Zelouf v. Zelouf, 2014 N.Y. Misc. LEXIS 4341 (Oct. 6, 2014)
When it comes to valuing a closely held company, New York law allows for the use of a marketability discount, and many times courts have applied it. But is it mandatory? This was a key issue in a recent New York ruling in a fair value proceeding.
Backstory: Nahal Zelouf obtained a 25% interest in the family-run textile business from her husband after he fell into a coma. The other owners were her brother-in-law, Rony Zelouf, and her nephew, Danny Zelouf, who had a majority stake. In 2009, Nahal made a books and records request and subsequently sued Danny and Rony for waste and misappropriation, alleging that the two men plundered the company for their personal gain.
During pretrial proceedings, in 2013, the parties jointly hired a neutral appraiser to perform a valuation of the company for mediation purposes. However, instead of settling the case, Danny and Rony pursued a freeze-out merger, forming a new company for the purpose of buying out Nahal and rendering her unable to pursue her derivative claims. Ultimately the court allowed the merger on condition that the court would rule on Nahal’s derivative claims as part of an appraisal proceeding and would allow for additional damages and legal fees if she won on those claims.
Probability of sale: Nahal rejected the company’s $1.5 million buyout offer, and the appraisal proceeding went forward. Both sides agreed that the neutral valuator’s appraisal should serve as the starting point of their analyses of what the fair value of Nahal’s shares was. At trial, the parties’ own experts focused on critiquing and adjusting the neutral appraiser’s report.
|Although many courts have applied a DLOM, “no New York case stands for the proposition that a DLOM must be applied to a closely-held company,”
The appraiser used the capitalization method under an income-based approach to determine the company’s fair value as a going concern on a controlling, marketable basis. After making normalizing adjustments to the company’s net income, he arrived at a value of approximately $8.9 million. In the alternative, he calculated the value on a controlling, nonmarketable basis, using a 30% DLOM, to arrive at a $6.2 million valuation.
The DLOM became a flashpoint. According to the neutral appraiser, “typically, a [DLOM] is usually only applicable for valuations of minority interests in closely-held companies under the assumption that a controlling owner would be able to force the sale of the company.” It was inappropriate in this case, he said, but he applied it at the direction of counsel. The parties’ experts argued over its application and the percentage it should take. In essence, Nahal’s expert maintained that under case law a DLOM was never applicable in this scenario; however, if the court allowed for one, it should not be more than 15%. The company’s expert contended New York law required a DLOM.
The court found Nahal’s expert cited the wrong case, but it agreed that a DLOM was inappropriate here. The idea underlying a DLOM is that the recovery of a frozen-out, minority shareholder should be less to account for the difficulty of selling a closely held company, especially in a niche business, as compared to a publicly traded company, the court explained. This rationale did not apply here, the court found, agreeing with the neutral valuator. It was unlikely that the company would or could ever be sold. A liquidity risk in this instance was “more theoretical than real,” said the court. Risk was “a function of probability times the threatened harm.” Here, although there would be harm in the form of a lower net purchase price, the probability that it would actually occur was “negligible.” In the absence of a risk, a DLOM was inappropriate. Although many courts have applied a DLOM, “no New York case stands for the proposition that a DLOM must be applied to a closely-held company,” the court said with emphasis. Based on the neutral appraiser’s valuation, it awarded Nahal $2.2 million for her 25% interest in the company and another $2.2 million based on her derivative claims.
The court in this case hitches the application of a DLOM to the probability of a sale. In his analysis of the case, Peter Mahler, in his blog, raises important questions about the wider implications of the court’s rationale for DLOM. Does it undermine the use of a DLOM in instances where a company is not for sale in the foreseeable future? As he sees it, “[s]uch a conclusion would rule out DLOM in most if not all fair value cases.”
I contend, and have testified accordingly, that many experts wrongly develop a DLOM in NY Fair Value cases, using market evidence for DLOMs for minority, non-control interests. Doing so, without empirically supporting equivalency between DLOMs for control interests and DLOMs for non-control interests, likely penalizes the oppressed shareholder for being a minority shareholder – which conflicts with case law that says otherwise.