Owners of small, closely held companies usually play key roles in the sales, operations, administration and finance of the business.  When the controlling shareholders terminate the employment of a minority shareholder who then petitions for dissolution, and whose shares are later valued in a contested “fair value” buyout proceeding, should the court apply a so-called key person discount reflecting the company’s potential diminished value from the loss of the minority shareholder’s services?

This was but one of several, thorny issues confronted by Special Referee Louis Crespo, whose 50-page Report and Recommendation valuing at $3.2 million a 49% interest in a company that leases, sells and services office copiers and other equipment, was recently confirmed by Manhattan Commercial Division Justice Barbara R. Kapnick in a case called Matter of Abraham (Elite Technology NY, Inc.), 2010 NY Slip Op 33225(U) (Sup Ct NY County Nov. 10, 2010).


The subject company, known as Elite Technology, was founded in 1993 by Hanhui (“Henry”) Lu and Yong Hong (“Jane”) Fan as sole shareholders.  In 2003, Phillip John and Thomas Abraham became sales managers and shareholders of Elite with a combined 49% interest.  Lu, as president, was in charge of management and the service department.  Fan headed finance, bookkeeping and accounting.  From 2003 to 2006, Elite expanded from one office to three with a sales staff of 26.  In that same period the gross revenues rose from $2.4 million to $6.4 million, with a high of $8.3 million in 2005.

Beginning in early 2006 the majority and minority factions had a falling out.  In July 2006, Lu terminated John’s and Abraham’s employment, contending that they were neglecting their sales responsibilities while continuing to charge entertainment expenses to the company.

The following month John and Abraham jointly filed a petition for judicial dissolution of Elite under Section 1104-a of the Business Corporation Law.  Their petition for minority shareholder oppression (read here) alleges that the majority shareholders blocked them from participating in Elite’s governance, and wasted and depleted Elite’s assets.  The majority shareholders responded by electing under BCL Section 1118 to purchase the petitioners’ shares for fair value as determined by the court.

The Expert Testimony

Special Referee Crespo held four days of hearing featuring the testimony of dueling valuation experts.  The expert for respondents Lu and Fan was a credentialed business appraiser and CPA associated with a large accounting firm.  Using an income approach, he calculated a normalized, tax affected free cash flow of $187,000 to which he applied a build-up capitalization rate of 25% which included a 6% key person discount reflecting the contributions by John and Abraham to the company’s success and the difficulty in replacing them.  After adjusting his capitalization rate for 4% long-term growth, and making other adjustments including a 25% discount for lack of marketability, Respondents’ expert opined that the value of the petitioners’ 49% stock interest was $527,240.

Petitioners’ expert was a CPA and Professor of Accounting with no valuation certifications and only one prior professional engagement as a business appraiser.  He used both income and market value approaches, assigning them two-thirds and one-third weights respectively, to arrive at a value for the petitioners’ 49% stock interest of almost $3.9 million, or over seven times the value opined by Respondents’ expert.  The huge variance is due to a variety of factors, including Petitioners’ expert’s exclusion of any key person discount or tax affecting; his assumption of a 7% long-term growth rate; his reliance on 2004-05 earnings instead of 2006; his substantially larger normalization adjustments for excess officer and related-party compensation and perks (e.g., by increasing 2004 reported net income of $246,000 to over $1.1 million); his determination of an 18.84% capitalization rate which excludes a specific company risk factor; and his use of a 19% marketability discount.

The Court’s Rejection of Key Person Discount

The theory (if not the application) of a key person discount is straightforward: when a business is highly reliant on one or more key employees, a valuation discount may be appropriate to account for the risk of reduced future earnings if such persons are lost.  The IRS, in its Valuation Training for Appeals Officers Coursebook, defines key person as

an individual whose contribution to a business is so significant that there is certainty that future earnings levels will be adversely affected by the loss of the individual.

In Section 4.02(b) of its Revenue Ruling 59-60, the IRS explains that, in determining whether to apply a key person discount, factors to be considered include (1) whether the claimed individual was actually responsible for the company’s profit levels, and (2) if there is a key person, whether the individual can be adequately replaced.

June 2010 article in BVWire (Issue 93-1) notes the lack of clarity surrounding the key person discount.  One attendee at a business appraiser conference is quoted saying that “there’s really nothing in the literature that really supports” the discount.  The article also comments that many business appraisers are “more comfortable trying to account for this factor by adjusting either the income stream, or the company specific risk component of the discount rate” as opposed to applying a separate percentage discount.

In his Report (pp. 42-45, paras. 55-68), Referee Crespo acknowledges New York case law — at least in the matrimonial valuation context — permitting key person discounts, including a key person discount “combined as part of a marketability discount” (citing Beckerman v. Beckerman, 126 AD2d 591 (2d Dept 1987), and Muller v. Muller, 116 Misc 2d 660 (Sup Ct Nassau County 1982)).

