The authors of this blog have a special affinity for fair value appraisal proceedings. The narrow hearings—where the sole issue before the court is the fair value of an owner’s interest in a business—require attorneys and appraisers to understand, convey, and advocate on both the intricacies of the business, and complex (and sometimes esoteric) valuation issues. Any miscalculation on methodology, assumptions, normalizations, or any of the countless factors that business appraisers consider can produce a major swing in valuation.
That affinity, plus all of the business divorce circumstances from which an appraisal proceeding can spawn (the death or retirement of a partner under Partnership Law § 73, a buyout election under BCL § 1118, a member’s withdrawal under LLC Law § 509, and the cash-out merger, to name a few), plus the many complex, deeply interesting issues that can dominate a valuation proceeding, stokes a healthy appetite among business divorce lawyers and appraisers for new valuation guidance from the courts.
With that appetite in mind, I’m delighted to blog about a recent decision from New York County Commercial Division Justice Jennifer Schecter, Rosenthal v Erber, No. 650771/2021 (Sup Ct, NY County 2023). The Court’s detailed analysis of the competing business appraisals—informed by its own obvious familiarity with appraisal proceedings and their issues—promises to satisfy business divorce lawyers and appraisers alike, at least until the next course.
Ted Rosenthal and Jeffery Erber founded 87th Street Optical Corporation (the “Corporation”) in 1995. The Corporation operated an optical and eyeglass retail business in Manhattan. Upon the Corporation’s founding, each shareholder took 50% of the outstanding shares in the Corporation. Although their relationship was never reduced to a shareholders’ agreement, Rosenthal generally was a passive owner, trusting Erber to run the business and pay distributions whenever the Corporation had the cash available to do so.
In 2004, Erber stopped paying distributions altogether, citing increased expenses and stagnant revenues. Rosenthal hardly complained. To the contrary, it seems that between 2004 and 2020, Erber and Rosenthal often went months, sometimes years without speaking at all.
In 2020, Erber contacted Rosenthal to obtain his signature on a PPP loan application. Awakened from his apparent slumber, Rosenthal took a deeper dive into the Corporation’s finances. When he did so, he alleges that he discovered Erber’s systematic waste of Corporation assets, including paying himself an above-market salary and awarding himself lavish perquisites.
Based on his discovery of Erber’s alleged excesses, Rosenthal in February 2021 petitioned for dissolution under BCL § 1104-a, on the grounds that Erber frustrated his “reasonable expectation of deriving some economic benefit from his stock ownership.” In response, Erber exercised his right under BCL § 1118 to purchase Rosenthal’s interest. This converted the action into a fair value appraisal proceeding, in which the sole issue before the Court was the fair value of Rosenthal’s 50% interest in the Corporation as of February 2, 2021, the day before the filing of the dissolution petition (the “Valuation Date”).
The Valuation Dispute
Rosenthal’s expert, Rockport Investment Partners, opined in a comprehensive appraisal report that the value of the Corporation as of the Valuation Date was $468,210, and, therefore, the fair value of Rosenthal’s 50% equity interest was $234,105.
Erber’s expert, Hoberman & Lesser concluded in their appraisal report that the Corporation’s “fair market value” was $0.
As often is the case, the respective experts’ rebuttal reports (Rosenthal’s here, and Erber’s here) has the good stuff, showing specifically where each side’s expert disagreed with the other. At the risk of oversimplifying the experts’ positions, the major difference in valuations between the experts boiled down to three items:
- Differences in valuation methodology used. Rosenthal’s expert used a blended approach, giving equal weight to four different valuation methodologies: a discounted cash flow method, a capitalization of earnings method, a guideline public company method, and a guideline transactions method. Erber’s expert utilized a capitalization of excess earnings method.
- Rent owed by the Corporation. A major driver of the difference between the two experts was a dispute over how much rent the Corporation owed to its landlord. Erber pointed to a one-page letter apparently prepared by the landlord stating that as of the valuation date, the Corporation owed $384,497.59 in rent arrears. Rosenthal cited the landlord’s own invoices establishing that as of the valuation date, the amount due was only $95,576.00.
- “Loans” to the Corporation. Erber’s expert included in his calculation a $106,000 “loan from officer,” arising from Erber’s alleged deferment of salary throughout the years. Rosenthal’s expert made no such adjustment.
Justice Schecter’s Analysis
The Court concluded that the fair value of the Corporation as of the Valuation Date was $283,816, resulting in a valuation of Rosenthal’s interest at $141,908. Here’s how it got there:
First, the Court stated that its starting point would be Rosenthal’s expert’s report, not Erber’s. The Court held:
[T]he court largely agrees with the valuation approach of Rosenthal’s expert, including his normalizing adjustments and exclusions. His reports were thorough and the court found him to be a credible witness. . . By contrast, the court was unpersuaded by the methodology of Erber’s expert, and his responses on cross-examination reinforced the court’s conclusion.”
