In December 2014, Kim Lund, one of four siblings who shared beneficial ownership of Minnesota’s Lund grocery empire, filed a lawsuit against her brother Tres Lund (the CEO of the business entities), the entities themselves, two directors, and a co-trustee of one of Kim’s trusts. In the action Kim sought to divest her Lund business entity interests, and the court decided it would order a buyout. After a trial in February 2017, the district judge entered an order valuing Kim’s business interests and resolving Kim’s request for the removal of certain trustees from her trusts. The district judge’s decision was appealed. On January 14, 2019, the Minnesota Court of Appeals decided the appeal.[1]
The Lund appellate opinion touches numerous issues of interest in Minnesota minority shareholder and trust litigation. This post considers the process of assessing the fair value of a business entity, as illustrated by Lund.
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After a court has decided to order a buyout of a shareholder, the struggle to determine the price of the buyout begins. The seller wants a high price, the buyer wants a low price, and the ordinary means of pricing an asset – offering it to the market to see what price would be paid by an arm’s-length buyer who is not obligated to buy – is unavailable. The court, therefore, must somehow determine on its own the proper price, fair to both sides. Usually the parties are eager to help, by providing the court with evidence supporting their own valuations.
Fair Value on Appeal. The parties in Lund took radically different views of the value of Kim’s one-quarter share of the disputed business interests. Kim argued for a value of $75.967 million. The defendants argued for a value of $21.275 million. Valuation was thus a $54+ million question.
Yet in the twenty-page opinion of the Court of Appeals, the discussion of the $54 million question occupies only about one and a half pages, laconically concluding the trial court “acted well within its discretion in determining fair value.”[2] The appellate court’s terse discussion of the valuation figure, in pragmatic terms the most important issue in the case by a light-year, plays out two critical undercurrents in business valuation litigation:
- First, valuation is a trial court game, not an appellate game. The trial court has “broad discretion both in the process and the ultimate determination of the ‘fair value’ of the shares to be sold,”[3] and on appeal the trial court’s decision will only be reviewed for an abuse of discretion, an exceedingly deferential standard. Absent unusual circumstances or a decisive question of legal procedure, the valuation game will be effectively over before any appeal is taken. “The trial court picked the wrong number” is not likely a winning appellate argument, even if a party can articulate well-supported reasons it believes the trial court picked the wrong number.
- Second, valuation is an art, not a science. The Lund trial court’s $45.2 million valuation conclusion was not the result of a calculation replicable by the defendants. Nevertheless, the Court of Appeals was satisfied by the conclusion because the trial court’s order discussed at length the evidence presented at trial and the court’s evaluation of that evidence, and because the court’s somewhat subjective valuation fell between the two figures offered by the parties’ competing experts.[4] The valuation was affirmed with the explanation, “The district court considered posttrial motions for amended findings, reaffirming its methodology and valuation. It observed that business valuation is an imprecise art and stated that it ‘based its value determinations on the evidence it deemed most persuasive, all the while minding its obligations to rule in a manner that was fair and equitable to all parties and shareholders.’ The district court’s painstaking efforts are commendable.”[5]
Both of these considerations paint bright, flashing arrows pointing at the trial court’s opinion, in valuation cases generally and in the Lund case specifically.
Business valuation is an art, not a science, and the trial court has “broad discretion both in the process and the ultimate determination of the ‘fair value’ of the shares to be sold.” Where the trial court’s valuation order discusses the evidence and the court’s evaluation of that evidence, it is likely to be affirmed on appeal.
Fair Value at Trial. The Lund trial court’s fifty-four page opinion provides a reasonable sampler of a typical business valuation litigation. The parties contested many commonly contested issues, and the opinion walks through those issues in a thorough but not overly lengthy fashion.
The opinion begins with a description of the Lund entities’ business, competitive environment, and future financial prospects. Two specific financial issues, pension liabilities and certain impending tax liabilities, receive individual attention. Valuation practice joins close attention to the details of the specific business together with application of overarching economic principles completely independent of the specific business.
Experts v. Judge. After the substantive introduction to the underlying facts, the trial court’s opinion considers in detail the expert testimony introduced by the parties, in which notable and experienced valuation professionals, Robert Reilly and Roger Grabowski, proffered their own calculations of the value of the Lund business entities. Ultimately, the trial court relies upon the experts’ testimony but declines to accept either expert’s conclusions wholesale, explaining, “While the Court finds that both Reilly and Grabowski are unquestionably qualified to testify on the issue of valuation, the obvious, zealous advocacy in which they engaged on behalf of their respective clients compromised their reliability in this instance.”
