The district judge in Minneapolis who ruled that Kim Lund was owed $45.2 million by Lunds & Byerlys for her share of this well-known grocery business carefully weighed the testimony of the valuation experts employed by both sides in her opinion. And she couldn’t have been any clearer on who she thought had gotten it wrong.
Both of them.
The judge here, Ivy Bernhardson, called these experts “unquestionably qualified.” The problem she identified is just the nature of expert witness assignment in lawsuits. They had been asked to sift through facts, tweak financial assumptions and construct a spreadsheet that gave their respective clients the valuation number they had hoped for.
That there ended up being a chasm between the two of them is hardly a surprise. It’s a reminder of a fundamental problem in business that even experienced executives seem to get wrong: Even the best opinion of what something is worth is no more than a highly educated guess.
Bernhardson is no novice in corporate deals, with a background in corporate law. Deep in her opinion she quoted a case from Delaware, noting that “valuation decisions are impossible to make with anything approaching complete confidence.”
The judge in the Delaware case had the same conundrum she did: having financial experts “organize data in support of wildly divergent valuations for the same entity.”
All any judge can do is hope to spot the gross distortions, then arrive at the fairest number out of a range of reasonable estimates.
To the extent that there’s a winner in this case at all, it’s Kim Lund, whose grandfather started Lunds. Through trusts, she owns a 25 percent stake in the Lunds & Byerlys business. The court had already decided she would be bought out, just not for how much.
Kim Lund contended in court that the business, actually made up of three entities, was worth nearly $322 million as of the valuation date last fall and thus her quarter interest was worth more than $80 million.
Lunds & Byerlys went to court to argue that that was complete nonsense. Back then the whole business was only worth about $91 million.
You have to admit, those are wildly divergent valuations for the same entity.
Kim’s valuation expert was Chicago-based Robert Reilly of Willamette Management Associates, while the company relied on Roger Grabowski of New York investment banking firm Duff & Phelps. The judge certainly accepted that they are both genuine experts in valuation, and how they ended up with such different estimates just illustrates what an imprecise exercise this is.
What the judge was after was “fair value.” The only way to be dead certain about that figure is knowing what a willing buyer just paid to a willing seller when both of them had pretty much the same information. Otherwise, no matter what methodology is used, the experts are estimating.
One of the main ways to arrive at an estimated value of a business is to forecast the cash to be collected by the owner in the future, and then determine what all that cash is worth today. We know from basic finance that a dollar collected two years from now isn’t worth what a dollar is today, and so the future cash flow is discounted. The process is called a discounted cash flow analysis, or DCF.
This is one exercise in the Lunds & Byerlys case that resulted in such different amounts. The judge noted that the experts disagreed “as to essentially every input and assumption contemplated in their DCF calculations.”
Reilly, the expert for Kim Lund, wanted a higher value so he was an optimist, although the judge noted he failed to note the competitive pressure from Hy-Vee and other grocery retailers. He also assumed a lower level of capital expenditures than what was probably needed for Lunds & Byerlys to remain competitive, and so on.
While the opinion of Grabowski, expert for Lunds & Byerlys, generally was treated a little better by the judge, he was criticized for tipping too far the other way. One factor was the choice of an estimated cost of capital, as he landed at 12 percent rather than Reilly’s estimate of 9 percent.
This can be a big deal in the math of a discounted cash flow valuation, as the higher the assumed cost of all the capital used in the business, the lower the value of the cash that gets collected by the owner in the future. The judge decided the right number was closer to Reilly’s estimate.
Finance majors probably know all about things like a DCF analysis, but business owners may not. And if business owners think getting the opinion of a valuation expert when it comes time to cash out will make everybody at the table happy, they are probably being naive.
In a big file of really good business agreements kept here at the office for reference is a contract that’s called a buy-sell agreement. This one lays out in detail how a shareholder in one privately held company would be bought out upon leaving the business, including a long section on what to do when the owners can’t agree on a value for an ownership stake.
In this case, the partners had all agreed that if they came to an impasse, not one appraiser would be hired, or even two, but three. The company was allowed to pick one, the owner who wanted out picked one, and then these two business valuation firms chose a third.
As all this would cost a lot of time — to say nothing of fees — the hope was that the partners would reread this section and sigh, then take a deep breath and go back into the conference room to hash out price.
It might be painful to reach a deal, but at least money wouldn’t be changing hands based on the estimate of some expert.