Lawsuits can have a long tenure in the court system, starting with the complaint and ending with a final decision. In the case of Wisniewski v. Walsh in New Jersey, that time period was nearly twenty years.1 While many issues in the matter were affirmed relatively quickly, one lingering issue remained on appeal: the discount for lack of marketability.
In general, investors prefer investments that have access to a liquid secondary market where they may convert the investment into cash at minimal cost. Equity interests without such marketability characteristics normally sell at a discount in order to provide the investor with compensation for this lack of liquidity.2 The discount for lack of marketability (or “DLOM”) associated with an interest in a privately held entity reflects the difficulty or inability of the investor to sell their interest owing to the fact that there is no active market for interests in privately held entities.
The present matter concerns three siblings, Frank, Norbert, and Patricia, who were all owners of a trucking and transportation services company. In the 1990s Norbert took control of the company. During the time of Norbert’s leadership, various decisions and activities were questioned by his siblings. Disagreements among the owners culminated in claims and counterclaims subsequently being filed under the oppressed shareholder statute.3
Over the years the matter moved through the court system. By 2014 Norbert was found to have exhibited oppressive behavior that harmed the other two shareholders and was ordered to sell his one-third ownership back to the Company or to Frank and Patricia for a value of $32.2 million, subsequently to be adjusted by a DLOM of 25 percent. Both parties appealed the DLOM, with Norbert arguing the valuation already reflected a DLOM, and Frank and Patricia arguing the DLOM should be higher.4
DLOM Analysis and Ruling
During the initial trial court hearings, both parties hired valuation experts to determine the value of the company and Norbert’s interest in the company. Norbert’s expert estimated the company’s value using the discounted cash flow approach. Of central importance to this matter was the expert’s discount rate, which was derived using the build-up method including the long-term Treasury bond yield, an equity risk premium, small company risk factor, and a company-specific risk factor. Missing from the analysis, however, was a discount for the lack of marketability, which the expert explained was unwarranted given the success of the company and the assumption that it would take no longer to sell this company than any other similar closely-held company. The expert also believed that shareholders would not lose liquidity during the marketing period given the substantial cash flow produced by the business. Further, the expert claimed that his discount rate had already accounted for many of the risk factors reflected in the marketability discount, such as the company’s customer concentration.5
Frank and Patricia’s expert did not rely on a DCF analysis, but rather used a market transaction approach. In addition, Frank and Patricia’s expert explicitly included a marketability discount, determined to be 35 percent, in his analysis. The discount was derived having accounted for risks such as liquidity, company size, profitability, customer concentration, and key man risk.6 Not only was key man risk considered in arriving at a value for the DLOM, but an additional “key man discount” of 15 percent was also separately applied (and agreed to by the court). The key man discount reflected the strong influence of Frank on the business and that his departure would have a significant negative impact on the overall value of the Company.
In the end the trial judge found that:
- Norbert’s expert did not include a DLOM in his analysis; and
- despite the analysis provided by Frank and Patricia’s expert regarding a DLOM of 35 percent, the judge settled on a 25 percent discount.7
The questions before the appeals court was (i) whether or not a DLOM is applicable in the instant case, (ii) whether or not the discount rate applied in Norbert’s expert’s analysis already implicitly accounted for a marketability discount and, (iii) if not, what should be the appropriate value for the DLOM.
In resolving the first issue, the court found that without any discount for marketability, the oppressing shareholder (in this case Norbert), would receive a “windfall” while the remaining shareholders would be left to suffer a diminished asset value upon a future sale of the company. This, in turn, would create an incentive for “oppressive behavior.”8 Thus, the appeals court agreed with the trial court that a DLOM was applicable in this matter.
As for the second issue of whether or not Norbert’s expert already implicitly included the discount for lack of marketability in his discount rate, the appeals court once again agreed with the trial court’s findings. That is, since Norbert’s expert testified that a discount for illiquidity should not be applied, both the trial and appeals courts found that a DLOM was not included in the expert’s analysis. Although the expert may have accounted for or considered marketability risks in the build-up approach to the discount rate, the expert could not specify to what degree it was applied, further supporting the finding that the discount was excluded.9 Despite claims by Norbert that the factors in the build-up approach already account for the same marketability factors and applying a DLOM would be double counting these risks, the court found (and the appeals court affirmed) that there was no DLOM in Norbert’s expert’s analysis.
Regarding the final issue of the value for the DLOM, Norbert asserted that the value should be zero since it was already accounted for in his expert’s analysis, while Frank’s widow and Patricia believed a 35 percent discount was warranted based on the fact that a DLOM for closely-held companies is typically between 30 and 40 percent. The appeals court upheld the trial court’s findings of a 25 percent DLOM, noting the equities considered by the trial court. The trial court had issued two findings: 1) despite Norbert’s suggestion, the appropriate value for the discount cannot be zero; and 2) a DLOM between 30 and 40 percent would “excessively punish Norbert, the oppressing shareholder, beyond what the equities of this case required” and that the remaining shareholders would receive a financial windfall.10 The trial judge, in reaching his decision, found that in some instances, a DLOM can be as low as 20 percent.11 Thus, together with the key man discount of 15 percent, the valuation was discounted in total by 40 percent (i.e., 25 percent DLOM plus 15 percent key man discount).
The appeals decision in New Jersey is noteworthy because the issue of a DLOM continues to stir debate in the valuation community. Many states do not consider a DLOM in determining shareholder value in oppression matters. Moreover, many valuation professionals believe that valuing ownership interests at “fair value” excludes the use of discounts. Some have argued that a DLOM was applied in Wisniewski due to the “bad behavior” of Norbert rather than basic economic principles. While the Court was not explicit in tying the DLOM to bad behavior, the Court did note the equity out of the outcome. The decision is a reminder for experts that the fairness of the outcome can be a central theme in the decision-making process by courts.
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1.Wisniewski v. Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 (Dec. 24, 2015). (“Appeal Decision”)
2.While some practitioners distinguish between liquidity and marketability, for purposes of this article we consider the two synonymous.
3.Appeal Decision at 6-8. Shareholder oppression is the unfair treatment of minority shareholders (esp. in a close corporation) by the directors or those in control of the corporation. Black’s Law Dictionary (7th ed. 1999).
4.Appeal Decision at 3-5.
5.Appeal Decision at 7-12.
6.Appeal Decision at 11.
7.Appeal Decision at 11-12.
8.Appeal Decision at 15.
9.Appeal Decision at 17.
10.Appeal Decision at 23.
11.Appeal Decision at 23-24.