In determining the fair value of corporate shares, should the discount for lack of marketability (DLOM) apply only to the company’s good will value, or to the entire enterprise value including tangible assets? Court decisions in New York tend to apply DLOM in the 25% range, so the answer can make a big difference in the ultimate award, particularly when the business is asset-heavy.
I’ve written before (read here) about conflicting case precedents in the Manhattan-based First Department (DLOM applies to enterprise value) and the Brooklyn-based Second Department (DLOM applies to good will value). Permit me to quote from that prior post, where I wrote:
With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it’ll likely take some yet-to-be-born big-money valuation case to wend its way up to New York’s highest court, the Court of Appeals, before we get a definitive answer.
Well, we still don’t have a definitive answer from the Court of Appeals, but we do have a new decision on the subject from one of the upstate departments. The result aligns the Rochester-based Fourth Department with the First Department (DLOM applies to enterprise value), but the decision offers no analysis and, if anything, further muddies the DLOM waters.
The Fourth Department’s decision in Matter of Rateau (DAPA Communications, Inc.), 59 AD3d 1037, 2009 NY Slip Op 00890 (4th Dept 2009), took an unusual path. DAPACom, founded in 1989 and based in Allegany, New York, manufactures and installs tower and antenna systems. The case started as a petition by 34% shareholders to dissolve the company under the minority shareholder oppression statute, Section 1104-a of the Business Corporation Law (BCL). The majority shareholders then caused DAPACom to elect to purchase the petitioner’s shares for fair value under BCL Section 1118. At the valuation trial, the petitioner’s expert valued the company between $728,000 and $755,000 using the adjusted net asset value method. This method, which basically adopts the company’s book value as adjusted for fair market value of assets and liabilities, normally undervalues an operating business and therefore is rarely given much if any weight by either side, and even less so by the party being bought out. In any event, using this method the petitioner’s expert computed the pro rata value of petitioner’s 34% interest around $250,000. DAPACom’s expert, using the income and market approaches to value the company as a going concern, testified that the petitioner’s shares had zero value, reflecting the company’s cumulative losses of $1.9 million in the four years prior to the valuation date. He alternatively valued the shares at $26,000 using the adjusted net asset approach after applying a 25% minority discount a/k/a discount for lack of control (DLOC) and a 30% DLOM.
In the first of two lower court decisions leading to the appeal, Cattaraugus County Judge Larry M. Himelein noted the three basic methods used to determine the going-concern value of a company: market value, investment or income value, and net asset value. The problem with DAPACom’s expert’s income and market approaches, observed Judge Himelein, was that "if the business were truly worth nothing, it would not continue to operate." Therefore, he went on, "based on the information provided, the court has no choice but to ascertain the company’s net asset value." Judge Himelein criticized the petitioner’s valuation of the company’s equipment because it was based, at least in part, on advertised prices without any indication of what the actual selling prices of the items were. Based on the court’s review of the testimony and the exhibits, Judge Himelein arrived at a "liquidation value" of the company of $180,000.
Judge Himelein then tackled discounts. First, citing numerous case authorities, he found "inappropriate" DAPACom’s expert’s application of a 25% minority discount (DLOC). He next addressed DLOM, writing as follows:
[Respondents’ expert] also applied a 30% lack of marketability discount, which is appropriate for an operating business. However, a lack of marketability discount may or may not be appropriate when talking about selling hard assets. On the other hand, there would be significant costs involved in selling off the equipment, i.e., advertising, auctioneers and the like. Therefore, whether deemed a lack of marketability discount or a cost of sale discount, the court will apply a discount of thirty percent. [Citations omitted.]
With a 30% discount, the value of the petitioner’s 34% interest was computed at $42,840.
The case took another turn pre-appeal, when the petitioners made a post-trial motion challenging the court’s valuation including its consideration of a cost-of-sale discount. In the second of his two written decisions, Judge Himelein expressed his "discomfort" using net asset value to value the company, but he went on to say that he had no choice but to use it given his rejection of DAPACom’s expert’s zero valuation of the company "as a going concern." Judge Himelein rebuffed the petitioner’s critique of his valuation of the company’s equipment based on the conflicting trial testimony, but he agreed with the petitioners that he should not have considered cost-of-sale discount, writing as follows:
The court noted that it was not clear that a lack of marketability discount was appropriate when selling off hard assets but there clearly would be costs associated with such a sale. However, petitioners are correct in their contention that no proof of an appropriate discount was introduced, and theoretically, if the company sold its assets, there might be little, if any, costs associated with the sale.
