Half-Baked LLC Agreement Yields Improvised Valuation Decision
May 06, 2019
A Plug for Cunningham on IRC 199A
Tax issues always have been an integral factor in valuing closely held business entities, whether for purposes of a court-supervised buyout or otherwise. The Tax Reform Act of 2018 added an important, new deduction for pass-through business owners, called the 199A deduction, providing business owners with federal income tax deductions of up to 20% of their net business income. I’ve started to see business appraisals that deal with the 199A deduction and, of course, the 199A deduction can provide substantial tax savings for business owners in the ordinary course, having nothing to do with appraisals or business divorce scenarios.
Taking advantage of the 199A deduction also can require a restructuring of the business, which is why I’m recommending a new book by my friend John Cunningham called Maximizing Pass-through Deductions under IRC Section 199A published by Wolters Kluwer. John has made it his mission to educate and help business owners navigate the complexities of the 199A deduction and with restructuring their businesses when required. Some of you may recognize John’s name from posts on this blog or my interview of John on my podcast on various LLC issues–a topic on which John also is a top expert and author of the leading LLC formbook and practice manual entitled Drafting Limited Liability Company Operating Agreements also published by Wolters Kluwer.
It was, as both principals of a start-up management consulting business testified at trial, a “partnership made in heaven,” which doesn’t exactly bode well for the celestial ambitions of the rest of us given that the litigation between the partners lasted longer than the partnership.
Vice Chancellor Glasscock’s recent valuation opinion in Smith v Promontory Financial Group, LLC, Mem. Op., C.A. No. 11255-VCG [Del Ch Apr. 30, 2019], tells the fascinating story of two individuals — Neil Smith, a seasoned management consultant in the profit improvement field, and Eugene Ludwig, a former U.S. comptroller of the currency and head of a financial services advisory firm — who together formed a Delaware company called Promontory Growth and Innovation, LLC (PGI), to provide management consulting services to financial services companies to enhance earnings and business performance.
Essentially, Ludwig had the rainmaking connections with CEOs of large companies while Smith had the expertise to close the deals and perform the client projects. PGI’s business model contemplated a very small number of one-shot engagements each year with large corporations, charging a contingency fee based on a percentage of the client’s increased profits. Landing an account, as Smith described it at trial, was like “finding the needle in the haystack,” requiring meeting with the right executive at the right time.
The “De Facto” LLC Agreement
Shortly after its formation in April 2009, Smith and Ludwig entered into a Letter of Intent (LOI). Under the LOI, Ludwig’s separate company, Promontory Financial Group, LLC (PFG), to which Ludwig later transferred his PGI membership interest, would provide working capital advances to PGI. Smith was designated PGI’s President and CEO responsible for running the day-to-day business. The LOI allocated economic interests Ludwig 50%-Smith 50% and governance interests Ludwig 60%-Smith 40%.
The LOI also gave Smith the right to withdraw and be bought out from PGI, this being the key provision in the eventual litigation. If he withdrew after three years from the start of PGI’s first client engagement, Smith was entitled to receive
over a period not to exceed 5 years 50% of the then going business value of [PGI] minus [Smith’s] services, the value to be decided between the parties at the time thereof.
Smith and Ludwig subsequently were unable to finalize a formal operating agreement for PGI, leading to their written agreement in April 2010 that the LOI would serve as PGI’s operating agreement. As VC Glasscock noted, the “rudimentary nature of this improvised operating agreement has led to difficulties in this litigation.”
In its first year (2009) PGI had no engagements. In 2010, it had two engagements generating approximately $6 million revenue. The third and last engagement during Smith’s tenure in 2011-12 with Bank of America was a whopper: it generated total revenue to PGI over $137 million of which at least $120 million was profit, virtually all of which was distributed to PGI’s two members. At trial Smith chalked up to “inadvertence” PGI’s non-retention of working capital and non-repayment of its then-debt to PFG out of the Bank of America proceeds.
From May 2012 until Smith’s withdrawal in August 2013, despite some close misses, PGI had no new engagements and earned no revenue. As of August 2013, PGI’s debt to PFG for working capital and loans totaled around $5.8 million.
The Debt/Equity Deal and Smith’s Withdrawal
In May 2013, as Ludwig pressed Smith on the issue of PGI’s unpaid debt to PFG, Smith, who opposed contributing his own funds to recapitalize the company, proposed that PGI’s debt be written off in exchange for reallocating the economic interests from 50-50 to 70% Ludwig-30% Smith. Smith explained his proposal to Ludwig:
You are writing off around $3.25 mm of my debt [for half the monies owed to PFG] for 20% of PGI which puts a value on PGI of just $16.25mm with me still in place. This is clearly absurd for a business which made $112mm in pretax profit last year and $22mm pretax the year before but I am willing to do this because of the unique circumstances I find myself in.
Smith expressly conditioned his debt/equity proposal on Ludwig’s consent and on discussing it with his tax accountant “before we finally agree to it.”
Between May and July 2013, Ludwig obtained his own tax counsel’s opinion and told Smith that he agreed to the proposal, while Smith continued to express his need for further professional advice. Finally, in late July, Smith called it off, stating that the deal “considerably undervalues PGI” and that he “will be responsible for 50% of PGI’s debt to [PFG], which will be paid back when the next deal hits.”
In mid-August, Ludwig advised Smith that PFG would not make further advances to PGI or allow any payments from PGI’s bank account without PFG’s consent. On August 18, 2013, which was more than three years after PGI’s first engagement, Smith tendered his resignation and notice of withdrawal.
