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My first in-depth experience understanding non-compete agreements was in graduate school (many years ago). At that time, the examples only included transactions between large, publicly held companies, so when I handed my very first non-compete valuation to the attorney, I was shaking like a leaf in a hurricane. As the years went on, we’ve been asked to value such agreements more and more. I saw that non-compete agreements involving closely held businesses become “standard fare,” with 30 million Americans subject to this restrictive covenant. However, the landscape has dramatically changed with the Federal Trade Commission’s final rule issued on April 23, 2024, which bans most non-compete agreements. Under the new rule, existing non-competes are no longer enforceable, with narrow exceptions including senior executives earning over $151,164 annually in policy-making positions (less than 0.75% of workers). Employers are also prohibited from entering into any new non-competes, even with this small subset of executives. The final rule also includes a limited exception that hasn’t been as publicized: non-compete clauses are permitted in connection with the sale of a business entity, a person’s ownership interest in a business entity, or substantially all of a business entity’s operating assets. The final rule eliminates the proposed 25 percent ownership requirement for the seller. Prior to the FTC ban, non-compete agreements helped businesses retain valuable employees, safeguard inside information, and prevent unfair competition. When valuing a non-compete, we considered several factors, such as the overall business value, probable damages from a breach, likelihood of competition, and […]

For the better of the past two years, we have been working on a shareholder buyout dispute centered on the value of a fifty percent interest in a business and its ability to support the buyout provisions. The shareholder’s agreement outlined the valuation standard and the terms of its payment. Despite this direction, each party’s valuation proposed at arbitration was millions of dollars apart. I will save the particulars of this case for another time but share with you that the value opined in our report was accepted in the arbitrator’s binding decision. One of the reasons for this favorable business divorce case outcome was that our client’s attorney respected our focus on essential valuation fundamentals. In return, his direct case and cross-examination led to a well-versed presentation of the issues at bar. Attorneys tend to many issues in a shareholder dissolution case; having a command of opposing valuation reports is just one. Here are five key considerations attorneys should consider when reviewing their experts’ reports and those of the opposing side. 1. Standard of Value The choice of a standard of value is fundamental to the valuation process. Two common standards often considered are fair market value and fair value. Fair market value is defined in Revenue Ruling 59-60 of the Internal Revenue Code: The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to […]

  Whether a company is being valued for a shareholder or an equitable distribution dispute, one of the most common normalization adjustments to a subject company’s income stream is owner compensation. Both the Court and the IRS tend to closely scrutinize this issue, with the IRS in frequent disagreement as to the reasonableness of shareholder-employee compensation. For income tax purposes, business owners typically prefer to classify payments as tax-deductible wages. This allocation reduces both their corporate taxes and their federal taxable income. As one might imagine, the IRS is correspondingly meticulous in its examination of these classifications. If it believes that owner compensation is excessive, it may claim that non-deductible dividends have been disguised as compensation. As they pertain to business valuation, the determination and application of reasonable shareholder-employee compensation are similarly contentious. The correlative relationship between owner compensation and cash flow means that when compensation is inflated, the available cash flow is reduced. Correspondingly, the indicated value under the income approach will be likewise reduced. But whether challenges to owner compensation emanate from taxing authorities or a rival valuation expert, the case law in this area strongly indicates that there is no global rule of thumb – reasonable officer compensation is determined according to the particular circumstances of an individual case. It is for this reason that Trial and Appellate Courts often struggle to resolve questions regarding reasonable officer compensation. For non-valuation professionals, this confusion is perhaps attributable to the number and diversity of sources used to ascertain reasonableness. […]