In favoring Rosenthal’s expert over Erber’s the Court pulled no punches in rejecting Erber’s reliance on a letter from the Corporation’s landlord stating that the Corporation owed much more than the landlord’s invoices reflected:
The court does not credit this wholly-unbelievable letter or landlord’s testimony about the veracity of this amount. The letter was sent after the landlord made a prior contrary representation in response to the subpoena and is suspect to say the least. The January-2022 letter states that the amount owed is “as of February 3, 2021.” The only plausible reason the landlord used this date is that it was at Erber’s direction (the landlord’s representative does not recall why). Indeed, the date is in a smaller font than the rest of the letter, suggesting that it was copied and pasted there.
The Court next made a series of its own adjustments to the report of Rosenthal’s expert:
- Adjustments to the DCF and capitalization of earnings methods. The Court found that the growth rates used by Rosenthal’s expert in its DCF and capitalization of earnings methods were “far too optimistic.” Accordingly, the Court made an “across-the-board 20% reduction” to those valuations to “fairly account for [the expert’s] aggressive assumptions.” That adjustment was proper, held the Court, because it was “prudent to take a conservative valuation approach under these circumstances given the nature of the business—a boutique optical shop on the Upper West Side being valued as of the middle of the pandemic.”
- Adjustments to the guideline transactions method. The Court found that the 2.7 EV/Discretionary Earnings multiple utilized by Rosenthal’s expert was “unjustifiably high and admittedly optimistic.” The Court elected to apply a more conservative multiple of 2.0.
- Adjustment due to Erber’s potential retirement. The Court further found that an arms’-length purchaser would also account for the fact that Erber might retire in a few years. Thus, the Court adjusted the valuation downward by $50,000 to account for the potential “loss of goodwill from customers who patronize a small Upper West Side business due to Erber being the proprietor.”
After all those adjustments, the Court arrived at its concluded value of Rosenthal’s interest at $141,908.
Lessons from Rosenthal v Erber
My summary hardly does the Court’s analysis in Rosenthal v Erber any justice. There’s a lesson—or perhaps more importantly, a citable foothold for future argument—in seemingly every paragraph. Here are a few of my favorite nuggets:
Experts have an independent duty to verify. In its critical assessment of Erber’s expert, the Court cited to portions of the expert’s cross-examination where the expert conceded that he did not independently verify certain figures provided by Erber. I’ve written before about how an expert’s blind reliance on data provided by the client might be grounds for exclusion (see this post). Rosenthal highlights the more significant risk: an expert’s reliance on unverified data can sink their credibility.
Experts should ask for more information where they believe it exists. Erber’s expert based his report on the Corporation’s tax returns, and Erber apparently did not provide his expert with access to the Corporation’s QuickBooks account. Nor did Erber produce the Corporation’s accountant or his records. The Court laid the blame for that failure on both Erber and his expert:
The gaps and inconsistencies in the Company’s financial records were exacerbated by Erber’s failure to provide all of those records to his expert. Erber’s expert only relied on the Company’s tax returns but not on its Quickbooks or financial statements. It is troubling that an expert would purport to render a serious opinion on the Company’s value based only on its tax returns, knowing his client could easily have given him a more complete set of records.
Courts may resolve gaps in records against the recordkeeper. In choosing to credit most of Rosenthal’s expert over Erber’s, the Court made a point to suggest that Erber bear the consequences of Corporation’s faulty recordkeeping: “Erber has complete control of the operations of the Company and could have ensured there was a clear record of the Company’s financials but failed to do so.”
Imprecise language creates credibility problems. Though he did not apply any discounts for lack of marketability or lack of control (in fact, there was no discussion of any discounts at all), Erber’s expert repeatedly described his exercise as calculating the fair market value of the Corporation. And Rosenthal’s attorneys seized on the sloppy language, arguing in Point I of their post-trial memorandum that Erber’s expert could not even get the standard of value correct. Perhaps it’s time for a refresher on FMV vs. FV.
Beware the $0 valuation. Erber’s expert concluded that the Corporation was worth $0. In my experience, even if a $0 valuation is technically supported by the numbers, absent some unique circumstance, it is perilous to argue that a going concern (especially one that employs the shareholder) is worth $0, because that valuation runs counter to the valuation proceeding itself. As the Rosenthal Court stated: “Indeed, that Erber’s expert could conclude based on the record evidence that the Company was worth $0 significantly undermines his credibility. The notion that the Company is worthless is belied by the significant value Erber continues to derive from it.”