Valuation

May 27, 2011

Oppressed Shareholders Avoid Key Person Discounts

This case goes into the “be careful what you say” category – particularly when it’s under oath, and particularly when you are involved in an oppressed shareholder action, or any other type of business divorce, for that matter.

Oppressed Shareholder Litigation

Oppressed shareholder actions almost invariably involve the purchase of the interests of some of the principals based upon valuations prepared by experts. One of the issues that the valuation expert will consider is whether a discount (or reduction in value) should be applied for the loss of a key person.

The inclination of the oppressed shareholder is to insist that they were absolutely critical to the success of the business, while the controlling shareholders insists that the shareholder who was forced out or frozen out was of no use anyway.

There is no bonus for being important to the business in valuation proceedings. In fact, the opposite is true. It runs contrary to the emotions of the parties and is completely counterintuitive to non-lawyers. For example, the big rainmaker who accounts for 80 percent of his professional firm’s business, but has somehow gotten frozen out of the enterprise, should keep his opinion about the extent of the contribution to himself or herself. The fact is that the enterprise is worth a lot less without them around, and that decrease in value may be reflected in a lower price for the purchase of their interests.

Key Person Discounts

There is surprisingly little case law on this topic in either New York or New Jersey and I am surprised that the issue does not come up more often between feuding principals. Yet you can have the unexpected situation in which a controlling shareholder fires key sales people and then asserts that they were absolutely critical – i.e., “key persons” – to the success of the business.

That was the case recently when the Supreme Court of New York County reviewed an application of this discount, which revealed an interesting point of the very personal nature of business divorce. Matter of Abraham (Elite Techonology NY, Inc.), 2010 NY Slip Op 33225(U) (Sup. Ct. NY County Nov. 10, 2010), (opinion here) (Thanks to Peter Mahler’s NY Business Divorce blog for finding the decision and publishing the referee’s report).

The key person discount, in the context of business valuation, is defined by….

April 12, 2011

LLC Does Not Distribute Clients on Dissolution

by Jay R. McDaniel, Esq.

When a limited liability company dissolves, it pays its creditors and distributes the remaining assets in the winding-down process. Many professional practices are organized as LLCs, and their principal assets are the clients they serve. That does not mean, however, that the professional limited liability company in dissolution has to divide up the clients.

This is an important holding for lawyers, accountants, doctors and other professionals that are practicing in New Jersey as a limited liability company. According to a New Jersey appeals court, the clients that the professionals, such as an accountant, bring to the LLC represent personal goodwill that belongs to the individual professional, rather than goodwill belonging to the enterprise. Thus, clients of professional limited liability companies are not considered assets of the LLC and on dissolution are not subject to distribution.

Accountants Seek Dissolution of Firm

January 24, 2011

Court Defers to Management’s Liquidation Value in Dissenting Shareholder Value

by Jay R. McDaniel, Esq.

The Business Judgement Rule presumes that a decision made by a majority of the board of directors in business matters is entitled to deference. Courts generally will not interfere with decisions that fall under the Business Judgment Rule.
Courts disregard the Business Judgment Rule when there is evidence of bad faith, misconduct or self dealing.
Even in a case involving the fair value of the shares of a dissenting minority shareholder, a court may consider the transaction at ‘arms length’ and defer to the board’s discretion.

August 13, 2010

An Early Cost-Benefit Analysis in Business Breakups Will Keep Dispute in Perspective

by Jay R. McDaniel, Esq.

When one or more of the owners of a business think it is time to get divorced, the decision in invariably accompanied by hard feelings. As most clients ultimately learn, the courts are incapable of resolving emotional issues. But they deal pretty well with money – which is why it makes sense to find out how much is at stake in the fight that is likely to ensue. Save the emotions for therapy; money is what the case is about.

The Pitfalls of Misinformation

My experience is that most clients are pretty thoroughly misinformed about the “fair value” of their business as well as their individual interests. Not infrequently, clients will presume that the high price-to-earnings ratio that one may find in the market of publicly traded stocks will apply equally to their closely held business. Not so. Others will fail to recognize the effect that the unusually high salaries paid to the owners will likely have in inflating the value of the business.

August 11, 2010

Lawyer Confidence May Be Poor Indicator of Results

by Jay R. McDaniel, Esq.

Lawyers must evaluate cases and try to predict the most likely outcome. To be successful, to attract and win clients, they must do so with confidence. A recent study of the accuracy of those predictions, however, reveals that lawyers are often overconfident and overly optimistic in their assessments of a client’s case.