  This has certainly been an eventful week. My beloved New York Mets were sold. Although I believe Steve Cohen will be up to the task, I am somewhat resentful that my bid to purchase the Amazins was rejected. On the other side of the plate, Joe Biden can claim victory in the turbulent presidential election. Despite the possible legal battle, it appears that the Biden-Harris battery is now warming up for a January 2021 inauguration. President-elect Biden has made no secret of his intent to raise $3.5 trillion in taxes over the next ten years. The intended contributors will be corporations and individuals earning over $400,000 per year. Conversely, lower-income taxpayers may benefit from tax-cutting incentives from items such as refundable credits, etc. Biden’s ability to effectuate any tax change heavily depends upon the Democrats’ ability to win both the House and Senate. The Democrats currently hold a majority in the House of Representatives but are taking swings at the two remaining Senate seats up for grabs. If the Democrats sweep both available seats and get a 50/50 split in the Senate, then the Biden tax reform vision could theoretically be passed without a single Republican defector. Pending a home-field advantage, the Biden tax reform could pass via a Budget Reconciliation which will not require 60 votes for passage. Alternatively, they will only need a majority of 51 votes. Assuming everyone votes along the party line, Vice President-elect Kamala Harris will cast the deciding vote. Without the benefit of […]

  Are loans due to or due from shareholders a bona fide debt obligation, a form of equity capital, or a hybrid of the two? This distinction is relevant when valuing a business – particularly in a shareholder dispute or in a divorce case. I customarily devote a good portion of class time discussing this issue in my class at Fordham Law School. This distinction may cause a material difference in the ultimate valuation of a closely-held business or even the income attributed to its owner. Often, experts turn to the Internal Revenue Service for objective guidance on this issue. What Would The IRS Say? Owners occasionally borrow funds from their businesses, say, to pay a child’s college costs or provide a down payment on a vacation home. These loans to shareholders appear on a company’s balance sheet as a receivable. For loans of more than $10,000, the IRS requires taxpayers to treat the transaction as a bona fide debt. Then the company must charge the shareholder an “adequate” rate of interest. Each month the IRS publishes its applicable federal rates (AFRs), which vary depending on the term of the loan. If the company doesn’t charge interest or follow a complicated set of below-market interest rules to impute interest on the loan, the IRS may claim the shareholder received a taxable dividend or compensation payment rather than a loan. The company may deduct the latter, but it will also be subject to payroll taxes. However, both dividends and additional compensation […]

  We are presently working of several assignments concerning dissenting shareholder disputes.  Attorneys that represent clients in such matters can attest that there are many challenges unique to these cases.  One of them, and perhaps the most prominent, relates to the value of the business subject to the dispute.  Within this broad context, attorneys need to be familiar with a number of valuation issues affecting their case.  These often include a familiarity of the standard of value, the valuation date, and valuation method to be employed. This week’s blog briefly discusses these issues. Hopefully, it will set you in the right direction. Standard Of Value The standard of value for dissenting shareholder cases in most states is fair value, although the term is subject to different statutory and judicial interpretations. Generally, fair value is defined as the value of the plaintiff’s shares immediately before the corporate action that the shareholder objected to. Fair value typically excludes any appreciation or depreciation related to the corporate action unless exclusion would be inequitable. This definition may not necessarily be synonymous with the “fair market value” standard of value. For instance, the dissenting shareholder is not usually a willing participant in the transaction; nor is the transaction consummated on an objective, unbiased basis. Also, fair value usually doesn’t always include discounts for lack of control and marketability. Some jurisdictions may recognize one of these discounts — or leave the application of these discounts to the court’s discretion based on the case’s facts and circumstances. […]

