While there is tremendous diversity from state to state when it comes to statutory and judge-made law in business divorce cases, business valuation principles are—with a few notable exceptions—far more homogenous. So it makes sense to occasionally venture beyond New York’s borders to see how other courts and experts are addressing the business valuation questions that New York-based business divorces often encounter.
This week’s post looks at several recent decisions across the country concerning valuation principles and discounts. While each case features different applicable rules and agreements, our New York readers would be wise to note the persuasive power of these cases, especially given the sometimes-thin body of New York caselaw on business valuation issues.
Maryland – Discounts for Lack of Control and Lack of Marketability Not Applicable in Breach of Equity Right of First Refusal.
Valuation discounts and buy-sell agreements are among my two favorite topics to cover. A recent decision from Maryland takes a long-form review of both.
Maryland Indoor Play LLC (“MIP”) was formed to open and operate Hyper Kidz, a children’s indoor play facility. In January 2018, Snowden Investment LLC loaned MIP $350,000 to open its first location. The loan agreement made Snowden a putative partner, of sorts: it provided Snowden with the right to obtain equity interests in any new related ventures, “on the same terms as the other equity holders.”
Shortly thereafter, MIP’s members decided to franchise their business. They formed Boomerang LLC, and through Boomerang sold Hyper Kidz franchises. MIP’s owners did not provide Snowden with an opportunity to become a member of Boomerang. Later, MIP’s members organized Ashburn Indoor Play LLC (“AIP”) to open another Hyper Kidz location. Again, they did not give Snowden an opportunity to become an equity member.
Snowden commenced suit for violation of its right of first refusal (“ROFR”). The trial court on summary judgment held that the ROFR had been breached, and ordered a trial on damages. The trial essentially became a valuation question: how much were Snowden’s lost equity interests in Boomerang and AIP worth?
Both sides offered the expert testimony of business appraisers, and both appraisers valued Boomerang and AIP using a discounted cash flow methodology, with widely differing inputs. A significant driver of the delta between the two experts was the defendants’ application of discounts for lack of marketability and lack of control. The trial court did not apply those discounts in its post-trial damages calculation.
On appeal, MIP argued that the trial court wrongly calculated “fair value” (no discounts) instead of “fair market value” (discounts), and the latter should be the economic damages for breach of the ROFR.
The Maryland Appellate Court this July undertook a painstaking review of each expert’s analysis, which itself is worth a read (Maryland Indoor Play, LLC v Snowden Inv. LLC, [Md Ct Spec App July 12, 2024]). But the great stuff comes with the Court’s discussion of discounts, and whether a DLOM or DLOC is appropriate to compensate a would-be member for breach of an equity purchase right. Analogizing to shareholder oppression cases, which in Maryland (unlike in New York) generally do not consider discounts for lack of marketability or control, the Court held that no discounts were applicable:
Although based in breach of contract rather than a claim asserting a statutory right, the scenario presented in this case is comparable to dissenting shareholder and withdrawing limited partner cases. In effect, Snowden was “forced out” of ownership of a portion of AIP, with Snowden’s interest in the company retained by the appellants. . . . Applying the discounts for lack of marketability and lack of control would ‘deprive[ Snowden] of their proportionate interest in a going concern.’”
The Court continued:
We see no reason why ‘fair market value’ must be applied in a breach of contract case where another valuation method will more accurately ‘place the injured party in the monetary position [it] would have occupied if the contract had been properly performed.’”
New York Takeaway: Unlike in many states, New York courts require consideration of a discount for lack of marketability in shareholder oppression cases (see this post). From my view, that suggests that a plaintiff in Snowden’s shoes—litigating a breach of an equity purchase right in New York—likely would be stuck with a discount for lack of marketability.
California – Partnership Agreement Does Not Require or Prohibit Consideration of Discounts
Also at the intersection of the DLOM and buy-sell agreements sits a recent California Federal Court decision resolving a dispute between two general partners in a housing development project.
For our discussion, the relevant parties are AMTAX, which holds a 99.9% partnership interest, and JAE, which holds a .0495% partnership interest.
The governing limited partnership agreement (“LPA”) provides that at the conclusion of a 15-year compliance window, AMTAX could force JAE to either (i) sell the underlying real estate to a third party, or (ii) buy out AMTAX at fair market value. In the case of the latter, fair market value is determined by agreement of MAIs hired by both AMTAX and JAE or, if those appraisers cannot agree, by a third appraiser appointed by the original appraisers.
At the end of the compliance window, JAE notified AMTAX that it would buy out AMTAX’s interest at the appraised fair market value.
In calculating the fair market value of AMTAX’s 99.9% interest, AMTAX’s appraiser did not include a discount for lack of control and lack of marketability. The appraiser reasoned that such a discount was inappropriate for two reasons: First, JAE in exercising its buyout rights would be consolidating control of the property. Second, under his interpretation of the LPA, AMTAX had the right to force a sale of the underlying property, which in his view rendered a DLOM inappropriate.
