Three shareholders co-own an 8-year old internet-based “marketeer” business that imports Chinese-manufactured sinks, faucets, and related plumbing fixtures that it sells primarily to distributors and retailers in the United States. They successfully apply with a bank for an increased credit facility up to $10 million. The loan application includes monthly cash flow projections prepared by the company’s CFO forecasting over 40% increase in sales the following fiscal year. The owners also submit their personal net worth statements valuing the company around $30 million.

The executed loan agreement includes borrower representations that the cash flow projections have a “reasonable basis.” The personal financial statements include signed certifications that the statements “are true and give a correct showing of my financial condition” and that the statements are submitted to “induce” the bank to extend credit and knowing that the bank “will rely upon the accuracy of all information and representations contained in this financial statement.” Applicable federal law criminalizes the knowing submission of false information to the bank to obtain a loan.

Three months later, one of the owners claiming shareholder oppression petitions for judicial dissolution. The other owners exercise their statutory right to purchase the petitioner’s 24% interest for “fair value.” By statute, the valuation date is the day before the filing of the petition, i.e., also about three months after the cash flow projections and personal financial statements were prepared and submitted to the bank.

At trial, the petitioner trumpets the respondents’ $30 million company valuation on their net worth statements given to the bank and the bank’s reliance thereon. Petitioner’s valuation expert, building on the management projections supplied to the bank, values the company around — you guessed it — $30 million giving 50/50 weight to his discounted cash flow (DCF) income approach (approximately $21.4 million) and his guideline public company market approach (approximately $38.8 million).

The court in its post-trial decision values the company around $6 million or 20% of the value concluded by the petitioner’s expert. Where did the other $24 million go? Read on and find out.

The Company

The above-described scenario played out in a lawsuit captioned Magarik v Kraus USA, Inc., that lasted almost four years, culminating last month with a post-trial decision by Nassau County Commercial Division Justice Vito M. DeStefano.

The company at the center of the dispute, Kraus USA, Inc. is a New York S-corporation founded in 2007 with around 50 employees headquartered on Long Island. Kraus imports and primarily wholesales kitchen and bathroom sinks, faucet and accessories sold online and through commercial distribution channels in partnership with major retailers such as Home Depot, Amazon, and Lowe’s.

Kraus’s three shareholders included the petitioner Sergio Magarik (24%) and respondents Michael Rukhlin (25%) and Russell Levi (51%).

The company pursued a seemingly aggressive growth strategy in the years preceding the September 30, 2015 valuation date, with gross sales rising from $21 million in 2012 to $36 million in 2015. Total stockholders’ equity fluctuated between $1 million and $2 million between 2011 and 2014.

The Company Obtains a $10 Million Credit Line in Mid-2015

In July 2015, Kraus refinanced its existing $5 million debt and closed on a revolving credit line with Bank Hapoalim with a maximum borrowing base of $10 million. As noted above, each of the owners submitted to the bank personal net worth statements valuing their stakes in the company based on a $30 million valuation. According to the respondents’ post-trial brief, Ruhklin testified at trial that the three shareholders understood that their value estimates “didn’t have a big effect” on the bank’s asset-based credit line and, after meeting for “about a minute,” agreed to Magarik’s suggestion to use the company’s gross sales number.

The company also gave the bank cash flow projections for the balance of 2015 and 2016 prepared by Kraus’s CFO, a certified public accountant with prior experience as a company controller. The projected net sales for 2016 showed a 40% increase over 2015.

Magarik Sues for Dissolution

In September 2015, Magarik petitioned to dissolve Kraus under section 1104-a of the Business Corporation Law based on alleged “illegal, fraudulent, and oppressive actions” by Rukhlin and Levi. The hybrid petition/complaint also included direct and derivative causes of action for breach of contract, breach of fiduciary duty, waste, conversion, and fraud.

Following initial motion practice, in May 2016 the respondents elected to purchase Magarik’s shares for fair value in lieu of dissolution under BCL section 1118. In July 2018, Magarik voluntarily discontinued his various causes of action, leaving valuation of his shares the sole issue for determination by the court.

Justice DeStefano presided over a seven-day bench trial featuring the testimony of the three principals, Kraus’s CFO, and the two sides’ business valuation experts.

The Experts’ Valuations

The appraisal reports of the two experts unfortunately are not accessible on the court’s website, so what follows is drawn from the fragmentary descriptions of the reports and testimony in the parties’ post-trial briefs which you can read here and here. For those who want to dig deeper, the dueling briefs provide some additional details in the course of attempting to undermine each other’s valuation.

Petitioner’s Valuation. Petitioner’s expert valued the company at $30,090,000, and Magarik’s 24% interest at $7,221,600, by averaging his widely disparate DCF income approach ($21.4 million) and his guideline public company market approach ($38.8 million). He applied no discount for lack of marketability.

Petitioner’s post-trial brief defended the expert’s DCF methodology as “more sound” than using “historical financial information” for a “high growth” company such as  Kraus focused on “taking market share from others.” Petitioner’s brief also defended as “reasonable” his expert’s reliance on the 2015-16 monthly cash flow projections prepared by Kraus’s CFO for the bank, which projected more than a 40% increase in net sales in 2016. For subsequent years the expert applied a steady, “conservative” 5% growth rate and also uniformly carried forward 2016 projected expense ratios. He applied an effective tax rate of 40%.

