NJ Courts Weigh in on Applying Marketability Discounts

Now Play Nice Children – NJ Courts Weigh in on Applying Marketability Discounts on Family Owned Businesses with Sibling Rivalry

Mama always warned you that bad behavior will get you nowhere – and New Jersey Appellate Courts agree.  A long withstanding New Jersey suit recently came to a head providing New Jersey valuation practitioners with a new reason to discount company value –for not playing nice with your siblings.

 

In the New Jersey case, Wisniewski v Walsh, some of the industry’s big guns weighed in on their take on appropriately utilizing a DLOM in a forced buy-out situation.  A 20 year litigation ensued when one brother (Norbert, and one-third Shareholder), of a NJ family-owned trucking business sued his sister and brother (Patricia and Frank, each also one-third Shareholders) under New Jersey’s oppressed shareholder statute.  Below is a timeline of salient facts that bring us up to date:

Case Timeline

  • 1952 – National Retail Transportation Inc. founded.
  • 1973 – Siblings Frank Walsh, Norbert Walsh, and Patricia Wisniewski assume equal 33.3% ownership following their father’s death. Frank assumes leadership of the Company and Norbert is a truck driver for the Business.
  • 1978 – Both Frank and Norbert function as Officers. Patricia’s husband, Raymond Wisniewski joins the firm.
  • 1992 – Frank is sentenced to prison for bribery and fraud. Norbert assumes leadership of the Company.  During this time, Norbert stirs things up in ceasing payments of certain perks Patricia expensed through the Business and billing function to company he owned (which had previously been provided by an entity owned by Patricia).
  • Sometime between 1992 and 1995 – Frank returns; however, Norbert continues to oppress Patricia’s involvement in trying to exclude her from a Company real estate deal. When Frank opposes, Norbert excludes both Frank and Patricia from the purchase.
  • 1995 – The siblings file several lawsuits against each other in hopes of obtaining control of the Company. Both Norbert and Patricia each vie for the court identifying one of them as the oppressed shareholder.
  • 2000 – The NJ Chancery Court finds Norbert as the Oppressed Shareholder and orders him to either sell his one-third interest back to the Company or to the remaining Shareholders, Frank and Patricia at fair value as of January 31, 1996 – the day Norbert filed his complaint.
  • 2001 – After reviewing reports provided by each party’s valuation experts, the court defines Norbert’s interest at $12.4M (or a total Company value of $37.2M).
  • 2004 – A NJ Appellate Court reverses the 2001 decision and calls for a hearing to reconsider the valuation.
  • 2007 – Trial Court changes the effective date of the valuation to nearly 5 years later, November 29, 2000 – the last day Norbert worked at the Company. The fair value estimate of Norbert’s 33.3% interest is restated at $32.2M, an increase of $19.8M in his interest, or a $59.4M increase in total Company valuation.  No marketability discount was applied.
  • 2007 & 2008 – The Trial Court’s decisions were appealed.
  • 2013 – The Appellate Court states that the Trial Court erred in not applying a marketability discount.
  • 2014 – A 25% marketability discount is applied. As expected, both partied appealed and cross- appealed this decision.
  • 2015 – The Appellate Court finds “no merit” in the most recent appeal and sticks with the 2014 opinion to utilize a 25% marketability discount.
  • 2016 – The Walsh family holds an ill attended family reunion (ok, maybe not.)

Whoopty Do!  What Does it All Mean, Basil?

Making Sense of Key Valuation Terms and Concepts Involved

Effective Date

The effective date of this case played a huge factor in the overall value of the business – a $59.4M factor to be exact.  While the original effective date was in line with when Norbert first submitted a complaint to the courts, the courts ultimately agreed that the date should be changed to the last day Norbert worked at the Company.  It was their ruling that while Norbert may have muddied the waters starting in the mid-90’s, he did not directly harm the earnings or profitability of the Business entity itself.  As a result, he should not be deprived of his interest in the Company’s significant growth that resulted between 1996 and 2000.

Standard of Value

The Court relied on Fair Value for this case as it is most commonly used in divorce and shareholder oppression proceedings compared to Fair Market Value.  By definition, Fair Value is often identified as, “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  In most cases, discounts for minority interests (i.e. Lack of Marketability or Lack of Control) are not appropriate absent extraordinary circumstances.

Playing the Victim

In a traditional case of he said, she said, both parties presented themselves as oppressed.  The court ruled that Norbert was the oppressor.  While it is customary for an oppressing party to buy out an oppressed member’s interest, the court indicated that in this case, allowing Norbert to buy Patricia’s interest would shift control to him – essentially, rewarding his bad behavior.  Instead, it was ruled that Norbert sell his shares back to the Company or to Patricia and Frank’s estate.

