As promised in the postscript to last week’s post about the appellate ruling in the Gould case, affirming Justice Platkin’s order granting the oppressed minority shareholder’s dissolution petition involving a pair of construction firms, we now arrive at Justice Platkin’s subsequent determination of the fair value of the minority shareholder’s equity stake.
The decision raises several important issues of interest to business appraisers and business divorce counsel, including selection of tax rates, the appropriate look-back period in determining historical earnings, adjustments for non-arm’s length inter-company transactions, and use of the market approach.
Justice Platkin’s valuation ruling last month in Matter of Digeser v Flach [Gould Erectors & Rigging, Inc.], 2017 NY Slip Op 50220(U) [Sup Ct Albany County Jan. 31, 2017], is the culmination of an oppressed minority shareholder dissolution petition filed in April 2013. In his November 2015 post-trial decision, which I wrote about here, Justice Platkin found that Digeser, a minority shareholder in the two corporations, established grounds for dissolution based on oppression, but he left open the question of remedy.
The majority shareholder, Flach, appealed the decision, but while it was pending the two shareholders agreed that the appropriate remedy is a buy-out of Digeser’s shares at their fair value as of the date of commencement of the dissolution proceeding. In 2016, Justice Platkin conducted a 3-day valuation hearing but held off issuing his ruling until after last month’s appellate ruling affirming his November 2015 decision.
The Companies. Gould Erectors & Rigging is a Subchapter C corporation formed in 1970 to perform commercial construction work. Flach Crane was formed in 1988 by Gould’s owners as a separate corporation to perform crane work. The companies became very successful and profitable, in some years generating millions in profits taken out by the two owners in the form of salary, bonus, and other compensation rather than as declared dividends.
At the valuation trial, the parties stipulated that the value of Digeser’s shares in Flach Crane is $842,000. The trial and Justice Platkin’s decision therefore only concerned the valuation of Digeser’s 24.5% interest in Gould.
Digeser’s Expert’s Appraisal
Digeser’s expert valued Gould using the single period capitalization method in which he relied exclusively on Gould’s financial statements for its fiscal year ended 9/30/12. He normalized Gould’s earnings by adjusting for depreciation, excess owners compensation, non-business related expenses, charitable contributions, and non arm’s-length payments to Flach Crane. He then applied a 25% corporate tax rate to Gould’s pre-tax earnings on the assumption that a hypothetical purchaser would elect to convert Gould to a Subchapter S corporation in order to avoid double taxation. He next applied a 20.1% capitalization rate to the after-tax earnings, added $4.4 million for non-operating assets, and applied a 10% marketability discount, arriving at an enterprise value of about $14.6 million thereby valuing Digeser’s interest at approximately $3.7 million.
Flach’s Expert’s Appraisal
Flach’s expert also capitalized Gould’s historical earnings, but instead of using a single period he relied upon a weighted average of four fiscal years. His analysis also parted ways with Digeser’s appraisal (1) by applying a combined tax rate of 38.7% reflective of Gould’s current status as a C corporation; (2) by normalizing Gould’s earnings for large underpayments to Flach Crane; and (3) by using a market approach to which he assigned a 20% weighting. Flach’s expert concluded that Digeser’s Gould shares had a far value of about $2.3 million.
The Court’s Analysis
Justice Platkin’s decision focused on four areas of difference between the opposing appraisals:
Weighting/Averaging of Income Periods. Justice Platkin rejected Digeser’s expert’s reliance on a single period for his capitalization method, citing the expert’s cross-examination testimony acknowledging “the additional risk associated with a valuation based upon a single year.” He agreed with Flach’s expert that “a willing purchaser is more likely to consider a business’s fiscal performance over a period longer than a single year” but determined not to give any weight to periods prior to 2011, and assigned equal weight to the two most recent years (2011 and 2012).
Adjustments for Related-Company Transactions. This factually complex topic took up a major portion of Justice Platkin’s decision, involving detailed, widely disparate analyses by the two experts in which each made differing assumptions about the market value and the extent of crane and mechanical services provided by Flach Crane to Gould versus actual payments made by Gould. Justice Platkin concluded that the opinion of Digeser’s expert in this regard lacked support in the record, but he also found that certain of Flach’s expert’s adjustments “are excessive and should be reduced.” The court’s adjusted reductions decreased by almost $700,000 the amount of Gould’s 2011 payments to Flach Crane and increased by almost $500,000 Gould’s 2012 payments.