According to his brief, petitioner’s expert’s public company market analysis selected “companies that sold plumbing fixtures, companies that had an e-commerce model, and companies that sold building supplies (to capture the fact that plumbing fixtures often go hand-in-hand with new construction).” The expert also reasoned that his market approach better captured the value of the company’s “brand.” The expert used the Capital IQ database to derive ratios (“equity plus debt divided by sales revenue”) that he then discounted 10% on account of Kraus’s “small size.”

Respondents’ Valuation. Respondent’s expert also used income and market approaches but arrived at radically lower company values than petitioner’s expert.

His income approach generated a range of values derived from capitalization of earnings ($6.16 million) and cash flow ($6.1 million and $5.9 million). His market approach also generated a range of values from $5.26 million to $6.1 million utilizing the merged and acquired company method relying on Pratt’s Stats for additional supporting data. The expert reconciled and concluded a company value of $6.05 million giving greater weight to his income approach. He then applied a 25% marketability discount to conclude a rounded value of $1.1 million for Magarik’s 24% interest.

The Court’s Fair Value Award

After a few, introductory paragraphs, Justice DeStefano’s six-page decision (read here) cut to the chase, accepting the $6.05 million company valuation of respondents’ expert as providing “a realistic assessment of Kraus’ fair value consistent with the credible evidence presented regarding Kraus’ successful business model as well as its debt and cash flow issues.” As Justice DeStefano further explained,

[respondents’ expert’s] valuation is supported by credible evidence which demonstrated a successful and growing business that was not especially liquid. The court does not accept the valuations provided by petitioner’s expert . . . as they exceeded the true value of the business, were based on income projections that were unrealistic and optimistic and not based on appropriate comparable businesses. Moreover, the two valuations provided were vastly disparate from each other, underscoring mistaken premises and assumptions. The Petitioner’s request that the court average the two incredibly disparate valuations is rejected.

Justice DeStefano’s decision also faulted Magarik’s expert’s valuation for insufficiently accounting for the “competitive nature of the internet business in which Kraus participated” and the company’s “lack of cash flow.” He also found that it “over-estimated the value of any so-called Kraus brand–which, ironically, was not even owned by Kraus but by an entity over which Kraus had no direct control.”

Justice DeStefano next took aim at Magarik’s expert’s heavy reliance on the management projections provided to Bank Hapoalim (referred to as BHI), as well as his misguided market approach, writing:

These projections were, put mildly, ambitious, and, in fact, were overstated. In the loan application to BHI, the parties valued Kraus at more than $30 million. In reality, the value of the business was never $30 million and the projections contained in the loan application were never realized. The court need not comment further on representations made by the parties to BHI in order to secure a loan, or what reliance may have been placed on such representations by BHI, except to note that, ultimately, the representations were not accurate. . . . [Magarik’s expert’s] income approach was based on unrealistic projections, proven to be unrealized and wrong; his market approach was based on incorrect comparables, to wit, public companies, not reasonably relatable to Kraus either in terms of size, ownership or marketability.

Justice DeStefano also agreed with respondents’ expert as to the appropriateness of a discount for lack of marketability (DLOM), “recognizing that the shares of Kraus, a close corporation, cannot be readily sold on a public market.” The court, however, did not accept the expert’s proposed 25% discount, instead concluding without further elaboration that “a DLOM of 5% is warranted under the circumstances.” Coincidentally or not, as pointed out in Magarik’s post-trial brief, respondents’ expert had persuaded the court to accept a 5% DLOM in a previous, unrelated fair value contest where he served as the petitioning minority shareholder’s valuation expert.

With the 5% DLOM, the court’s fair value award came in at $1,379,400 — less than 20% of the petitioner’s own valuation.

Finally, Justice DeStefano’s decision awarded Magarik pre-judgment interest on the award at the statutory rate of 9% and granted respondents two years to pay the award so as “to balance the cash flow issues experienced by Kraus with the fact that he has not received the value of his interest during the pendency of the proceedings.”

Reliance on Projections is a Risky Business

In the annals of judicial appraisal proceedings, many a DCF-based valuation has been tossed aside as unreliable, overly speculative, and based on unsupported and unrealizable income and expense projections. The DCF methodology used by petitioner’s expert in Magarik, as the court found, suffered from these maladies and more.

When business owners apply for bank loans or life insurance policies to fund buy-sell agreements, they can be tempted to use rosy cash flow projections and inflated equity values (they may think, justifiably or not) to better the chances of securing the desired loan or policy. That is what appears to have happened with Kraus’s owners when they sought a new and bigger line of credit shortly before Magarik sued for dissolution.

The apparent fact that Kraus had no prior history of preparing management projections in the normal course of its business, and no record of stable earnings, only added to the perception that the projections given to Bank Hapoalim were not reliable. Nor does the available record indicate the extent to which, if any, Magarik’s expert independently and critically tested the assumptions made in those projections. Throw into the mix the same expert’s market approach yielding a value almost double his DCF income appraisal, and, well, you can fully appreciate the court’s skepticism of both approaches’ outputs.

A business owner can certify under penalties or perjury or otherwise that his or her company is worth one dollar or a billion dollars. But, as Magarik found out the hard way, that doesn’t make it so. In the end, it’s the court’s job to determine fair value based on the credible evidence and reliable valuation methodologies presented by the parties and their experts.