Valuation Methodologies Utilized

Ultimately, the Company relied upon Norbert’s expert’s (Gary Trugman of Trugman Valuation Associates) Discounted Cash Flow (DCF) analysis to arrive at the $32.2M valuation for Norbert’s 33% interest.   While Trugman’s methodology was utilized, the court did rely on assumptions and normalizing adjustments to operating expenses suggested by Patricia’s expert, Roger Grabowski of Duff & Phelps.

 

The question now became, does Trugman’s discount rate take into account the key facts that relate to a marketability discount – in essence double counting a discount if applying an additional DLOM of 25%?  Also, what ever happened to that 15% Key Man discount previously utilized?

Elements Contributing to Trugman’s Company Specific Risk

Risk Factors

  • Shareholder dependency on Frank’s active involvement in managing the Business and customers.
  • Customer Concentrations
  • Debt Structure of the Company
  • The fact that the Company is closely-held

Value Drivers

  • The Company was profitable and had a history of strong growth.
  • The Company made substantial and consistent distributions to Shareholders.
  • The Company was able to maintain profitability even during Frank’s time in prison and under Norbert’s management.

 

Elements Contributing to Grabowski’s DLOM

  • Shareholder dependency on Frank’s active involvement in managing the Business and customers.
  • Customer Concentrations
  • The fact that the Company is closely-held
  • Company Size
  • Company Profitability
  • Anticipated holding period (illiquidity analysis)

Furthermore, Grabowski argued that a marketability discount was applicable based on prior case law (Balsamides v Protameen Chemicals, Inc.) where a DLOM was warranted on the grounds that the seller/oppressor should not be rewarded when the suit forced a buyout, ultimately harming the remaining shareholders.  They suggested a 35% discount as appropriate for the subject Company.

The Elephant in the Room: DLOM versus Discount Rates

So yeah, some of these points are whistling the same tune, but they should be addressing two different issues – the ability to achieve an identified earnings stream, and the illiquidity of the Business.

 

In the end (well, what we think is the end), the court upheld its decision to keep a 25% DLOM in place based on the following facts:

  • The build-up discount rate utilized in Trugman’s DCF approach did incorporate factors to discount based on company size and company specific factors such as industry concentration, reliance on key employees, and high debt. These elements mirrored points discussed in Grabowski’s DLOM analysis; however, these factors were utilized differently by each expert.  Ultimately:
    • Trugman’s DCF was derived to adjust for the risk in receiving the defined and anticipated income stream, while
    • Grabowski’s DLOM analysis accounted for the illiquidity in the one-third interest.

These discounts were ruled to be independent of one another.

  • The New Jersey Supreme Court provided that marketability discounts for closely-held companies may go as low as 20%, but frequently range between 30-40%.
  • The judge ruled that while a 30-34% DLOM would “excessively punish” the seller, a 25% DLOM was applicable as it fell on the “low end of normal.”

Extraordinary Circumstances

In order to utilize a Discount for Lack of Marketability, Grabowski needed to demonstrate extraordinary circumstances to base the need for and level of the discount utilized.  Ultimately, the final Appellate Court ruled that a DLOM is warranted as a result of Norbert’s ill will towards Patricia.   The court reversed its previous decision against the implementation of a DLOM under the premise that if they did not allow a discount, this would incentivize other shareholders to be hostile or create a hostile environment in order to force a buyout of their interest at a premium.

Summary

Ultimately, this court case presents one glaring issue – the courts ruled a marketability discount is warranted, but not based on the illiquidity or marketability of the business — based on trying to level the playing field in the purchase price of the business between an oppressed and oppressing shareholder.  As valuation analysts, a significant portion of our analysis is focused on researching, selecting, and justifying our opinions of company value.  Subjectivity needs to be eliminated and analysis of market value needs to be determined.  The case at hand is a demonstration of today’s society in which everyone receives a participation trophy instead of awarding 1st place.  Discounts are a slippery slope and traditionally scrutinized in order to ensure that unnecessary measures are not taken to benefit a particular party (normally the engaged business owner).  At the end of the day, a marketability discount assessing a company’s illiquidity is imputed based solely on one brother not playing nice with his sister.  The relationship between these siblings and feelings towards one another ultimately does not have an impact on the ability to market and sell this profitable business to a third party.  So we now have a precedent sent indicating that using a discount to assess illiquidity when illiquidity is in fact not present is ok…sometimes.  Yes, we’re scratching our head too.

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