This is the final installment of a three-part series about the basics of contested New York business appraisal proceedings. The first post addresses the various ways in which business owners can steer a dispute into an appraisal proceeding. The second post addresses the legal rules and principles that apply in appraisal proceedings. This final post addresses the appraisal methodologies and principles that apply in valuation proceedings. Without further ado, let’s talk accounting.
The date on which a business interest is appraised – the “valuation date” – can have a huge impact on its worth. For example, for a real estate holding company in a rising market, generally speaking, the later the valuation date the greater the value. If the valuation date is earlier, the seller may receive and the buyer may pay less for an ownership stake. For most kinds of appraisal proceedings, the valuation date is set by statute, so there is little to litigate on the subject.
Under Partnership Law 69 and 73, a wrongfully withdrawn, retired, or deceased partner is entitled to have the “value” of his or her interest determined as of the date of “dissolution,” meaning the event of withdrawal, retirement, or death.
Under BCL 623, a dissenting shareholder is entitled to “fair value” “as of the close of business the day prior to the shareholders’ authorization date” – for example, the day before a shareholder vote to effectuate a corporate merger.
Under BCL 1104-a and 1118, upon an election to purchase by the respondents, a shareholder suing for dissolution based on oppression is entitled to fair value “as of the day prior to the date on which such petition was filed.”
Under LLC Law 509, unless provided otherwise in the operating agreement, a withdrawing LLC member is entitled to fair value “as of the date of withdrawal.”
Under LLC Law 1002, an LLC member who dissents from a merger is entitled to fair value “as of the close of business of the day prior to the effective date of the merger.”
A notable exception to the general rule that the valuation date is determined by statute is the LLC equitable buyout. Because the LLC equitable buyout is a common-law remedy, there is no fixed statutory valuation date. In In re Superior Vending, 71 AD3d 1153 [2d Dept 2010], for example, the court affirmed a valuation date of November 2002, the date the bought-out member effectively withdrew from the LLC’s affairs, nearly five years before the buying-out member sued for dissolution. The case law in this area is developing and unsettled.
“Known or Knowable” Future Events
What information may appraisers and courts consider as of the valuation date?
“The Court may consider the company’s past performance as well as future events that are ‘known or susceptible of proof’ as of the valuation date” (Ferolito v AriZona Beverages USA LLC, 2014 NY Slip Op 32830(U) [Sup Ct, Nassau County Oct. 14, 2014]). “But the Court must not speculate about the company’s future performance.”
This means a few things. First, courts generally may not consider the company’s financial performance post-valuation date. Second, if significant upward or downward forces on value were “known” at the valuation date, then a court may consider them. Third, if events occurred post-valuation date that were not “known,” even if they had a tremendous impact on value, the court is generally prohibited from considering them. For example, in Murphy v U.S. Dredging Corp., 74 AD3d 815 [2d Dept 2010], the court affirmed the disallowance of a $2,000,000 pension liability incurred one month after the valuation date, significantly reducing the value of the business, because in the court’s view it “did not constitute a future event which was ‘known or susceptible of proof’ as of the valuation date.”
The concept of “known or knowable” means that courts also cannot consider the “synergistic” value of a sale to a “strategic” purchaser. In Ferolito, the court explained that it “may not consider Arizona’s ‘strategic’ or ‘synergistic’ value to a hypothetical third-party purchaser . . . . A valuation that incorporates such a ‘strategic’ or ‘synergistic’ element would not rely on actual facts that relate to AriZona as an operating business, but rather would force the Court to speculate about the future.”
The Three Methods for Determining “Value”
The three accounting methodologies for determining the value of a business are (i) the asset approach, (ii) the income (i.e., investment) approach, and (iii) the market approach. “[A]ll three appraisal methods do not have to influence the result in every valuation proceeding. It suffices if they are all considered” (Cawley v SCM Corp., 72 NY2d 465 ).
Very simply stated, the asset approach determines the value of a business based on the sum total of its assets and liabilities. “Net asset value is generally the standard applicable in evaluating . . . real estate and investment holding companies” (Matter of Blake v Blake Agency, 107 AD2d 139 [2d Dept 1985]).
The income approach determines the value of a business as a function of its net operating income. The income approach is most commonly used in valuing operating businesses, like sales or service-oriented business. For example, in Ferolito, both parties adopted a valuation of AriZona Beverages USA LLC using the investment approach by calculating the company’s Discounted Cash Flow.
The market approach determines the value of a business based on sales of comparable firms or one of the guideline methods using comparable public company transactions. The market approach is less frequently used than the asset or income approaches because it is often difficult to find sales of “comparable” businesses – closely-held businesses tend to be unique and thus “comp” defying (see e.g. Matter of Vetco, Inc., 292 AD2d 391 [2d Dept 2002] [rejecting market approach because companies used were not in “similar financial situations”]).
Before arriving at a valuation, appraisers often make “adjustments” to a company’s historical financial statements to reflect more accurately the business’s true value. Normalizing adjustments are often made to account for items that cause the company’s value, according to its financial records, to be potentially skewed, including owners’ compensation and perquisites, above- or below-market rent, and extraordinary or non-recurring items unrelated the company’s ordinary day-to-day affairs.
