Matter of Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)
A New York appeals court recently affirmed a stock valuation that occurred in the context of an oppressed shareholder suit. While the appeals court decision is short, the underlying 2011 trial court decision provides invaluable insight into the factors courts consider when assessing the qualification and performance of appraisers. Solid valuation credentials, a thorough work product, and a demonstrated knowledge of valuation-related legal principles carried the day.
The Backstory. In 1948, the petitioner and his brother started a business in Brooklyn, N.Y., buying and distributing pickles. In good time, a third brother joined the company, which eventually became the largest distributor of Caribbean food in the New York area. By 2006, the petitioner’s two brothers gave their one-third interests to their sons and the petitioner held the remaining one-third ownership stake. In 2007, the petitioner fell ill and was absent from the business for a while. When he returned, the two nephews offered to buy him out. He refused, and the relationship deteriorated. Eventually, he filed suit, alleging they took oppressive actions to force him out and petitioning for a judicial dissolution of the business under New York Business Corporation Law (BLC) Section 1104-a.
After the New York Supreme Court (trial court) denied the nephews’ motion to dismiss the petition, the company elected to buy the petitioner’s shares pursuant to BCL Section 1118. In 2011, the court held a valuation hearing featuring the opinions of both parties’ experts.
Company’s expert uses one method. The company’s expert was a CPA but not a credentialed appraiser. He stated he had performed about 50 valuations. He submitted a three-page report based on his review of the company’s tax returns and “the sparse records he found.” He also had conversations with the company’s accountant and principals. He said he used a capitalized income method because he could not find any comparable businesses and the company was not a public corporation issuing stocks and dividends. He made adjustments to salaries, depreciation, and outstanding loans and weighted current earnings more heavily, arriving at average normalized earnings of $206,000. He determined a capitalization rate of 20%, translating into 5x earnings. It included company-specific risk factors, such as limited management and the company’s large amount of business with the A&P supermarket chain, which was in jeopardy because of A&P’s bankruptcy. He said he considered the company’s growth in sales, which had doubled between 2004 and 2010, but found no “dramatic” growth in profits. He concluded the petitioner’s one-third interest in the company was worth $230,000. Importantly, he also applied what he called a 20% discount for lack of marketability (DLOM). He said the DLOM accounted for the “difficulty finding somebody to buy a one-third interest. There’s really no market. It’s a privately-held company. Anybody who bought that one-third interest would conceivably have nothing to say about the company.”
Petitioner’s expert uses three methods. The petitioner’s expert was a CPA and credentialed appraiser. He visited the company’s premises and reviewed its books and records, which he found to be “minimal.” In addition, he reviewed company tax returns for 2004 through 2010, the compiled financial statement trend that the company’s appraiser had prepared, the general ledger, bank statements, and available truck manifests. He also took note of the petitioner’s account that big stores paid by check through central billing, whereas small bodegas paid cash on delivery, which the truck driver collected. While the latter sales were not in the computer, they should appear in the salesmen’s reports. According to the petitioner, smaller stores made up about 20% of the entire business.
The petitioner’s expert became aware that from 2004 through 2010 the company’s sales basically doubled and costs of goods sold increased commensurably, while the gross profit margin steadily decreased from a high of 27.5% to 24% in the last two years. During that very period, officer compensation went from zero to more than $500,000 per year for two officers. The only explanation, he concluded, was the existence of unreported sales. He performed a “stress test” on sales invoices and other available data and found the company had a gross margin of profitability of almost 35%, instead of the 25% appearing on the company’s tax return. Based on this differential in profitability, he concluded that, for a company with gross sales of $10 million, the amount of unrecorded sales in 2010 was approximately $1 million. Accordingly, he imputed gross profit at the industrywide level of 35% rather than the 25% reported by the company.
He used the capitalization of earnings method, determining a weighted average net income of $486,000 and a capitalization rate of 12%, as opposed to the competing expert’s 20%. Applying the cap rate to the earnings base, he calculated the company was worth $4,051,862 on a controlling, marketable basis. He assigned a 70% weight to this value.
As a cross-check, he also used a market-based approach—the merged and acquired company method—drawing on Pratt’s Stats to determine valuation multiples of revenues, gross profit, and EBITDA. The resulting values ranged from $3,990,000 to $4,094,000 to $4,191,000, which he weighted at 10% each. All the weighted values resulted in a control, marketable value of $4,063,800. The expert applied a 5% discount for lack of marketability reflecting the lower range of transaction costs, which he said in a sale of a small business typically ranged between 5% and 10% of the sales prices. He concluded that the petitioner’s one-third interest on a controlling, nonmarketable basis was worth $1,287,000.
One expert’s contradictory statements. At the outset of its analysis, the trial court noted that the valuation “rests primarily on the credibility of the appraisers and the reliability of their valuation methods.” It also pointed out that “the extent of the witness’s qualifications has a bearing on the weight to be given to his testimony.” Here, the court said the testimony and report of the petitioner’s expert were “credible and reliable.” It noted his extensive valuation and financial credentials and highlighted his thorough evaluation of the company, including making a site visit, developing an understanding of the company, learning about the industry, considering the economy, and selecting valuation approaches and valuation factors. “He methodically chose such critical factors in the evaluation process as the capitalization rate and lack of marketability discount based on studies in the evaluation field.” Importantly, he demonstrated legal acumen: He knew that under New York law it was appropriate to discount for lack of marketability but not for minority status. He paid attention to the petitioner’s testimony that considerable business took place in cash payments that did not appear on financial statements, and he explained how the financial statements indicated unreported sales. In sum, his valuation report was “clear, thorough, professional, and reliable.”
In contrast, the trial court said, the company’s expert lacked valuation credentials. He prepared a three-page report relying on the company’s accountant. He failed to consider the existence of cash sales, and his discount rate leaned on the petitioner’s minority status. He relied on one method of valuation, without doing a cross-check. He contradicted himself, acknowledging that the company’s sales “had more than doubled” but saying profitability had been “basically flat.” At the same time, he said the gross profit of the company also doubled during the relevant period. For all these reasons, the court gave “diminished weight” to his opinion.
No adjustment for shareholders’ conduct. The petitioner wanted more. He asked for an upward adjustment of the valuation, arguing the two remaining shareholders had given themselves salaries, distributions, and benefits in the amount of nearly $864,000 to his detriment.
The trial court denied the request. This adjustment, it said, “functioned as a component of Petitioner’s calculation of the fair value of his shares”—perhaps referring to the adjustments the petitioner’s expert made to the financial statements. Also, this proceeding under BCL Section 1118 was only concerned with determining the fair value of the petitioner’s shares. “Any misconduct or self-dealing by [the nephews] is not relevant to that determination.” Moreover, the petitioner’s expert did not state or suggest that the salaries represented “willful or reckless dissipation” of company assets.
No second-guessing. Both sides appealed. The company contested the trial court’s valuation, and the petitioner objected to the trial court’s denying his request for additional sums. The appeals court promptly disposed of the parties’ arguments. The trial court’s valuation was based on expert testimony. The sums related to salaries and disbursements to company officers were accounted for in the valuation the petitioner’s expert performed, which the New York Supreme Court adopted. Therefore, the appeals court affirmed the $1,287,000 valuation.