A recent study published in Psychology, Public Policy and Law revealed that the more confidence a lawyer expressed in his or her ability to achieve a possible result, the more likely he or she will fail to achieve those results. You can read the full article here (Insightful or Wishful – Lawyers Ability to Predict Case Outcomes.pdf).

The lesson appears to be that clients might want to maintain some skepticism about the results that the supremely confident lawyer predicts, even as they recognize that the statistics don’t tell the whole story. The lawyer who doesn’t believe in a case, or who lacks confidence will have a difficult time being the zealous advocate that is the touchstone of an effective litigator. We may not meet our lofty goals as often, but that is not to say that we don’t do better for our clients when we are confident in the case. In our next post, we’ll take a look at predicting the outcome in a business dispute case.

June 11, 2010

Limited Liability Company Subject to Claims By Former Managers Holding Membership Interests

by Jay R. McDaniel, Esq.

I often find myself counseling caution to business owners that want to use equity to reward or attract key employees. The reason, quite simply, is that if the relationship sours, the employee not only has to be fired but you then have to deal — at best — with a disgruntled former employee as owner or, more likely, he or she likely will have to be bought out.

It’s Not Easy to Fire the Owner-Employee

To get a sense of how difficult these circumstances can be, let’s look at Ross Holding and Management Co. v. Advance Realty Group (Ross Holding v. Advance Realty (Del).pdf), a case recently decided in Delaware construing New Jersey law. Advance Realty Group managed real estate properties on the East Coast and awarded membership interests to key managers. The managers received “Class A” general ownership units and “Class B” units reserved for management. Reading between the lines of the opinion, it seems that a new investor came into the business and the old management team got their walking papers.

May 28, 2010

NJ Entire Controversy Doctrine Bars Claim That Former LLC Member Owns Factory

by Jay R. McDaniel, Esq.

Without John Murray, the former CEO of Crystex Composites, LLC, the Clifton manufacturer of composite materials would likely not exist. It was Murray who bought the plant in a bankruptcy sale and ultimately ended up with nothing for his efforts. Murray’s failure, however, to assert that he was the rightful owner of the Crystex plant was cut off by application of New Jersey’s Entire Controversy Doctrine, which requires that any claim between the parties to a lawsuit be resolved in one action.

This case has a long history. Murray put together a management team, investors, and arranged financing for the reborn of Crystex in 2003, but he was ousted by the other members of the LLC in May 2004 after failing to make a capital contribution of $200,000. Murray sued, alleging that his pledge of stock to secure a line of credit satisfied his obligation to the business and challenging his removal from the business.

The case went to trial in state court in 2006, with claims of misconduct by both sides. Ultimately, the case turned the issue of whether a Memorandum of Understanding, by which Murray agreed to make his contribution by March 2004 or forfeit his interest, was enforceable. Murray lost, with the court finding that he had “never acquired an interest in Crystex.” Murray appealed, but was unable to reverse the trial court’s decision on the core issue of his ownership. Opinion here.

May 27, 2010

Exercise Care in Valuing Interests in New Jersey Business Breakups

by Jay R. McDaniel, Esq.

A court orders a business valuation in a matter involving an oppressed shareholder claim. The appraiser, carefully applying the standards of his profession, sends an engagement letter describing a fair market value determination. The appraisal will value the enterprise as a whole, then apply minority and marketability discounts. The selling shareholder is going to argue for discounts – they always do – but the report will have all the information necessary for a determination either way.

For the minority shareholder, this can be a trap. And it may be the wrong move to wait for the trial to fight out the discount issue and the battle over the definition of fair value should be fought as early in the case as possible. Here are a few reasons why.

The appraiser is going to prepare a report based on the standards of the valuation industry and that standard is fair market value – what a willing buyer would pay a willing seller. He is going to try to avoid the tough issue of whether any discounts should apply. The AICPA’s Statement on Standards for Valuation Services No. 1 relegates the definition of “fair value” to a single paragraph in an appendix as a matter determined by state law in judicial proceedings.

Oppressed Shareholder Litigation

Key Person Discounts

Accountants Seek Dissolution of Firm

The Business Judgement Rule presumes that a decision made by a majority of the board of directors in business matters is entitled to deference. Courts generally will not interfere with decisions that fall under the Business Judgment Rule.

Courts disregard the Business Judgment Rule when there is evidence of bad faith, misconduct or self dealing.

Even in a case involving the fair value of the shares of a dissenting minority shareholder, a court may consider the transaction at ‘arms length’ and defer to the board’s discretion.

The Pitfalls of Misinformation

It’s Not Easy to Fire the Owner-Employee