Shareholder Buyout: Battle of the Valuation Experts

In a recent New York buyout case — Sergio Magarik v. Kraus USA, Inc. — the sole issue before the court was the fair value of the petitioner’s interest in the respondent corporation. The outcome turned on the credibility of opposing valuation experts and the soundness of their methods.

Case Facts

The case involved a privately held corporation and internet-based seller of imported plumbing fixtures that was formed in 2007. The petitioner was a minority shareholder who held 24% of the company’s shares. The company enjoyed rapid growth. Though its sales grew from $21 million in 2012 to $36 million by 2015, the company was saddled with negative cash flow and significant debt.

On September 21, 2015, the minority shareholder petitioned for dissolution of the corporation and sought damages from the other owners on grounds of shareholder oppression. The respondent shareholders elected to exercise their statutory right to buy the petitioner’s interest for fair value. As a result, all other claims and counterclaims were dropped, and the sole issue for the court was the fair value of the petitioner’s interest.

Valuation Approaches

Both experts used a combination of the income and market approaches to value the company. The petitioner’s expert valued the company at $21.9 million under the discounted cash flow (DCF) method (income approach) and $38.8 million under the guideline public company method (market approach). He averaged the two to arrive at a value of roughly $30 million.

The respondents’ expert computed preliminary values under the income approach using the capitalization of earnings method ($6.16 million) and DCF method ($6.1 million and $5.9 million). His market approach valuation, based on the “merged and acquired company method,” produced values ranging from $5.26 million to $6.1 million. Assigning greater weight to the income approach, the expert valued the company at $6.05 million.

Court Ruling

In its post-trial decision, the court highlighted several flaws in the methods used by the petitioner’s expert:

• His income projections were unrealistic. He relied heavily on projected earnings prepared by the company’s controller in connection with a loan application. These projections were “ambitious, and, in fact, were overstated.” The company never realized these projections.
• His valuation failed to sufficiently account for the competitive nature of the company’s internet business and its lack of cash flow.
• The valuation overestimated the value of the company’s brand, which the company didn’t even own.
• His application of the market approach relied on “incorrect comparables” that were publicly traded and not reasonably comparable to the subject company in terms of size, ownership, or marketability.

The court concluded that the vast disparity between the income and market valuations underscored “mistaken premises and assumptions.” In contrast, the court explained that the methodology used by the respondents’ expert provided “a realistic assessment” of the company’s fair value.

The court applied a discount for lack of marketability of 5%, rather than the 25% discount suggested by the respondents’ expert. As a result, the court concluded that the fair value of the petitioner’s interest was $1,379,400 (24% × $6.05 million, less a 5% discount for lack of marketability).

Court Faced with Monumental Valuation Challenge

In William Richard Kruse v. Synapse Wireless, Inc., the sole issue was the fair value of a dissenting shareholder’s interest in the company before its 2016 merger. The Delaware Chancery Court attempted to arrive at a reasonable valuation, even though it was provided with unreliable estimates from both sides.

The experts’ cases reached “monumentally different” conclusions: The dissenting shareholder’s expert opined that the company was worth $4.1876 per share at the time of the 2016 merger. The company’s expert provided a range of values from $0.06 to $0.11 per share.

Both experts relied on these three valuation techniques:

1. Prior purchases of the company’s stock,
2. Comparable transactions, and
3. Discounted cash flow (DCF) models.

The court rejected the experts’ market-based analyses. It determined that previous prices didn’t result from a competitive sales process and their comparable transactions analyses had significant flaws.

The court also criticized management’s projections, which both experts relied on in their DCF analyses. It found that these analyses were “difficult to reconcile with [the company’s] operative reality.”

The court noted that, in a typical litigation context, absent reliable evidence, a fact finder might conclude that neither party is entitled to a verdict. However, that’s not an option in statutory appraisal cases.

Under these circumstances, a court is free to wholly or partially adopt the more credible valuation. In this case, the court accepted the DCF valuation prepared by the company’s expert, with minor adjustments. It explained that the expert “credibly made the best of less than perfect data to reach a proportionately reliable conclusion.” Based on this approach, the court set the fair value at $0.228 per share.

Valuable Lesson

In this case, the court’s fair value calculation was only one-fifth of the amount sought by the petitioner. This case illustrates the profound impact of a credible valuation based on sound assumptions and methods.