Jay E. Link is the son of John (Jack) Link and the brother of Troy Link. Jack and Troy ousted Jay from the family business, Link Holding, Inc., L.S.I., Inc., Linked Snacks, etc. (“LSI” or “the Company”) they collectively owned in 2005.
A Buy-Sell Agreement
There was a buy-sell agreement, which, among other things, granted the Company the right to redeem, in whole or in part, any of the shareholder’s shares if their employment with the Company was terminated, with or without cause.
The purchase price was to be the fair market value of the shares (all were minority shares, apparently), taking into account their lack of control and lack of marketability. Such fair market value was to be determined by a business appraiser mutually agreed upon by the parties.
This was a case of a buy-sell agreement gone bad.
Massive and multi-year, multi-state litigation ensued.
The buy-sell agreement valuation process, calling for the parties to agree on a single appraiser, was not invoked. After considerable fighting, both sides filed suit in late 2005. Accusations abounded and both sides asked for punitive damages. As result of the litigation, agreement was reached for a three appraiser process calling for conclusions regarding fair market value and the fair value of Jay’s shares in the Companies.
The litigation culminated in opinions rendered by the Supreme Courts of both South Dakota (Link v. L.S.I., Inc., 793 N.W.2d 44 (S.D. Dec. 29, 2010)) and Wisconsin (Northern Air Services, Inc. v Link Case No. 2008AP2897 (WI S.Ct., Jul. 14, 2011)). Interested readers can look at both cases and any number of articles about this litigation, including here and here.
South Dakota Statutory Fair Value
The preceding background is appropriate to set the stage to discuss an important issue in the South Dakota Supreme Court case. The valuation processes had already occurred. The South Dakota Supreme Court (“SDSC”) was determining, in part, whether the circuit court (Third Judicial Circuit, Jerauld County, South Dakota) had erred in determining the fair value of Jay’s shares.
- The parties were unable to negotiate a buy-out of Jay’s shares. They had to agree on a single appraiser per the buy-sell agreement, and that most assuredly was not going to happen.
- Jay filed an action in South Dakota on November 17, 2005 to dissolve LSI, and LSI filed an election to purchase Jay’s shares on the same day.
There was an agreed upon valuation process in the Wisconsin action calling for three business appraisers. Jay and LSI each selected an appraiser and there was a third, neutral business appraiser.
- The appraisers were to determine both the fair market value (including valuation discounts) and the fair value (excluding valuation discounts) of the shares.
- The appraised price was to be reached by agreement of any two of the three appraisers.
- Draft reports were exchanged among the business appraisers.
- The neutral appraiser’s initial conclusion of the fair value of Jay’s shares was $21.0 million. The appraisers talked to each other following the exchange of drafts.
- LSI’s appraiser convinced the neutral appraiser that, because the Company had only one customer, its value should be reduced to appropriately account for this customer concentration risk.
- The final determination of fair value was $16.55 million based on majority vote of the appraisers (presumably, the Company’s appraiser and the neutral appraiser). The (discounted) fair market value determination was $11.2 million.
With the conclusion reached in the Wisconsin action, LSI noticed a hearing to lift the stay on the South Dakota action calling for LSI to purchase Jay’s shares. There was an extensive hearing with testimony from the three appraisers from the Wisconsin matter in Jerauld County Circuit Court. The court issued a memorandum decision (not cited in the SDSC opinion) and reached the conclusion that the fair value of Jay’s shares in LSI was $16.55 million. The value of all of his shares in all companies was $43.2 million.
There were other issues, but the conclusion of fair value is the one of interest today. In particular, the focus is on the “discount” in the neutral appraiser’s valuation conclusion from the original $21.0 million to the final, agreed upon value of $16.55 million.
Fair Value and Valuation Discounts
Reading through the lines, it appears that Jay argued in the appeal that fair value was to be an undiscounted value. He appears to have argued that the use of the “concentration risk discount” (my term) implicit in the reduction of the neutral appraiser’s conclusion from $21.0 million to $16.55 million was a “marketability” valuation discount that should not be allowed.
The SDSC noted that the agreed upon valuation procedure had been followed and that the final conclusion of the appraisers represented “the undiscounted fair value of Jay’s shares.”
The neutral appraiser testified that when he issued his initial report, in which he initially valued Jay’s shares at $21,000,000, he did not take into account LSI’s ‘extremely concentrated customer base relative to the peer group of companies that we utilized from a market perspective.’ LSI’s only customer is Link Snacks. After discussion, the neutral appraiser testified he was persuaded that he had not considered all the different risks associated with only having one customer and that this was a ‘proper’ criticism of his initial opinion. Jay argues that this ‘give and take’ process included a decrease in valuation because ‘a hypothetical willing buyer would pay less for LSI because of the significant risk associated with such a high customer concentration.’
