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Court Cases Illustrate Key Valuation Concepts

12/1/2016 - By Zachary Farrington

For valuation professionals, there’s never a shortage of interesting court cases to learn from. Here are two recent cases that shed light on the key concepts of tax affecting and loss of value.

 New Ruling on Tax Affecting

In the case of Owen v. Cannon, three partners built a successful software company. The plaintiff, the company’s president, owned about a third of the company and the defendants owned nearly all the rest.

The company was successful and revenue in the five years prior to the litigation climbed dramatically. A disagreement resulted in the defendants terminating the plaintiff as president. But though he stopped working, he continued to receive his salary, benefits and distributions. 

The defendants prepared to buy out the plaintiff and hired a big accounting firm to value the company and help obtain financing. The firm prepared a discounted cash flow (DCF) analysis as part of a series of valuations. In the fall of 2012, the firm valued the plaintiff’s share at $25.3 million, excluding cash on hand. 

Around this time, the company offered the plaintiff a buyout of $18 million, based on an older (2011) valuation. He rejected this, saying the company was “exploding in growth.” 

In 2012, the company was about to lose its biggest customer, and new 2013 projections were indeed lower. Based on those numbers, the accounting firm prepared another DCF valuation. The defendants offered the plaintiff $26.3 million, including cash on hand, and went after financing for the buyout based on that number. 

The plaintiff never responded to that offer, and the defendants scheduled a special board meeting to vote on a proposed merger that would result in a buyout of the plaintiff. He subsequently filed a complaint with the Delaware Court of Chancery asking for a fair value determination of his shares. 

Both sides produced a DCF analysis to value the plaintiff’s shares. The plaintiff’s expert based her valuation on the 2013 projections. Notably, she tax-affected the company’s tax rate to reflect its S status. Her figure: $52.65 million.

Instead of using the 2013 projections, the company’s expert created a 10-year set of projections that were significantly lower. He also argued that it was inappropriate to tax-affect the company’s earnings. His opinion of the plaintiff’s interest’s value: $21.5 million. 

Rejecting both of these numbers, the court performed its own valuation, noting that most of the gap between the two numbers was based on disagreement over the projections and tax affecting. 

The plaintiff argued that the 2013 projections prepared by the company reflected the best estimate of the company’s future. Oddly, the company backed away from its own 2013 valuation, saying that the projections they’d prepared were “not the product of a robust process.” In an expansive opinion, the court concluded that there was no sound reason to reject the 2013 projections.

Relative to the tax-affecting question, the plaintiff’s expert argued that the plaintiff’s interest should be tax affected to capture the denial (due to the proposed merger) of the future benefits of the company’s S corp status. The court agreed. Using the model determined by the seminal tax-affecting court case to date, Kessler, the court determined a hypothetical corporate tax rate of 22.71% — very close to the initial rate of 21.5% proposed by the plaintiff’s expert. 

Accounting for a few other disputed inputs, the court valued the plaintiff’s shares at $42.16 million.

 Lesson learned: First, a no-brainer: don’t produce projections for bank financing if you won’t later stand by them in court. Second (and perhaps more important), this case is a good one for proponents of tax affecting. It has given many valuation analysts hope that the Delaware Chancery Court’s clout will influence more cases in favor of tax affecting. 

Loss of Franchise Value 

In the case of TriCounty Wholesale Distributors v. Labatt USA, two beer distributors had franchise agreements with a number of beer brands, including Labatt. In 2013, Labatt terminated the agreements with the two distributors and agreed to compensate them for the diminished value of the business “directly related to the sale of the … brand terminated.”

The plaintiffs proposed two ways to determine the diminished value: a DCF analysis applied to the plaintiffs’ businesses with and without the brands, and an analysis using comparable transactions. 

The plaintiffs’ valuation expert concluded that, based on the DCF analysis, for Plaintiff 1 the drop in value was $646,000, and for Plaintiff 2 it was close to $6.1 million. These numbers reflected warehouse, delivery and labor-related cost savings as a result of losing the brands.

The plaintiffs’ expert also asked the court to consider comparable transactions based on a gross profit multiple approach. He suggested a multiple of 6x gross profits on the lost brands for Plaintiff 1 and 2.25x on all beer sales for Plaintiff 2. 

The defendant’s expert produced only a DCF analysis for the value of the lost brands. He said he had intended to value the businesses in their entirety, but that the evidence showed the termination of the franchises would have no noticeable impact on the plaintiffs’ other assets. Moreover, he rejected the plaintiffs’ comparable transactions argument and disparaged the use of multiples.

The defendant’s expert determined that damages for Plaintiff 1 were close to $134,000 and for Plaintiff 2 were approximately $723,000.

The court rejected both experts’ approaches. Instead, the court decided to use a “hybrid” approach which involved determining fair market value of the franchise contracts using DCF, then adding in any losses resulting from the agreement termination. 

The court found that the defendant’s DCF analysis was more credible and straightforward. The court faulted the plaintiffs’ expert for not explaining his calculations and charts, which devalued his testimony. 

That said, the court modified the defendant’s valuation based on assumptions he made about capital structure, cost savings and post-determination benefits. The court also rejected the use of gross multiples, although it eventually adjusted the defendant’s DCF analysis in a way that brought it in line with industry average gross multiples. 

The court awarded Plaintiff 1 $302,700 and Plaintiff 2 approximately $2.76 million. 

Lesson learned: The court didn’t really find either expert’s conclusions to be credible, but it especially criticized the plaintiffs’ expert for not better explaining his approach and conclusions. Ensuring that the court understands your argument is imperative. If not, the court may well find its own “hybrid” path.

Each court case is based on its own specific facts and circumstances. However, examining the ins and outs of valuation cases like these can be illuminating for all parties involved in litigation.

Looking for analysts who can defend their work in court? Contact our Saltmarsh valuation team to learn how we can help you.

 

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