Tax Rate. In support of his 25% tax rate used to compute the net cash flow to equity, Digeser’s expert contended that Gould’s owners effectively operated the corporation as a pass-through entity and avoided double taxation attendant to C corporations “by distributing de facto dividends in the form of excessive compensation and payment of the owners’ personal expenses,” and that “it would be a simple matter for a purchaser of Gould to convert to S corporation status.” Justice Platkin disagreed, noting the expert’s testimony on cross-examination “that this conversion would not be available if Gould were purchased by a C corporation”; that “conversion of Gould to an S corporation prior to sale would limit the universe of potential buyers”; that Gould “was a C corporation, not an S corporation, on . . . the pertinent valuation date”; and that even if converted to an S corporation the proposed 25% rate “is well below the marginal income tax rate that would be applied to dividends and excess compensation from such an entity.” Justice Platkin accordingly saw no “basis for deviating from the 38.7% combined taxation rate generally applicable to C corporations such as Gould.”
Use of Market Approach. As noted above, Digeser’s expert relied solely on an income approach whereas Flach’s expert also used the market approach to which he assigned a weighting of 20%. Relying on four private company market databases, Flach’s expert opined that Gould had a total value of $5.8 million — far short of his value based on his income approach. Justice Platkin declined to give any weight to the market approach, finding “no record basis for concluding that the contractors selected by [Flach’s expert] actually are comparable to Gould.”
The Court’s Conclusion of Fair Value
Based on his resolution of the above differences between the two appraisals, and adopting for the most part the analysis supplied by Flach’s expert, Justice Platkin assigned a fair value of about $2.8 million to Digeser’s Gould shares as of the April 2013 valuation date. Here’s how he laid it out in the decision:
In valuing petitioner’s shares in Gould, the Court begins with the analysis supplied by [Flach’s expert], which the Court finds persuasive, credible and well-supported, except to the extent specifically indicated herein. Thus, the Court begins with Gould’s normalized income for fiscal years 2011 and 2012, and then modifies respondent’s proposed normalization for non arm’s length transactions between Gould and Flach Crane in accordance with the foregoing. The Court then computes an average of the revised normalized incomes for the two fiscal years ($2,691,938). After reducing this figure by the combined income tax rate (38.7%) and non-owner’s market-based replacement compensation, and further adjusting for expected non-cash charges, expected capital expenditures and working capital reserves, the Court determines the net cash flow to equity, which is $1,419,287.
Application of the discount rate proposed by [Flach’s expert], which the Court finds reasonable and substantially similar to the rate applied by [Digeser’s expert], then results in a capitalized value for Gould of $7,797,826. With the addition of the non-operating assets owned by Gould, the total fair value of the corporation as of April 30, 2013 is found to be $11,415,976, and the value of petitioner’s shares on such date is found to be $2,795,750.
Interest on the Fair Value Award
The last contested item addressed in the decision was Digeser’s request for interest on his fair value award from the valuation date at the general 9% statutory rate for pre-judgment interest. Justice Platkin noted that under the governing case authority, “justice” normally “requires” payment of interest at an “equitable” rate that may or may not equal the statutory rate.
Flach argued against any award of interest (1) because of Digeser’s “bad faith” conduct that allegedly justified Flach freezing him out of the business, and (2) because Digeser has been competing against Gould since filing his dissolution petition.
Justice Platkin disagreed on both counts, noting that the court previously rejected the bad-faith allegation in its 2015 decision in Digeser’s favor, and that Digeser’s need to earn a living after being terminated by Flach likewise negated any bad faith associated with his post-termination employment at a competing company owned by his wife.
Flach evidently offered no evidence at trial regarding an equitable rate of interest, hence Justice Platkin ordered an award of interest at the 9% statutory rate. In a footnote Justice Platkin also observed that Flach made no request to the court concerning payment terms. The court’s order thus requires Flach to pay Digeser over $3.6 million plus pre-judgment interest within 60 days from entry of judgment.
Closing Thoughts. It took the better part of four years and who knows how much in legal and expert fees to get to a buy-out in the Gould case. I have no clue whether buy-out discussions occurred before the litigation or in its early stages or, if they did, how far apart the numbers were. The fact that the parties were able to agree at trial on the value of Flach Crane, and that Justice Platkin’s valuation of Gould was not that far off the midpoint between the two experts’ appraisals, certainly suggests that, perhaps with the help of a skillful mediator, the parties could have negotiated a similar buy-out agreement without enduring years of litigation.