After determining the top line value of the entity as of the valuation date, certain discounts – depending on the kind of entity – may (but not necessarily will) apply. The following three discounts are frequently encountered but are not the only ones.
The Discount for Lack of Marketability
The discount for lack of marketability (“DLOM”) is permissible, but not necessarily required, in partnership, corporate, and LLC appraisal cases under both the fair value and fair market value standards. As the Court explained in Congel v Malfitano, 31 NY3d 272 , DLOM is “a deduction from the value of [an] ownership interest reflecting the relative illiquidity or deficit in marketability of the interest.” The idea is that an arms-length purchaser may be less (or dis)inclined to buy shares in a closely-held entity because it may be difficult to liquidate those shares for cash.
Recently, in some instances courts have declined to impose DLOM for companies where the owners have no real inclination to sell the business or other circumstances render application of DLOM unfair. In Zelouf Intl. Corp. v Zelouf, 47 Misc 3d 346 [Sup Ct, NY County 2014], the court noted that “no New York appellate court has ever held that a DLOM must be applied to a fair value appraisal of a closely held company.” The court declined to impose a DLOM because the majority shareholders testified they would never sell the business, rendering a discount for lack a marketability, in the court’s view, only theoretical and thus unfair. The court reached the same conclusion in La Verghetta v Lawlor, 2016 NY Slip Op 30423(U) [Sup Ct, Westchester County Mar. 9, 2016], holding that a marketability discount would have been “inappropriate in this context” because the majority “made clear in their testimony that they did not intend to sell . . . and that no amount of money would tempt them to do so.”
There are also cases in which courts have declined to apply marketability discounts to real estate holding companies, on the theory that lack of marketability or illiquidity is already incorporated into the market value of the underlying real estate asset. Examples of such cases include Chiu v Chiu, 125 AD3d 824 [2d Dept 2015], and Kassab v Kasab, 56 Misc 1213(A) [Sup Ct, Queens County 2017].
The subject of discounts has resulted in a great deal of litigation and debate. This blog has written about the subject many times, including here and here. Whether discounts will apply in any particular case depends on a number of factors, including the form of entity, the kind of asset it owns, the circumstances leading to an appraisal proceeding, and the unique facts and circumstances of the case.
The Discount for Lack of Control
The second kind of discount – permissible in partnership dissolution cases, impermissible in corporation (and likely also LLC) dissolution cases – is the discount for lack of control (“DLOC”). In Congel, the Court of Appeals held that it was appropriate under the facts of that case to impose an unusual, massive 66% discount on the withdrawn partner’s 3% interest in the business attributable to his lack of control / minority status in the business. Congel explained the minority discount as reflecting the fact that a willing, arms-length purchaser would likely pay far less for a minority, non-controlling stake in the business than a majority stake – in the Court’s view “a minority interest is worth less to anyone buying that interest alone.”
Outside of partnership dissolution cases, DLOC is categorically prohibited in New York cases applying the statutory fair value standard. The Court of Appeals has long held that, in the context of corporations, to “impose upon petitioning minority shareholders a penalty because they lack control would . . . deprive minority shareholders of their proportionate interest in the corporation as a going concern” and “would result in shares of the same class being treated unequally” (In re Dissolution of Penepent Corp., Inc., 96 NY2d 186 ).
The Goodwill Discount
The third discount – permissible only in wrongful partnership withdrawal cases – is the discount for goodwill. This discount comes via the express language of Partnership Law 69, which states that in determining “value” of the wrongfully withdrawn partner’s interest, “the good-will of the business shall not be considered.” In Congel, the Court of Appeals affirmed a 15% reduction in the value of a minority owner’s interest in a shopping mall attributable to the entity’s goodwill, rejecting the partner’s contention that “goodwill does not exist in a real estate holding.” The Court held that whether an entity has discountable goodwill “is a factual one,” and in that case, “the shopping mall and the mall’s tenants attract regular, loyal shoppers,” so there was evidentiary support for the trial court’s finding that “the value of the Partnership included, in addition to its real property and cash, a goodwill component.”
At long last, after determining the value of a business interest, and applying any applicable discounts to arrive at a bottom line number, the court must award pre-judgment interest. Pre-judgment interest is mandatory, as many courts have held, but the rate of interest is discretionary. In practice, however, courts tend to stick to the statutory rate of 9% under CPLR 5004 (see e.g. Ferolito v AriZona Beverages USA LLC [“prejudgment interest must be awarded at an ‘equitable’ rate. Typically, that rate does, in fact, mirror the statutory nine percent rate”]).
If one had to summarize the difficult area of business appraisals in a few pithy sentences, one could say the following. First, there are few hard and fast rules of law. Second, the rules that do apply will depend primarily on the kind of entity, the kind of underlying asset, and the equities of the particular dispute (i.e., general notions of fairness). Third, there is a tremendous amount of room for courts to exercise their discretion in arriving at a correct valuation. Fourth and finally, because of the lack of concrete rules, and the great deal of judicial discretion, the experience, skill, and credibility of the appraisers (and lawyers) is vital. Choose wisely.