Business Break-Ups or Business Divorces occur when business owners can no longer agree on operations or future of a company. As we wrote in this article, What Should I Consider During a Business Divorce, messy (and expensive) business break-ups can be minimized or avoided by careful planning.
In a recent case, the plaintiff shareholder filed for dissolution of the corporation. Another shareholder filed an election to purchase the plaintiff’s shares in lieu of dissolution. The litigated issue was how to value the business and its shares. The Court considered the appropriate valuation method to use, finding the discounted cash flow method most appropriate under the specific circumstances. The Court also determined the application of the marketability discount would be unjust and inequitable and the plaintiff’s shares would be valued based on the full fair value of the corporation.
Jones v. A Town Smoke House & Catering Inc.
In Jones v. A Town Smoke House & Catering Inc., Case No. CL19000199-00, Oct. 19, 2020, 25th Cir. Ct. (Dryer), A Town Smoke House and Catering Inc. (“A Town”) was formed in 2016 and began operating The Fishin’ Pig, a restaurant, in 2017. Joseph Jones, Perry Fridley and Leighton Justice were the sole shareholders of the corporation, each owning 1,000 shares of A Town stock, and the initial directors. Each shareholder loaned A Town $100,000 as the initial capitalization. Jones was president, Justice was vice-president, and Fridley was treasurer of A Town. Jones and Justice initially served as managers of the restaurant and Fridley served as a silent partner and “handy man.” A Town operated The Fishin’ Pig under a franchise agreement with the Big Red Barn Rice Va., LLC.
Jones, Fridley, and Justice began having difficulties with one another in April 28, 2019. On April 28, Justice was under the influence at a wedding A Town was catering and was later charged with multiple unrelated felonies. On May 7, Jones and Fridley discussed unauthorized expenditures from A Town. Justice admitted to the police he had stolen money from A Town and it was decided that Jones would conduct an audit of A Town’s books. On May 14, A Town terminated Justice’s employment. On May 15, Jones, Fridley, and principals of Big Red Barn made two proposals to buyout Justice’s shares in A Town for $100,000. Jones rejected both proposals stating A Town bylaws required the shares first be offered to the corporation and then to the other shareholders. Jones suggested A Town purchase Justice’s shares for $100,000 and retire them, leaving Jones and Fridley equal shareholders, but this proposal was also rejected.
On June 11, 2019, Fridley and Justice held a meeting whereby they executed a document removing Jones as president of A Town and terminating his employment. The document alleged Jones had violated the franchise agreement and may cause A Town to lose its Fishin’ Pig franchise, as well as accused Jones of mismanagement of daily cash deposits. Fridley also alleged Jones had been using the A Town debit card for personal expenditures amounting to around $50,000 and had given himself a $20,000 raise. On November 1, 2019, Jones was removed as a director of A Town. Jones filed a Complaint seeking dissolution of A Town and Fridley filed an election to purchase Jones’s shares in lieu of dissolution. The Court was tasked with establishing the fair value of A Town for the purpose of Fridley’s election to purchase Jones’s shares.
Fridley’s Valuation of A Town Stock
Fridley’s valuation expert, Harold Martin, utilized the discounted economic income method to value the A Town shares. Martin used the standard of value set forth in Virginia Code Section 13.1-749.1 and chose this valuation method based on IRS Ruling 59-60, which states “the appraiser will accord primary consideration to earnings when valuing the stocks of companies which sell products or services to the public.” Martin used the discounted cash flow method, despite A Town’s income stabilization, due to the effect of the Tax Cuts and Jobs Act of 2018 (“TCJA”), which changed the manner in how depreciation is calculated. Martin argued that under this change, an appraiser cannot assume the subject company would have a stable cash flow as of the date of valuation, so the capitalization of income method can’t be used. Under this method, Martin made normalization adjustments to A Town’s historical financial information and projected future financial results through 2025 and the terminal period. Martin projected the net cash flows and projected this amount to a present value and arrived at a corporate operating equity value of $532,582.00. Martin then applied a 35% lack of marketability discount to the shares, equaling a $346,178 corporate equity value. Martin argued a lack of marketability discount was appropriate because Jones’s stock is a restricted stock, as well as a minority interest in the corporation, and no dividend had been paid and there were no prospective buyers of the stock. Martin did not apply a minority owner discount since all three corporate shareholders own equal shares. Martin concluded Jones’s shares were valued at $115,000 (rounded from $115,393).
