because they lack control would violate two “central equitable principles of corporate governance.” First, a minority discount would deprive minority shareholders of their proportionate interest in the corporation as a going concern. Second, it would result in shares of the same class being treated unequally.
The Blake decision also endorsed use of DLOM in determining fair value, stating as follows:
A discount for lack of marketability is properly factored into the equation because the shares of a closely held corporation cannot be readily sold on a public market. Such a discount bears no relation to the fact that the petitioner’s shares in the corporation represent a minority interest.
The New York Court of Appeals later placed its imprimatur on DLOM in fair value proceedings in Matter of Seagroatt Floral Co., 78 NY2d 439 (1991), where it wrote:
Valuing a closely-held corporation is not an exact science. Accordingly, courts in such proceedings confront a variety of evidence and methods aimed at determining the price of minority interests in closely-held corporations–legal entities that by their nature contradict the concept of a “market” value. The 1979 amendments to the Business Corporation Law were motivated, in part, by recognition of the fact that shareholders in closely-held corporations, as contrasted with shareholders in public companies, are unlikely to find prospective buyers for their shares. It follows that, whatever the method of valuing an interest in such an enterprise, it should include consideration of any risk associated with illiquidity of the shares. [Citations omitted.]
It’s important to note that New York’s proscription against DLOC under the “fair value” standard does not carry over to other types of valuation proceedings under the “fair market value” standard, such as matrimonial valuation proceedings. (See my prior piece on fair value vs. fair market value here.)
By the way, the testimony quoted at the top of the post is from an unpublished decision in Matter of O’Brien (Academe Paving, Inc.), Index No. 99-2594 (Sup Ct Broome County Sept. 25, 2000). It’s a noteworthy case in which the majority shareholders took some serious lumps by presenting expert valuation testimony by the same appraiser who, before hostilities broke out, valued the combined companies at $7.6 million for purposes of an unconsummated sale to a third party but who later, on behalf of the majority shareholders, re-valued the companies for litigation purposes at a substantially lower number.