On that basis Judge Himelein vacated the 30% discount and increased the petitioner’s valuation award to $61,200.
DAPACom appealed from the modified award. It argued that (1) the case authorities require application of marketability discount; (2) the lower court should have valued DAPACom as a going concern and not based on its liquidation value; and (3) the lower court’s $180,000 net asset valuation was "arbitrary and capricious". It did not argue for application of a cost-of-sale discount as postulated in Judge Himelein’s original order. (See bottom of page for links to all the appellate briefs.)
In their brief opposing the appeal, the petitioners cited Second Department case law, including Matter of Cinque, 212 AD2d 608 (1995), Matter of Whalen, 234 AD2d 552 (1996), and Cohen v. Cohen, 279 AD2d 599 (2001), to argue that the lower court properly excluded DLOM since the company’s valuation based on adjusted net asset value did not include any good will. They also argued that the lower court’s use of the adjusted net asset value was proper because (1) DAPACom’s expert acknowledged that the company had a "tangible net value" even if it was losing money from its operations, and (2) liquidation value generally is lower than going concern value, so DAPACom had no basis to complain.
DAPACom’s reply brief argued that under the Court of Appeals’ decision in a matrimonial valuation case, Amodio v. Amodio, 70 NY2d 5 (1987), the court must apply DLOM in valuing the shares of a closely held corporation. The brief did not directly respond to petitioner’s Second Department cases, nor did it refer to the First Department’s decision in Hall v. King, 265 AD2d 244 (1999), which affirmed a lower court ruling that applied DLOM to net asset value and expressly disagreed with the Second Department cases. (DAPACom’s initial appeal brief cites Hall v. King but without any discussion of it.)
The Fourth Department’s decision on the appeal is disappointingly brief, devoting only one sentence to the DLOM controversy which it decided in DAPACom’s favor as follows:
We agree with DAPACom, however, that the court erred in failing to apply a discount for the lack of marketability of petitioners’ shares in DAPACom (see Seagroatt Floral Co., 78 NY2d at 445-446; Amodio v Amodio, 70 NY2d 5, 7 ; Hall, 265 AD2d 244 ; cf. Matter of Whalen v Whalen’s Moving & Stor. Co., 234 AD2d 552, 554 ; Matter of Quill v Cathedral Corp., 215 AD2d 960, 963 , lv dismissed 86 NY2d 838 ).
Note how the decision cites both Hall v. King and Matter of Whalen even though the two cases disagree on the very issue before the court. The cite to Whalen is preceded by the "cf." signal which means the case cited supports by analogy the stated proposition. I find that very hard to fathom given Whalen‘s express limitation of DLOM to the good will component of a company’s value of which there was none in the case at hand. Go figure.
DAPACom did not fare as well on its argument that the lower court failed to value the company as a going concern. Here’s what the Fourth Department said:
Contrary to DAPACom’s contentions, we conclude that the court properly valued DAPACom " ‘as an operating business’ " and that the court properly used the net asset valuation method. We further conclude that the court’s valuation of DAPACom falls "within the range of testimony presented" and should not be disturbed. [Citations omitted.]
I’m advised by case counsel that, on remand following the appeal and without a written decision, Judge Himelein entered amended judgment using a 20% DLOM (down from 30%) to value the petitioner’s shares.
No doubt about it, Matter of Rateau is a quirky case that not only fails to shed new light on an important facet of New York stock valuation proceedings, but only confuses the matter by its reliance on contradictory precedent. I wish the lower court decisions, and the appellate briefs, had focused more directly on the issue whether DLOM applies to entire enterprise value or only good will. I wish the Fourth Department had written a decision that acknowledged the split between the downstate departments and that offered a reasoned explanation for its seeming agreement with the First Department’s position in Hall v. King.
Update October 13, 2009: Readers interested in this topic will want to read my recent post on the Jamaica Aquisition case in which the Nassau County trial court sided with Hall v. King in applying 25% DLOM to the entire enterprise value of several real estate holding corporations.