Referee Crespo nonetheless concludes that, “[i]n the circumstances of this case applying a key person discount in addition to the lack of marketability discount would be error.”  He gives five, specific reasons:

  1. In an affidavit at the outset of the case, respondent Lu averred that the two respondents “were not material to the increase of sales of Elite.”  The Referee discredits Lu’s later testimony at trial to the opposite effect.  In addition, Lu “easily replaced John with a new manager” for one of Elite’s offices one year before terminating the petitioners.
  2. Abraham testified that by the time petitioners left Elite, the company had “a large sales staff in place, already trained and working under two other managers.”  Additionally, Elite replaced both petitioners a year after their termination and revenues increased after they left.  “The credible proof,” Referee Crespo writes, “supports the finding that [neither] Abraham nor John was unique, irreplaceable sales persons/managers.”
  3. Respondents’ expert’s “ignorance to his own clients’ averred facts (sworn statements) and his unequivocal reliance on what his clients told him after litigation commenced” led Referee Crespo “to conclude that his testimony on key person discount is of no credible moment.” (N.B.: Be sure not to overlook footnote 12 on page 13 of the Report, where Referee Crespo comments that “paid experts are in most instances alter egos of their clients” and quotes commentary referring to “the unfettered ability of the attorneys who retain them to direct, control and shape their testimony.”)
  4. Respondents’ expert also failed to explain whether the 6% key person discount was mooted after Referee Crespo permitted him, over petitioners’ objection, to orally modify his report to add a 25% marketability discount.  (N.B.: Coincidentally or not, the 19% marketability discount used by petitioners’ expert is 6% lower than the marketability discount adopted by the Referee.)
  5. Petitioners’ expert credibly testified that no key person discount was necessary “as Abraham and John were clearly replaceable, the revenue of sales increased . . . after petitioners’ departure, and that other multiples and discount factors incorporate or reference a key person discount.”

Referee Crespo buttresses his conclusion with the following observations:

The heart of the business is not based on any unique, G-d given ability or specialized service of Abraham or John, but on the training that was implemented and continues to this day.  Abraham’s testimony that he trains staff to do the work and that after that training is completed, it is the team that brings about results and not one individual, is credible. . . .  The proof suggests that at the beginning the petitioners’ services were critical, but by the end of their tenure, their services were no longer unique or irreplaceable. . . . I agree with [petitioners’ expert’s] opinion and the credible proof that the key person discount proposed by [respondents’ expert] ignores that the buyers are already in this business and have a presence in the industry and that any “slippage” in revenue was temporary.  . . . It is clear to the fact finder that Abraham and John did not rule the whole show.

Referee Crespo accordingly rejects respondents’ expert’s 6% key person discount.

Other Rulings of Interest

Referee Crespo’s Report contains numerous additional rulings of interest which I’ll just mention briefly with page references to the Report for those who want to learn more:

  • Neither side has the burden of proof in a valuation proceeding (p. 30, para. 2).
  • Referee Crespo rejects respondents’ argument that petitioners’ expert lacks the qualifications to opine on valuation (p. 31, paras. 9-10).
  • Referee Crespo gives “very little weight” to Petitioners’ expert’s partial reliance on the market value approach, finding “flaws” in his market value multiples (pp. 33-34, paras. 17-21).
  • Respondents’ expert’s consideration of revenues in 2006, including after petitioners were terminated, resulted in a “skewed analysis of value” (pp. 36-37, paras. 30-33).
  • Referee Crespo accepts petitioners’ expert’s reliance on a salary survey by the staffing firm, Robert Half, over respondents’ objection that there is no reported court decision accepting that particular survey (p. 37, paras. 35-37).
  • Referee Crespo accepts most but not all of the net income normalization adjustments made by petitioners’ expert, resulting in 2004-05 average normalized income of about $935,000 (p. 39, para. 43).
  • Referee Crespo agrees with petitioners’ expert’s failure to tax affect Elite’s net income, citing a number of case precedents and commentary (pp. 40-41, paras. 45-48).
  • Referee Crespo agrees with petitioners’ expert’s use of a 9.83% small company risk premium but rejects his exclusion of an industry premium, finding no support for his opinion that Elite is “less riskier than other companies in the same industry” (pp. 41-42, paras. 52-54).
  • Referee Crespo concludes that the appropriate capitalization rate is 16.51% computed as follows: 5.08% for risk-free + 7.10% for equity risk return + 9.83% for small company size premium = 22.01% less 5.50% long-term growth rate (computed as the average of the respective experts’ proposed 4% and 7% rates) (pp. 45-46, paras. 69-71).
  • Referee Crespo recommends that a deferred payment schedule for the fair value award be ordered; that interest be awarded at 4%; that no attorney’s fees be awarded; and that court costs and disbursements be apportioned two-thirds to petitioners and one-third to respondents (pp. 48-49, paras. 81-84).

The Referee’s Final Valuation

Applying the Gordon Growth Model used by both experts, Referee Crespo computes a valuation multiple of 9.38 which he applies to the average normalized income for 2004-05 of about $935,000 resulting in an enterprise value for Elite of approximately $8.76 million.  He finds reasonable a 25% discount for lack of marketability based on respondents’ expert’s testimony and relevant case precedent, thereby lowering Elite’s value to $6.57 million generating a value of approximately $3.22 million for petitioners’ 49% interest.

The Court’s Order Confirming the Referee’s Report 

The petitioners moved to confirm Referee Crespo’s Report in all respects, while the respondents moved to confirm in part and reject in part the Report.  Petitioners also requested that the court set a pay-out period of no more than six months.

In her decision, Justice Kapnick states that the findings of fact and conclusions of law contained in Referee Crespo’s Report have substantial support in the record of the proceedings and therefore must be confirmed.  She specifically rejects respondents’ argument that Referee Crespo should have given more weight to their credentialed valuation expert than to petitioners’ non-credentialed expert.  She also rejects respondents’ challenge to the Referee’s refusal to apply a key person discount; she lets stand his decision not to tax affect Elite’s earnings; and she approves his reliance on the Robert Half salary data utilized by petitioners’ expert.

Finally, Justice Kapnick orders that respondents pay the $3.22 million award over a one-year period rather than the six months requested by petitioners, with interest at 4% from the filing date of the petition.