Costume Jewelry Business Valued per Delaware Block Method

Tennessee business valuation law case summary – wholesale costume jewelry business.

Freiden v. Alabaster – Tennessee Business Valuation

This was an action for fraud and negligent misrepresentation by plaintiff Bernard Freiden against defendants Samuel Alabaster and Alabaster Originals, Inc., in connection with a stock purchase agreement of Alabaster Originals, a wholesale costume jewelry business.  As a result of the agreement, shares of a corporation owned by the plaintiff were invalid.  Both the trial court and the Court of Appeals agreed that the plaintiff had not established the fraud claim, but had established the cause of action for negligent misrepresentation.

As the remedy, the trial court held that the plaintiff was entitled to judgment in an amount equal to twenty percent of the corporation’s value, minus the amount owing under a note.  The trial court referred the case to a master to make the determination as to the corporation’s value.   The trial court directed the master to make the determination in accordance with the “Delaware Rule,”, which the Tennessee Supreme Court adopted in Blasingame v. American Materials, Inc., 654 S.W.2d 659 (Tenn. 1983).  Under the Delaware Rule, the value is determined by taking the weighted average of the market value, the asset value, and the investment or earnings value.

Under the Delaware Rule, the weights assigned to each value are within the trial court’s discretion.  In cases where there is no reliable market, the market value is not considered at all.  A higher asset value is assigned only when the primary purpose of the company is to hold assets for appreciation.  In a commercial business, the earnings value is normally given the greatest weight.

The master determined that the business had no market value, and assigned zero weight to the market value.  He determined that the asset value was $315,000 and assigned a weight of 25%.  The master gave a low weighting to the asset value partly because the company’s assets were subject to fashion trends.  He determined that the earnings value was $85,252 and assigned a weight of 75%.  This resulted in a valuation of $142,689, with a 20% share of that amount being valued at $28,538.

In determining the earnings value, the master averaged the corporation’s taxable income between 1974 and 1978, and used a capitalization rate of 4.

After the master made this determination, the plaintiff argued that the value of the business cannot be less than its liquidation value.  He presented the deposition testimony of Aiden Underwood, who testified that the business had a liquidation value of $270,138, which he calculated from assets of $803,017 minus liabilities of $522,879.  The 20% share of the liquidation value was thus calculated as being valued at $54,027, and the plaintiff argued that this should be the minimum value placed on his shares.

The master disagreed with this argument, noting that the liquidation value is similar to the asset value, and must be weighted as required by the Delaware Rule.  The trial court agreed and adopted the master’s findings.

The plaintiff had retained two experts. The first was Calvin King, a licensed CPA.  Mr. King testified that for many years, his chief client had been Malone & Hyde, a large regional grocery firm based in Memphis.

Plaintiff’s other expert was Robert Rogers, and attorney and banker.  Mr. Rogers had several years of experience with First Tennessee Bank, and had also served on the board of Malone & Hyde.

Defendant’s expert witness was Christopher Mercer.  Mr. Mercer held an MBA and had recently been certified as a chartered financial analyst.  He had previously been employed by First Tennessee Bank, and had served as a vice president of the Memphis investment securities firm Morgan Keegan.  He testified that he had previously valued minority interests in about sixty companies for the SEC, IRS, and for private individuals.

All of the experts agreed that no weight should be applied to the company’s market value, since there was no market for the stock.

There was little difference of opinion as to the asset value of the company.  The plaintiff’s experts, Mr. King and Mr. Rogers, placed this value at $315,502 and $336,160, respectively.  The defendant’s expert, Mr. Mercer, valued it at $309,144.  The master and the trial court placed the value at $315,000.  The weightings assigned by the experts were also similar.  Plaintiff’s experts King and Rogers weighted this value at 20%, and defendant’s expert Mercer placed it at 14%.  The master and the trial court determined that this figure should be weighted at 25%.

The most controversy surrounded the issue of the earnings value of the company.

Plaintiff’s experts King and Rogers placed this value at $984,266 and $700,000, respectively.  Defendant’s expert Mercer placed this value at $51,000.  The plaintiff argued that this value should have been ignored, because it was based more upon the company’s actual earnings, as opposed to the earning capacity, which he argued was the factor that is relevant under the Delaware Rule.  He argued that the actual earnings were subject to discretionary expenses which could be controlled by a majority stockholder.

In keeping with this approach, plaintiff’s expert King added back all discretionary expenses, including shareholder/officer salaries, travel expenses, auto expenses, pension and profit-sharing, and charitable contributions.  He thus arrived at a much higher value for “earnings” than did defendant’s expert.

Plaintiff’s expert Rogers was somewhat more conservative in adding discretionary expenses back into the earnings.  He added back those expenses in excess of the amount which he believed a prospective buyer would view as being necessary to run the business.

The defendant’s expert, Mr. Mercer, argued that no such adjustment was necessary, since there were no expenses that were out of the ordinary or unnecessary.  He pointed out that the corporation had been audited by the IRS, and the tax returns were approved without any of these expenses being disallowed.

The master, the trial court, and the Court of Appeals all agreed that such adjustments were not necessary.  The Court of Appeals found no precedents suggesting a need to add discretionary expenses back into the company’s earnings.  It favorably cited a law review which stated that such adjustments should not be made in the absence of misrepresentation or waste.

The court of appeals affirmed the judgment of the master and the trial court.

1990 WL 14562 (Tenn. Ct. App. 1990)

See original opinion for exact language. Legal citations omitted.

To learn more about Tennessee business valuation law, see Business Valuation in Tennessee Divorce Law. To learn more about the division and valuation of professional practices in divorce, see When Professionals Divorce in Tennessee: Valuing Professional Practices.

Miles Mason, Sr. JD, CPA handles complex divorce matters including business valuations and forensic accounting issues. View his professional biography listing books and articles published on business valuation and forensic accounting and seminars presented to lawyers, judges, business valuation experts, and forensic accountants. Miles Mason, Sr. authored The Forensic Accounting Deskbook: A Practical Guide to Financial Investigation and Analysis for Family Lawyers, published by the American Bar Association. The Miles Mason Family Law Group, PLC’s offices are located in Memphis, Tennessee and serves West Tennessee and Nashville. Contact Us today at (901) 683-1850.