Applying its own judgment, the court briefly discusses the three standard valuation methodologies (income approach, market approach, and asset-based approach) and concludes the income approach is most appropriate for valuing two of the Lund entities, while the asset-based approach is most appropriate for valuing the third entity, a real estate holding company. The court rejects both experts’ market approaches – an outcome not unusual in business valuation disputes, where finding a truly comparable recent sale may be impossible.
Income Approach. The trial court’s opinion provides a twelve-page discussion of the two experts’ income approach analyses. The income approach values a business by projecting the business’s likely cash flow in future years, then “discounting” that cash flow down to its present-day lower value. Because this process requires projecting unknowable future events, it is inherently subjective, although experts rely on past data to formulate informed predictions.
The primary individual pieces of an income approach valuation calculation are an estimation of cash flows over a specific period of years, a terminal value calculation (which represents the projected value of cash flows after the specific period of years), and a discount rate (which is used to reduce future cash flows to their lower present value).
In Lund, the trial court summarizes, “the experts—presumably to advance the incentives of their respective clients—disagree as to essentially every input and assumption” in the income approach calculations. The court explains in further detail:
- The experts presented radically different estimates of the companies’ future profitability and tax and pension obligations. Both relied, as is typical, on an analysis of the companies’ past financial statements, and both considered financial projections which had been created by the companies’ management. However, the two experts reached different conclusions about the future cash flows, with the expert retained by Kim (who sought a high valuation) taking a much more optimistic view of the companies’ future prospects.
- The experts used different long-term growth rates to calculate the Lund companies’ terminal value. The expert retained by Kim used an optimistic 4 percent growth rate, while the expert retained by the defendants (who sought a low valuation) used a more conservative growth rate of 3 percent.
- The experts reached very different conclusions concerning the appropriate discount rate to apply, because they relied upon different assumptions about the appropriate capital structure for the Lund companies. One expert testified that a 75% equity/25% debt capital structure was appropriate for valuation purposes, while the other testified that it would be more appropriate to use the companies’ actual capital structure of 100% equity/0% debt. The defendants’ expert explained that this difference in assumed capital structure, alone, created a $100 million difference in the two experts’ valuation of the companies as a whole.
Valuation Conclusion. After working through the disputes between the experts on each of these points and other related points, and after explaining which view it believes more reasonable on each point, the trial court states that it conducts its own calculation to arrive at an income approach valuation for two of the Lund business entities. The trial court says that it uses a discount rate of 10 percent (which falls between the 9 percent and the 12 percent figures advocated by the two experts); the 3 percent growth rate advocated by the defendants’ expert, Grabowski; and a cash flow estimate that excludes the tax and pension obligations that Grabowski included. Using these inputs, the court apparently calculates its own valuation for two of the Lund entities. It notes that its value is comparable to certain appraisals performed independently of the litigation, while Grabowski’s offered value was half this amount and Reilly’s offered value nearly double.
The primary pieces of an income approach valuation calculation, or discounted cash flow analysis, are (1) an estimation of the business’s income over a specific period of years in the future; (2) a terminal value calculation of the projected value of income beyond that period; and (3) a discount rate that is used to reduce future projected income to its lower present value.
The trial court then applies the asset-based approach to value the third entity, a real estate company. The asset-based approach adds the appraised values of the assets owned by the company and subtracts the company’s liabilities to yield a net asset value.
After reaching its conclusion on the value of the Lund companies as a whole, the trial court considers whether to apply any discounts to the value of Kim’s minority interests in the companies, to reflect a lack of marketability and a lack of control. The trial court concludes no extraordinary circumstances exist to justify applying a discount, and “fair value” under Minnesota law precludes discounts in the absence of extraordinary circumstances.
The detail-oriented, careful approach articulated by the trial court in Lund blazes a trail through a thicket of conflicting expert testimony offered by the parties, leading to a $45.2 million “fair value” figure that falls between the two experts’ valuations of $76.0 million and $21.3 million, but which clearly is not simply a split-the-difference approach. The trial court’s explanation for its decision provides a useful sample of the nuts and bolts that can drive a typical business valuation dispute.
[1] On February 12, 2019, the Lund defendants filed a petition asking the Minnesota Supreme Court to review the decision of the Court of Appeals. That petition remains pending.
[2] Lund v. Lund, no. A18-0120 (Jan. 14, 2019), sl. op. at 14.
[3] Lund, sl. op. at 13 (quoting Adv. Comm. Design, Inc. v. Follett, 615 N.W.2d 285, 290 (Minn. 2000)).
[4] Lund, sl. op. at 13.
[5] Lund, sl. op. at 14.
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