  Last week we published the first of three installments of our Delaware Appraiser Series. We reviewed the fair value standard and some notable differences between the fair value standard used in the Delaware Chancery Court and fair market value defined in Revenue Ruling 59-60 of the Internal Revenue Code. There have been some recent developments in the Delaware Chancery Court providing further guidance on fair value. A number of these cases focus on the process used in “shopping” the subject company for sale; particularly when one side is seeking value in excess of an actual transaction. The Court has highly scrutinized or ignored the transactional value, depending on the sale process relied upon in their analysis. We leave the formal “briefing” to you, but we wanted to identify those cases that we think will be of interest. DELL INC V. MAGNETAR GLOBAL EVENT DRIVEN MASTER FUND LTD ET AL DECISION 12/14/17 https://courts.delaware.gov/Opinions/Download.aspx?id=266610 On appeal, the Delaware Chancery Court revised its opinion as to whether Silver Like Partners had perfected their appraisal rights. Silver Like Partners claimed Dell’s shares were worth more than the management buy-out price of $13.75 per share, a 37% premium to the Company’s ninety-day average unaffected stock price. The Court found that market pricings of Dell’s shares should not have been ignored and were relevant. In its original determination, the Court used a discounted cash flow method only, because the market was determined to be “inefficient.” A key finding in this appeal is summarized below: “The […]

  According to a recent Delaware Division of Corporations Annual Report, more than 66% of the Fortune 500 companies are registered in the State of Delaware.  That being said, it is not surprising that the Delaware Chancery Court is widely recognized as one of the nation’s leading courts in settling shareholder appraisal disputes. Delaware affords protection to shareholders by granting appraisal rights within Delaware §262 where fair value is defined §262(h): After the Court determines the stockholders entitled to an appraisal, the appraisal proceeding shall be conducted in accordance with the rules of the Court of Chancery, including any rules specifically governing appraisal proceedings. Through such proceeding the Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors. This definition can cause an appraiser to consider alternative methodologies and/or apply discounts and premiums differently than for different jurisdictions or for tax valuations. As you may be aware, Fair market value as defined by Revenue ruling 59-60 is:  “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” The […]

  As the business valuation discipline matures, judges, attorneys and other people who rely on appraisal conclusions are becoming more comfortable with the income approach. But how does a business’s perceived risk translate into a reasonable discount rate? This is one of the most subjective — and contentious — aspects of valuing a business. Breaking down the income approach Under the income approach, value is a function of a company’s expected economic benefits and its risk relative to other investment types. Valuators typically gauge expected economic benefits in terms of net cash flow. They measure risk by the company’s cost of capital, which is the expected rate of return investors require to invest in the subject company. Riskier businesses have lower values as a result of lower projected income, higher discount rates — or a combination of these. The two most common methods that fall under the income approach are the capitalization of earnings and discounted cash flow methods. Discounting future cash flow The key to both of these methods is converting expected cash flows (or other economic benefits) to present value. This requires the valuator to use a discount rate that reflects the time value of money and the degree of risk associated with an investment in the business. Put another way, the discount rate reflects the risk associated with achieving the expected cash flows. When valuing a company’s equity, valuators may estimate expected cash flows to equity investors and use the cost of equity as the discount rate. […]

  The hiring of a joint business valuation expert can often be useful. This strategy assumes that the parties will openly share information and act in good faith. But it may not be realistic in all situations, including contentious divorces and shareholder disputes. Sharing fees and information When using a joint valuation expert, the parties will only be satisfied by the outcome if there’s a mutual perception of fairness. Perceived fairness is enhanced when: • Both parties have a say in the interviewing and selection of the credentialed expert, • The expert and both parties have full access to relevant information, such as tax returns, financial statements, responses to questionnaires and notes from site visits, • The expert’s communications between the parties are shared, and • Both parties contribute to the expert’s costs. The expert should explain upfront that the valuation will be performed in an objective, unbiased manner. If either party suspects that a joint valuation expert is biased, dissatisfaction may ensue, possibly leading to appeals and additional fees. Potential upsides When the conditions are right, using a joint expert can benefit both sides. The benefits extend beyond just saving money and streamlining the valuation process. A joint expert also helps minimize disruptions to business operations from site visits, information requests and management interviews. Additionally, parties that share a valuation expert prove that they can trust each other, improving the chances of effectively working together in the future. For example, buyers and sellers who share an expert to conduct […]