Jones’s Valuation of A Town Stock
Jones’s valuation expert, Gregory Waller, used the capitalization of income approach and the market-based approach to value the A Town stock. Waller used the standard of value set forth in Virginia Code Section 13.1-729 and did not apply any minority shareholder discounts or lack of marketability discounts. Waller’s valuation utilized A Town’s tax returns and financial reports and adjusted A Town’s income statement and balance sheets. As part of those adjustments, Waller eliminated Jones, Fridley, and Justice’s salaries (amounting to $137,199.00); eliminated operating expenses A Town paid to Jones for hotel, fuel, and meal expenses (amounting to $9,509.00); and reduced capital expenditures. After these adjustments, there was a 2019 net income before taxes of $199,013, rather than the $41,255 shown on A Town’s 2019 income statement. Waller also made adjustments to A Town’s balance sheet and used the adjusted 2019 statements for his valuation calculation. Waller calculated A Town’s estimated free cash flow to be $168,249.00 and applied a capitalization rate of 14.30%. Using the capitalization of earnings method, Waller valued A Town at $1,083,054.00 as of December 31, 2019.
Waller also used a market-based approach, which uses data related to the stock price of publicly traded companies, or the transaction price of a sold company, and applies this data against the subject company’s income to estimate the value of the subject. Under this approach, Waller valued A Town at $958,000.00. Waller concluded his valuation by applying 70% of the final valuation to the capitalization of income approach and 30% from the market-based approach to arrive at a final corporate value of $1,155,000.00. Based on this valuation, Jones’s shares would be valued at $385,000.00.
The Court’s Valuation
Under the Virginia Code, if the shareholders are unable to agree on valuation of the corporation’s shares, the Court will determine the fair value of the shares. When determining the fair value, “all relevant facts and circumstances” should be considered, including: the petitioner’s minority status; the marketability of the petitioner’s shares; the relevant terms of any shareholder’s agreement; and the petitioner’s proportionate claim for any compensable corporate injury, if the corporation was diminished by the wrongful conduct of controlling shareholders. Application of minority or marketability discounts are discretionary.
The court noted that both experts used an income approach to valuation, but utilized different methodologies. The court determined that Matin’s discounted cash flow method “is the more accurate means of determining the value of Jones’s stock.” The discounted cash flow method projects income for multiple periods into the future until the subject company’s income has stabilized. The Court reasoned that while A Town had two full years and a partial year of income figures, “the discounted cash flow approach affords more flexibility over growth rates and capitalization over a short term.” The Court also noted that Martin’s approach considered the impacts of the TCJA and how the legislation will affect A Town moving forward. While Waller argued A Town’s income had stabilized, he later stated the corporation had “operational inefficiencies,” which indicates inconsistent positions as to A Town’s stabilization of income. The Court found that the market-based approach is less reliable in this case, since this method is most often used to value a business that will be sold. The Court found that Waller’s selection of comparable companies didn’t include relevant considerations, such as the motivation of the buyers and sellers or the terms of the sale for any of the comparable companies.
Application of the Marketability Discount
In close corporations, the stock is typically not liquid or readily convertible to cash. This lack of liquidity results in purchasers often seeking a reduction in the purchase price, referred to as the marketability discount. Most U.S. courts reject marketability discounts, except in extraordinary circumstances, as applying such discounts “denies the petitioning shareholder the full value of their shares that they would receive upon dissolution of the corporation.” However, Virginia does not follow this majority rule and “instead requires the application of the marketability discount, unless doing so would be unjust” or inequitable. The Court determined that the case at hand represents a “squeeze out” of a minority shareholder through the combined efforts of the other shareholders. “Abrupt removal of a minority shareholder from positions of employment and management can be a devastatingly effective squeeze-out technique.”
The Court concluded that Jones’s dismissal as president and employee of A Town was “an abrupt and unexpected action by Fridley and Justice given the events that had transpired the previous month.” Additionally, Fridley began taking a $65,000 salary after assuming Jones’s duties and reinstated Justice as an employee with a $65,000 salary. Fridley also used blank checks to transfer funds from A Town’s bank account to a new bank account. Despite Fridley and A Town’s counterclaim alleging embezzlement and fraud, the Court found no one had produced credible evidence to counter Jones’s argument that application of the marketability discount would be unjust and inequitable. The Court also listed other “oppressive conduct” resulting in Jones being excluded from management of the corporation, being deprived of employment income, his loan to A Town not being current, and he was deprived of other benefits of his investment that he reasonably expected at the time of his investment. The Court concluded that “Fridley and Justice put Jones in the untenable position of being a shareholder in a corporation in which he would receive no dividends, no salary from employment, but still have tax liability for the corporation’s profits.” Thus, the Court concluded “application of the marketability discount would be unjust and inequitable.” The Court valued A Town’s equity at $532,582.00 and Jones’s shares at $177,530.00.
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This case shows the importance of handling business disputes appropriately. The Court here found the marketability discount didn’t apply because of the “oppressive conduct” of shareholders towards the plaintiff shareholder. This case also highlights the complexities of valuing a business.
Attorneys at General Counsel, P.C. are specialized in business disputes and related matters and have experience working with business owners and individuals across Virginia, specifically in Fairfax County, Arlington, Loudoun County, and Prince William. Contact the business law experts at General Counsel, P.C. today at 703-991-7973 for more guidance or information.
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