Business Litigation: Case On Point
December 6, 2000
Valuation Professionals and Counsel take note. Never forget the timeworn axiom that "fair value" of a closely held corporation "is best measured by what a willing buyer would pay a willing seller in a voluntary transaction." That is what the Illinois appellate court very recently had to say in Marriage of Grunsten (1st Dist. 2/11/99) after the expert witnesses, counsel and trial court all concluded otherwise in valuing the husband's marketing services corporation (GSP). Here's what happened.
Using the "capitalization of earnings" valuation method, the husband's expert valued GSP at $418,954. The expert calculated that figure by multiplying a weighted average of net corporate earnings ($152,021) by a high business risk factor (3.93) and taking a 30% marketability discount. To determine the risk factor, the husband's expert divided 100 by the product of 4 (denoting the highest level of business risk) times the then current 30-year T-Bill rate of 6.35%.
The wife's expert valued the corporation at $1,043,771 by adding a goodwill component to GSP's net tangible assets, taking a marketability discount and then averaging various rates of return on net tangible assets and capitalization rates. The wife's expert established the amount of goodwill by capitalizing the weighted average of the portion of the husband's annual salary which exceeded what her expert considered to be a normal salary.
The trial judge rejected both the foregoing analyses, and set GSP's value at $558,667. The judge ruled that the wife's valuation was too high because the husband's salary was not excessive and the capitalization rates relied on by her expert were not specific to either the relevant industry or geographic location. The judge then ruled that the husband's valuation was too low because GSP's business was not as risky as the husband's expert had opined.
Reversing the trial court, and greatly simplifying the analysis, the appellate court focused on what the husband had paid the family of his deceased former co-shareholder (Simonek) about four years earlier for 50% of GSP's stock. The appellate court thereby set a floor value of GSP at (i) double the amount the husband paid Simonek's widow ($245,246), plus (ii) amounts he paid her for the next three years for ""consulting"" services ($45,833.34/yr.) and to establish a college fund for her daughter ($25,000). The court then multiplied the floor figure by a conservative growth factor of 25%, yielding a value of $816,240.
Using the willing buyer/willing seller approach, the appellate court thus eliminated much of the statistical and judgmental considerations propounded by the expert witnesses. Instead, in large part, the court relied on common sense. A humbling experience for the experts and counsel, to be sure.
Still, the expert opinions at trial were vital to the ultimate outcome of the case. The appellate court acknowledged that valuing a closely held business is "inherently subjective" — a difficult task in which the court "merely rely on experts who may differ significantly both in methodology and valuation." The court also noted that "as long as the [trial] court's valuation is within the range testified to by the expert witnesses, it ordinarily will not be disturbed on appeal unless it is against the manifest weight of the evidence."
(The husband has petitioned the appellate court for rehearing of the appeal. Such petitions are infrequently granted.)
The moral of this story: Not always–or even often–do valuation professionals and counsel have the benefit of a relatively recent arm's length transaction in which a willing buyer and seller placed a price on part of an entity being valued in litigation. But when they do, in formulating their valuation analysis, experts and counsel must place greatest weight on the price so established. If they fail to do so, as seen in Grunsten, sooner or later the court will do so for them.
Copyright © 2000 Levenfeld Pearlstein. This article contains general commentary on legal matters. It should not be relied upon as a substitute for legal advice as to any particular situation.
Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document."