The SDSC was satisfied that the circuit court had considered perceived issues with the conclusion of Jay’s appraiser and had exercised judicial discretion in rejecting his higher conclusion. The SDSC opinion then, quite perceptively, concluded:
Furthermore, the decrease from the neutral appraiser’s initial report was not a discount. The decrease was due to further discussion and consideration of LSI’s high customer concentration, which is one of the factors the appraisers considered in reaching the final opinion of the fair value of Jay’s shares. In looking at the entire appraisal process, to which Jay agreed, and the many factors of the business that had to be considered, this decrease was not a discount.
The court concluded that the lower court had, indeed, applied an appropriate valuation method in arriving at its conclusion, sustaining the final valuation of $16.55 million for Jay’s shares.
Valuation Adjustments in Enterprise Valuations
Jay was attempting to lump the “discount” for customer risk together with the more commonly used “valuation discounts” found in the South Dakota definition of fair value per SDCL 47-1A-1301(4):
“Fair value,” the value of the corporation’s shares determined:
a) Immediately before the effectuation of the corporate action to which the shareholder objects;
b) Using customary and current valuation concepts generally employed for similar businesses in the context of the transaction requiring appraisal; and
c) Without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant to subdivision 47-1A-1302(5).
Letter c) discusses the familiar marketability discount (of discount for lack of marketability) and the minority interest discount (or discount for lack of control), suggesting that their use in fair value determinations is generally inappropriate.
The purpose of discussing these two valuation discounts is to define the intended fair value at the appropriate level of value on the levels of value chart. We have talked about this chart in the Statutory Fair Value series (see #1 through #18) on this blog. We have interpreted this level of value to be the functional equivalent of the fair market value of a subject company at the financial control level of value in Statutory Fair Value #16 and other posts.
The minority interest discount is reflected as MID in the chart above. Minority interest and marketability discounts, if appropriate for a particular appraisal, are applied once the business appraiser has reached a conclusion at the enterprise level. Their application is not appropriate according to the definition cited above and the SDSC opinion in Jay E. Link v. L.S.I., Inc, et al.
The Fundamental Adjustment
In Business Valuation: An Integrated Theory Second Edition, we discuss the fact that in reaching conclusions of value at the enterprise levels, it may be appropriate to adjust selected multiples from comparable guideline public companies. These adjustments, which we call fundamental adjustments, are necessary to reflect risks present (or not) in private companies that are not (are) present in the reference public group. These same risks must be accounted for in the development of discount rates applicable to private companies
Fundamental adjustments can be positive (premiums) or negative (discounts), and relate to differences in expected risks and expected growth of cash flows relative to guideline public companies. Regarding risks:
- When comparing a subject private company with public guideline companies, the objective is to ascertain the appropriate discount rate, or capitalization rate, for the subject private company. In doing so, appraisers must contemplate that the appropriate discount rate for the subject private company may be less than, equal to, or greater than those of the guideline public companies.
- Quite often, the subject private company is riskier than the public guideline companies [as was, apparently, the case for LSI]. For example, the subject company may be smaller, have key person risks, customer concentrations, or other risks not present in most or all of the selected guideline public companies … (Integrated Theory, pp. 132-133)
The SDSC recognized that courts (and business appraisers, of course) should consider appropriate valuation methods and all relevant information in reaching determinations of fair value.
Although the definitions of fair value provided by SDCL 47-1A-1301(4) and Olsen are not controlling, it is appropriate in this case to draw from them for guidance, as the circuit court did. This approach is supported by the comments to the Model Business Corporation Act (“MBCA”). The MBCA comments on which SDCL ch 47-1A is based, note that § 14.34 “does not specify the components of ‘fair value,’ and the court may find it useful to consider valuation methods that would be relevant to a judicial appraisal of shares under section 13.30.”
The bottom line is that the SDSC recognized that customer concentration risks in a subject company that are not present in selected guideline companies warrant a downward adjustment to the public median (or average) multiples. These fundamental adjustments are necessary when developing values at the enterprise (financial control or marketable minority) level in statutory fair value determinations.
I have made what some might seem to think a large point about what might seem to be a small comment (“this decrease was not a discount”). However, it is a case in which the court was presented with potentially confusing evidence regarding valuation and reached the right (valuation) conclusion.
This case will likely be cited in numerous fair value determinations where there are risk differences between a subject private (or public, for that matter) company being valued in a statutory fair value proceeding. The same logic could, of course, be used to justify fundamental adjustments based on differences in expected growth.