PGI continued to operate with other staff for about three years until ceasing operations in mid-2016. In that period it had two engagements with $12 million in revenue.
The Valuation Contest
Smith brought suit in 2015, requesting the determination and award of 50% of the going business value of PGI minus Smith’s services as of his August 2013 withdrawal date. At trial Smith’s expert appraiser used a discounted cash flow (DCF) analysis to value PGI without Smith at $37.5 million, or $18.75 million for Smith’s one-half.
PFG took a two-pronged approach. First, it argued that Smith’s debt/equity offer was accepted and therefore he was only entitled to 30% rather than 50% of any amount of the value of PGI without Smith. Second, it relied on the opinion of its expert appraiser who used the “asset accumulation” method to value PGI without Smith at $0. PFG also counter-sued Smith for payment of his negative capital account in PGI of about $3.1 million consisting mostly of his half of the debt owed to PFG.
The Court’s Rejection of Smith’s Appraisal
VC Glasscock rejected in its entirety Smith’s expert’s DCF-based appraisal, for several reasons:
- PGI’s cash flows were “erratic and sparse” wrote the court, adding, “[s]uch boom or bust economics do not produce a reliable DCF analysis.”
- Smith’s expert relied on “spurious” and “stale” projections of cash flows that in turn relied on original projections made in 2012 by Smith who “had no prior experience creating long term projections.”
- “PGI’s business model and operating history show that a DCF was generally an inappropriate method to value PGI.”
The Court’s Rejection of PFG’s Appraisal
Using the asset accumulation method, PFG’s expert concluded that PGI had a value of zero because it had more liabilities than assets as of Smith’s withdrawal date. On the asset side, besides the fact that PGI’s consulting business had few tangible assets, the expert valued PGI’s workforce at cost and found that various goodwill assets either did not belong to PGI or had no value. On the liability side, PGI had a large debt owed to PFG.
VC Glasscock found that “an asset approach is inappropriate to value PGI.” PGI’s value, he wrote,
was largely attributable to its intangible assets, which are difficult to value. An asset approach for a viable services business, like PGI, would tend to undervalue such a business. The problem was exacerbated here by the episodic nature of PGI’s hunter/gatherer business model; the primary flaw of an asset approach, in this circumstance, is its inadequacy to value PGI’s prospects.
VC Glasscock also rejected PFG’s legal argument, that Smith was entitled only to 30% of PGI’s value based on PFG’s acceptance of the debt/equity deal, finding that Smith’s offer to reduce his equity percentage was conditional, that the stated conditions were not met, and therefore no binding agreement was reached.
The Court Nonetheless Values PGI Using the Debt/Equity Deal
Although not a binding agreement, VC Glasscock had further use for the debt/equity deal, finding that it was
the best indicator of value, with Smith at the helm. Smith made the initial proposal in the Debt/Equity Deal and explicitly noted that his proposal valued PGI at $16.25 million (with Smith). Ludwig agreed to the proposal. The Debt/Equity Deal was initially delayed to satisfy Smith’s tax concerns. While Smith later claimed the Debt/Equity Deal undervalued PGI, it represents the best evidence of PGI’s value with Smith in place. . . . Moreover, the Letter of Intent refers to a valuation as agreed to by the parties; the Debt/Equity Deal is such an agreement, near-contemporaneous with Smith’s withdrawal. [Italics in original.]
Having concluded a value for PGI of $16.25 million with Smith, VC Glasscock next valued PGI “minus” Smith. Smith’s expert opined that a reduction of one-half of entity value was appropriate to account for Smith’s departure. PFG argued that PGI’s value fell by more than 50% because Smith and Ludwig “performed different, complimentary and essential, functions” and that without Smith, “Ludwig’s entre into the business world lost much of that value, because Smith’s departure left no one to perform the underlying work.”
VC Glasscock agreed with Smith’s expert and valued PGI at 50% of $16.25 million or $8.125 million, which he then reduced 50% as provided in the LOI to value Smith’s interest at slightly over $4 million. He then reduced that sum by approximately $3.1 million on account of Smith’s negative capital account, leaving Smith with a net award of approximately $930,000. The court left for further proceedings resolution of the parties’ competing claims for prejudgment interest.
Sophisticated Parties, Half-Baked Agreement
It never ceases to amaze when sophisticated entrepreneurs with decades of business experience enter into a high stakes venture, in which they invest serious money and sweat equity, without first securing a comprehensive, carefully crafted, definitive agreement addressing the panoply of issues affecting the rights and obligations between themselves.
It would have been a miracle if the LOI’s half-baked withdrawal provision did not result in a lawsuit. The provision omitted any standard of value or any other valuation parameters. It gave no clue how to value PGI “minus” Smith or as to the process by which value was supposed to be “decided between the parties.”
Smith filed his lawsuit under § 18-111 of the Delaware LLC Act, which authorizes an action to be brought in Chancery Court “to interpret, apply or enforce the provisions of a limited liability company agreement.” Given the LOI’s reference to a value “decided between the parties,” and regardless whether the appraisal methods used by the opposing experts had merit, the statute gave VC Glasscock no choice but to search the record for evidence of some agreement on value between Smith and Ludwig.
In other words, VC Glasscock effectively had no choice but to adopt the value implied by Smith’s debt/equity deal because that was the sole evidence of anything approaching an agreement “between the parties.” It also required him to discount Smith’s contemporaneous, stated rationale for pulling the plug on the debt/equity deal, i.e., that his offer “considerably undervalues PGI.”
Rough justice? Perhaps. But perhaps the only justice possible given, as VC Glasscock described it, the difficulties caused by the “rudimentary nature of this improvised operating agreement.”