Tuesday, November 26, 2019

Court Applies “Reality Check” to Valuation of Minority Interest in LLC

Court Applies “Reality Check” to Valuation of Minority Interest in LLC

      In a recent decision from Ohio, the court applied a “reality check” to the evaluation of a minority interest in LLC, the court rejecting the suggestion that a 25% interest therein held a negative value. Kapp v. Kapp, 2019 Ohio 4097, 2019 WL 4894057 (Ohio Ct. App 2nd Dist. Oct. 4, 2019). 

      Jessica and Tyler Kapp had previously been married; this decision arose out of the divorce decree entered by the trial court. For purposes of this review, she alleged that the value attributed to her interests in two self storage businesses was in error. Tyler and Jessica were each 25% members of Home Road Self-Storage and in Key and Lock of Enon. The balance of the interests in the companies were held by Tyler’s sister and her husband. The trial court, after determining that the interest in each of the LLCs had, as to Jessica, negative discounted present value, had awarded those interests to Tyler without any offsetting compensation to Jessica.

      Tyler’s appraiser began by doing an appraisal of each company, dividing that by four to reach the pro forma value of a 25% interest therein. He then applied a 35% discount to each interest. Then, he deducted from that value 25% of the mortgage indebtedness, an action which drove each of the values negative. Jessica objected to this approach by noting that, while her interest in each company had been discounted, no discount had been applied to the mortgage debt.

In contrast to the trial court’s approach, Jessica argues that it first should have determined the net market value of her interest by subtracting all debt from Horner’s appraised market value of the properties. She asserts that the result would then have been divided by four to determine the market value of her interest, which then should have been discounted by 35%. According to Jessica, if this methodology had been followed, the discounted market value of her interest in the two companies would be nearly $80,000.
This the court did not accept, writing:
It is not clear to us, however, why the debt should be discounted. Appraiser Horner explained why it was necessary to discount the market value of Jessica’s 25 percent interest in Home Road and Key and Lock. Most significantly, the value of her minority interest in the two companies is impaired by a lack of marketability or control. To determine what a buyer would pay for her share of the companies, Horner had to consider these impairments, which reduce the market value of what Jessica owns. The same is not true for the mortgage debt. Marketability or control issues impact the value of Jessica’s interest in the companies, but such issues have no impact on the companies’ debt. No lender would reduce the existing mortgage debt by 35 percent in recognition of the discount applied to Jessica’s ownership interest in the companies. As a practical matter, then, a prospective purchaser would be buying Jessica’s discounted ownership interest, which remains encumbered by the full, undiscounted pro rata share of the companies’ debt. There may be some explanation for discounting the debt in this case, but it is not found in the record before us. Therefore, we cannot say the trial court erred in failing to adopt Jessica’s valuation approach. 2019 WL 4894057,*4 (footnotes omitted).
      However, notwithstanding that rebuttal of her argument, all was not lost for Jessica. Rather, the court wrote: 

Despite the foregoing conclusion, we agree with Jessica that the trial court acted unreasonably in assigning no positive actual value to her 25 percent interest in the two companies. The record reflects that Home Road and Key and Lock are successful and profitable businesses. The undiscounted net market value of the two businesses, after subtracting their debt, is roughly half a million dollars. Certified public accountant Mike Fissel testified that Home Road was projected to have free cash flow of $20,518.86 over the upcoming year after servicing its debt and making one-time capital expenditures of $48,000 for needed repairs. The Key and Lock property was projected to have free cash flow of $3,379 after debt service. But an anticipated capital expenditure for driveway resealing was expected to reduce free cash flow to negative $1,621 for the upcoming year. In any event, the two businesses together easily were cash-flow positive after all debt servicing and capital expenditures. In addition, based on a current accelerated debt-repayment schedule, the Home Road property, which itself appraised for $920,000, is expected to be mortgage free by December 2026. Paying off the mortgage will allow the company to retain an additional $6,841.43 per month based on the current payment schedule. In short, the record establishes that relatively soon the two companies, which currently are paying for themselves, together will have equity in excess of one million dollars and will be generating substantial free cash flow. We find it unreasonable to conclude that Jessica’s 25 percent ownership interest in this enterprise is worthless and, in fact, is worth less than zero. The apparent value of Jessica’s interest is reflected in the fact that both she and Tyler desire ownership of it. Jessica testified at trial that if she were not awarded at least “book value” for her interest in the two companies, then she would prefer to keep her interest. At trial, the companies’ accountant, CPA Fissel, determined that the book value of Home Road was $97,533.60, and the book value of Key and Lock was $81,446.66. The combined book value of these businesses was $178,980.26. Jessica’s attorney calculated that 25 percent of the combined book value was $44,744.92. Jessica testified that she was agreeable to transferring her interest in the companies to Tyler for at least that amount. Otherwise, she wanted to retain her interest in Home Road and Key and Lock. Id. (citations to record and footnote deleted).
      From there, turning back to the company’s operating agreement, it was silent as to divorce and expressly excluded its application with respect to “transfer by sale, gift or bequest between or to current Members.” Still, the court made reference to the “fair market value” methodology set forth therein, one which valued Jessica’s interest $44,744.92. The court as well noted that as Tyler was already a 25% member of the company and, apparently, one of its only two managers, her interest was to him more valuable than it would be to a “hypothetical prospective purchaser,” the court observing “Because the ‘purchaser’ in the present case is a person who will own fifty percent of the companies and who shares control with only one other person, Jessica’s interest reasonably should have more value to him than to a random person.”

      From that assessment, the court turned to the crux of its decision, namely: 

Based on the foregoing reasoning, we hold that the trial court abused its discretion in finding Jessica’s interest in Home Road and Key and Lock to have a negative market value and in awarding that interest to Tyler without any compensation to her. Such a disposition was not reasonable based on the record before us. Although a trial court in a divorce proceeding should endeavor to disentangle the parties financially when possible, we believe the most appropriate resolution in the present case is for the trial court to give Tyler a choice. He can give Jessica $44,744.92 for her interest in the two companies and have that interest transferred to him. Or he can decline to do so, and she can keep her interest. Although it may be preferable to separate the parties’ business affairs, Jessica should not be compelled to give her interest in the companies to Tyler without any compensation, which is what the trial court ordered. If Tyler truly believes Jessica’s interest has no current market value, as he argues on appeal, then he can allow her to keep that interest, which she testified has financial value to her. Because Tyler and his sister enjoy decision-making control, Jessica essentially would remain a silent partner. The first assignment of error is sustained. Id., *6.

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