A few weeks ago I wrote about issues with valuing a partial ownership interest in a marijuana dispensary. (Of course, these also apply to other companies). This post focused on how the entity choice chosen at formation can affect later value determinations. By and large, valuation problems can arise when a majority owner tries to buy out a minority owner’s stake, or vice versa. Or when one or more members try to expel one or more other members. Or when a majority or minority owner simply wants to get out of the marijuana pharmacy and wants to sell her interest.
When the pharmacy is incorporated as a Limited Liability Company (LLC), the operating agreement often includes provisions regarding the buying and selling of membership shares. A common provision is a right of first refusal – meaning the selling member must first offer to sell his interest to the other members before selling to a stranger. A good company agreement – and we see a lot of poor people in cannabis – should also specify how members rate the interest and process for it. A first key concept is whether the value of a member’s interests is valued at “fair value” or “fair value” and whether discounts apply for lack of control and / or lack of marketability. These concepts should be included in company documents to avoid litigation.
A major consideration in any valuation is which value standard applies. Company appraisers need to determine and apply a “standard of value”. According to the AICPA, the standard of value is to “identify the type of value used in a particular order; For example fair market value, fair value, investment value. “
The definitions of “fair value” and “fair market value” used by CPAs are technical. For laypeople, the main difference, in most cases, is whether or not discounts apply. For example, a valuer may conclude that a 33% interest in a pharmacy has a “fair value” of $ 300,000. This would mean the appraiser believes the entire pharmacy is worth $ 900,000 and 1/3 of that is $ 300,000. However, in determining the “fair market value”, the appraiser may apply unmarketability and control discounts to conclude that the 33% stake is worth only $ 150,000. This corresponds to a discount of 50% from the “fair value” of the interest in order to arrive at the “fair value”.
The “fair market value” is intended to express the price at which the interest changes between a hypothetical willing and able buyer and a hypothetical willing and able seller who trades in an open and unrestricted market under normal market conditions when no one is under duress to buy or sell and when both have adequate knowledge of the relevant facts. When an appraiser gives an opinion on the “fair market value” of an interest, the appraiser is simply giving an opinion on what price the appraiser believes a fair buyer would pay for the interest in an open market.
So do your corporate documents provide a “fair value” or a “fair market value”? Or. . . Shudder … don’t they say anything at all and don’t let members argue about what standards and discounts apply?
Discounts for a lack of control and marketability
There are two main discounts to consider when determining the value of a minority stake. The Unchecked Discount (“DLOC”) and the Unmarketable Discount (“DLOM”). DLOC believes that the lack of control negatively affects the value of the interest concerned. If the 33% shareholder does not have meaningful control over the management and operations of the company, for example because of majority rules, the interest of a potential buyer in buying a company without the ability to run the company is less attractive. As a result, an appraiser can apply a DLOC which reduces the value of the interest.
The DLOM takes into account the difficulty and cost of finding a buyer of private interest. The AICPA defines DLOM as “an amount or percentage that is deducted from the value of a property interest to reflect the relative lack of marketability”. For example, there is usually no DLOM when evaluating the value of stocks in a public company. This is because there is a market in which stakes in the company can be bought and sold. (e.g. Gamestop, Apple, Google, Tesla). However, finding a market for an interest in a privately held company for which data is not publicly available varies greatly. In such circumstances, a reviewer can use a DLOM.
Factors influencing DLOM include a company’s profitability, earnings, revenue and growth, the product it sells, and industry risk. A significant risk to marijuana dispensaries is that the business will continue to be illegal nationwide. This significantly narrows the pool of potential investors, making the interest less marketable, and leading to a higher DLOM – and a lower value of a given interest. Courts and commentators are more likely to agree that the percentage discount that applies in a given situation is more art than science. In a leading case, Mandelbaum v Comm’r, 69 TCM 2852, 2865 (1995), one expert suggested a 70-75% discount and the other a 30% discount based on studies of restricted stock deals. In other cases, the courts have approved discounts between 15% and 70% depending on the above factors.
All of this creates a significant amount of uncertainty surrounding a marijuana dispensary. Uncertainty means risk. The seller of an interest may find that his interest is significantly discounted and worth much less than he thought, or that the interest may only be discounted minimally, causing other members to pay more than they think is appropriate. Despite the uncertainty, the fair value approach is more common in corporate documents than the fair value approach. This is because the goal of the fair market value approach is to arrive at a value inference that tracks exactly what the interest in the market is actually worth.
Readers may recall my previous post that one difference between corporations and limited liability companies is the existence of “dissenting rights” in the previous business structure. As a rule, the rights of those who think differently provide for a determination of “fair value”. However, there are significant differences between jurisdictions and some jurisdictions that indicate “fair value” may allow discounts to be applied in certain circumstances. See Columbia Mgmt. Co. v. Wyss, 94 Or. En App. 195 (1988). Even if you and your partners choose a “fair value” approach, there is no reason not to indicate whether discounts apply.
In addition to the decision on the evaluation of a member’s share, the works agreement can also specify how the evaluation is carried out. This is no small matter, especially when a later separation of companies is controversial. Questions that should be resolved in the company agreement include: Will the company keep an independent appraiser if a member wishes to leave the company? Is the determination of this valuer considered binding on the members? Can a member keep their own reviewer? How are disputes between reviewers resolved? What is the schedule for purchasing the outgoing member’s shares? How are capital accounts and deposits treated? Does it matter if the outgoing member is compelled for a breach of duty?
For posts that dig deep into scoring, here are a few more:
Below are some early, but still relevant, posts on buying and selling cannabis businesses in Oregon: