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Chancery Address Valuation Issues Arising From LLC Member’s Withdrawal

Posted In Valuation

Smith v. Promontory Financial Group, LLC, C.A. No. 11255-VCG (Del. Ch. April 30, 2019).

In the limited liability company context, LLC agreements sometimes provide for a buyout of a member deciding to withdraw its investment.  Coming in many forms, such provisions give rise to potential valuation issues.  This decision arises in that setting.

In a decision driven by unique facts, the Court of Chancery relied upon the plaintiff's proposed valuation from an unconsummated deal to value a professional services company with “erratic and sparse” cash flows. The Court concluded that the company’s business model rendered both an asset accumulation method and a discounted cash flow method inappropriate.

Plaintiff Smith, through Plaintiff NTS, LLC, owned half of Defendant Promontory Growth and Innovation, LLC ("PGI"). Defendant Promontory Financial Group, LLC, owned the other half. As envisioned, Promontory's principal would identify executives and companies with a need for Smith's profit-improvement expertise, and then PGI would provide one-time consulting services in exchange for a share of the increased profits. But PGI faltered and accumulated substantial debt to Promontory. Rather than reinvest, Smith proposed a deal in which Promontory would write off Smith’s portion of PGI’s debt in return for Smith reducing his equity in PGI. Smith's proposal included his estimation of PGI's value, but, ultimately, it was Smith who rejected the deal because he concluded his own valuation was too low.

Tasked with valuing Smith’s rights under an operating agreement described by the Court as "rudimentary" and "improvised," the Court found that discounted cash flow was unworkable because PGI's “boom or bust” business model produced wide swings in revenue. Likewise, an asset accumulation method undervalued PGI because PGI provided consulting services and its few assets were intangible. Instead, the Court chose to use the valuation from the debt/equity deal proposal because both sides agreed to the valuation in principle, even if Smith later backed away. For purposes of Smith’s payout, the Court divided PGI’s value by half to account for the loss of Smith's services. Smith was awarded that amount, minus moneys owed to satisfy his part of the Promontory debt and his negative capital account.