JAE’s appraiser, by contrast, considered JAE’s right to forestall a sale of the underlying property by purchasing AMTAX’s interest, and therefore concluded, “that AMTAX’s limited partnership suffers from a lack of control, including no right to force a sale of the real estate, and suffers from a lack [of] marketability including contractual restrictions on transfer.” He applied substantial discounts.
With the parties’ valuations diametrically opposed based on the discounts, and the apparent propriety of the discounts hinging on whether AMTAX had authority to force a sale of the underlying real estate, JAE commenced suit. JAE sought a declaratory judgment stating that (i) JAE had negotiating power when determining the disposition of the property and (ii) that the LPA requires the neutral appraiser to discount for lack of marketability and lack of control when valuing AMTAX’s interest in the partnership.
The United States District Court for the Southern District of California wasn’t buying it (JAE Properties, Inc. v AMTAX Holdings 2001-XX, LLC, 3:19-CV-02075 [SD Cal Feb. 9, 2024]). As to the requested declaratory judgment concerning JAE’s “negotiating power,” the Court held the request “is inappropriate in light of the plain terms of the contract.”
As to JAE’s request for a declaration requiring the neutral appraiser to apply a DLOM and DLOC, the Court held that the applicability or non-applicability of discounts is a fact-specific determination that should be made, in the first instance, by the appraiser: “Certainly, the use of discounts for marketability and lack of control are not prohibited by the express language of the LPA, but it appears its fitness and use lies in the discretion of the appointed appraisers.”
More interestingly, the Court, in dutiful adherence to the applicable standard of value, squarely rejected AMTAX’s argument that a DLOM/DLOC should not be applied because, in exercising its buyout right, JAE was actually consolidating its control of the partnership:
[T]hat JAE would be ‘consolidating its control’ is irrelevant to the Court’s analysis, as it does not represent a valuation based on a hypothetical willing buyer and a hypothetical willing seller, accounting instead for the specific relationship between JAE and AMTAX.”
This left the parties essentially where they started. The Court would not say that any discount definitely applied, nor would it say that any discount was definitely inapplicable.
New York Takeaway: Business appraisers considering the applicability and amount of a discount for lack of marketability often resort to the same few piles of information: restricted stock studies, option models, and—in some cases—the QMDM. JAE is a helpful reminder that a partner’s control over the enterprise (or lack thereof) may be an appropriate consideration in the DLOM debate (see Mandelbaum et al. v. Commissioner of the Internal Revenue, 69 TCM 2852 [1995]). I’m also reminded of a post I wrote several years ago after encountering in arbitration an issue very similar to JAE’s: Fueling the DLOM Debate: Control Transfer Restrictions and the Discount for Lack of Marketability.
South Carolina – Ambiguous Severance Agreement Muddies Clear Valuation Process and Nets Reversal of LLC’s Bid to Buy out Member.
An architectural firm and South Carolina based LLC had proposed to its members an amended operating agreement with a relatively straightforward valuation formula for dissociating members: members would be entitled to “fair market value” of their interests. The amended operating agreement gave the firm’s management committee the right to determine fair market value annually. If they did not do so, and the firm and the dissociating member are unable to reach agreement, fair market value “should be determined by a qualified appraiser chosen by the management committee.” Member Donza Mattison refused to sign this proposed amended operating agreement.
In 2017, Mattison went on medical leave. When she did so, she signed a severance agreement rife with contradiction. It stated: (i) “the parties agree that the value of [Mattison’s] membership units shall be mutually determined in early 2018,” but also that (ii) “the Proper Dissociation . . . will be done in accordance with the [amended operating agreement].”
When negotiations over Mattinson’s buyout soured, the LLC—acting under the operating agreement—hired a business appraiser to determine the value of Mattison’s interest. That valuation included discounts for lack of control (10%) and lack of marketability (20%). Mattison balked at the value, and litigation ensued over the firm’s bid to enforce their appraised value.
The trial court held that the language of the severance agreement quoted above bound Mattison to the operating agreement’s valuation process, and that Mattison was therefore required to sell her interest at the value calculated by the LLC’s appraiser.
By order dated August 7, 2024 (McMillan Pazdan Smith, LLC v Mattison, 2021-000365, 2024 WL 3688344 [SC Ct App Aug. 7, 2024]), the South Carolina Court of Appeals reversed. The Court held that the severance agreement is ambiguous because it not only calls for valuation in accordance with the operating agreement, but also requires the value of Mattison’s membership interest to be “mutually determined.” Unable to square those two requirements based on the agreements alone, the Court remanded the case for discovery concerning the meaning of the severance agreement.
New York Takeaway: Let this be a lesson on the peril of cross-references. There was nothing ambiguous about the valuation process in the LLC’s amended operating agreement itself. But an after-the-fact severance agreement with a contradictory cross-reference sent the whole thing awry.
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