7th Circuit explains the ‘gold standard’ of valuation

While building a fast-food business, the owner promised that once he bought out his PE investors, he would distribute 50% of the equity to his top 20 managers. When he failed to do so, the managers sued for breach of contract. The federal district court found an agreement, but said the plaintiffs’ estimate of damages was “too simple.”  From the buy-out price, they inferred the entire business was worth $48 million, of which they were entitled to half. But “it was impossible to derive the value of the whole firm from the amount paid for its holdings,” the court said, in dismissing the suit. Moreover, the amount the PE investors were paid depended on how much the business could borrow rather than its “true value.”

The plaintiffs appealed to the U.S. Court of Appeals for the 7th Circuit. In an opinion written by Chief Judge Frank Easterbrook—a former University of Chicago law professor, who is widely respected for his creative applications of economic theory—the court found neither of the lower court’s valuation propositions was sound. “Indeed, each supposes that there is some measure of ‘true’ value that differs from what a willing buyer will pay a willing seller in an arms’-length transaction.”

“Yet that is the gold standard of valuation,” Judge Easterbrook wrote. “The value of a thing is what people will pay.” The price a willing buyer and seller agree on “is the value of the asset,” he said, with repeated emphasis. “The judiciary should not reject actual transaction prices when they are available.” In remanding the case, the learned judge also pointed out the “real problems” with the plaintiffs’ calculations (which may have them scrambling to find a damages expert). Read the complete digest of Malik v. Falcon Holdings, LLC, 2012 U.S. App. LEXIS 5336 (March 14, 2012) in the July 2012 issue of Business Valuation Update. The court’s decision will be posted soon at BVLaw.