How do you rationalize a $12 million personal goodwill claim when you already receive compensation for signing a consulting and noncompete agreement? This was the issue explored in a recent ruling in a dissenting shareholder case.
Valuation follows price: An advertising company was embroiled in a five-year litigation with a competitor over the legality of the competitor’s business practices, which threatened to ruin the company. One week into trial, the company accepted the competitor’s settlement offer.
The competitor insisted on buying only the company’s assets, not its stock, and wanted to eliminate the risk of future competition from the company or its four officers. In return, it offered $29.5 million on a “take-it-or-leave-it” basis. This amount was not based on any prior valuation of the company’s assets.
The buyer specified that none of the money should be allocated toward the settlement, presumably so as not to admit liability for any of the claims in the lawsuit. It required the company and the four officers to execute a noncompete agreement and also entered into one-year consulting agreements at $1,000 per month for each of the individuals. Based on the buyer’s instructions, the CEO of the company had to allocate the proceeds to the following categories: (1) retailer contracts; (2) inventory; (3) noncompete agreements; and (4) consulting agreements.
The CEO’s valuation assigned $13 million to cover the value of the company’s assets and inventory, over $4.45 million to cover the defendants’ noncompete agreements, $48,000 to cover the consulting agreements, and $12 million to cover the four officers’ “personal goodwill.” A true-up from a renowned appraisal firm did not occur until some eight months later. The CEO chose the appraiser, and the buyer approved the selection. At trial, the appraiser explained he was not allowed to create any new categories and was “solving back” to the purchase price. Under his analysis, the retailer contracts were worth only $9.3 million and the noncompetes only about $3 million. This left $16.7 million to cover the defendants’ personal goodwill. The CEO ultimately adopted his figures.
‘Plug’ figure: The plaintiff, on behalf of the minority shareholders, sued the officers, who were majority shareholders in the company, alleging self-dealing. According to the plaintiff’s expert, the company had little, if any, value, at the time of the transaction. Consequently, the noncompete and consulting agreements from the four defendants were worthless. The entire $29.5 million purchase price was in effect payment for settling the lawsuit and belonged to the company, the expert said.
The court agreed that there was no meaningful valuation. It also agreed that the deal was not an arm’s-length transaction in an open and unrestricted market. However, in light of the potential the company had to offer to certain synergistic buyers, it was reasonable for the buyer to pay $13 million for the retailer contracts. This amount belonged to the company, the court determined. It also was reasonable for the defendants to be compensated for their consulting agreements and the noncompetes.
But the court flat out rejected the 40% allocation to personal goodwill. Considering the company’s financial situation, it would take a lot to convince a fact finder that it is appropriate for the CEO to award himself and the other officers an additional $12 million because “they worked so hard and deserved it,” the court said. It found the personal goodwill agreements “stunning in that it is not clear that anything is being sold.” It rejected the idea that personal goodwill could serve as a “plug” figure. The defendants were unjustly enriched by the $12 million allocation for personal goodwill, the court concluded, and ordered them to pay the amount to the company.
Takeaway: Jim Alerding (Alerding Consulting LLC) notes that the court was well aware that there was no fair market transaction and there never was any intent on the part of the buyer to purchase any personal goodwill. In fact, by the CEO’s own admission, the buyer seemed unfamiliar with the very concept of personal goodwill. To the extent there was any tradable personal goodwill, the noncompete and consulting agreements ensure that such value was transferred to the buyer, and the buyer paid compensation for it, says Alerding. He also notes that, without saying so, the court seems to recognize that there is such a thing as “pure personal goodwill,” goodwill that cannot be transferred by its nature and thus has no “market value.”
Find an extended discussion of Potok v. Rebh, 2014 Phila. Ct. Com. Pl. LEXIS 318 (Sept. 16, 2014) in the December issue of Business Valuation Update; the court’s opinion will be available soon at BVLaw.