One of the best parts of being a business litigator is the frequent opportunity it affords to work with (and against) expert witnesses of all stripes. And perhaps because there are so many ways that a business divorce can turn into a special proceeding in which the sole question before the court is the appraised value of the business, the business appraiser often is the most important expert witness. 

So when the chance comes along to blog about a noteworthy motion to exclude a business appraiser in a New York valuation proceeding, I can hardly resist.  And there’s some pride of authorship here—Peter Mahler and I represented the prevailing party in the motion. 

The motion to preclude was the final chapter in the LMEG Wireless saga—a business divorce instant classic.  Lessons abound for both lawyers and appraisers, from the criticality of scrutinizing evidentiary foundations to the perennial reminder: “Garbage In; Garbage Out.” 

LMEG Wireless and the Cash-Out Merger

LMEG Wireless LLC should be a familiar name to the regular readers of this blog.  Formed in 2003, LMEG refurbished and sold aftermarket cell phone accessories.  By 2011, LMEG had three one-third owners: Zalman Schochet, Levi Wilhelm, and Menachem Farro.

The dispute between LMEG’s members made waves among business divorce aficionados in 2021, when the Second Department held that Schochet and Wilhelm were within their rights as the majority owners to orchestrate a cash-out merger that extinguished Farro’s ownership in the Company.  The Second Department held that Farro could not assert fraud or rescission claims to unwind the cash-out merger; rather his “sole remedy” under LLC Law § 1002(g) was an appraisal proceeding to determine the fair value of his interest.  Read about that phase of the case here and here.

The Failed Private Equity Deal

The cash-out merger was the beginning of the end of a long-simmering dispute between Farro, on the one hand, and Schochet and Wilhelm on the other.  As relevant here, that dispute began around 2014, when tensions between the three owners began to rise.  At that time, the three members agreed to market the Company for sale through an investment banking firm.  By 2016, the “LMEG Roadshow”—an enormous effort to market the Company and the quality of its earnings—ultimately resulted in a private equity firm expressing serious interest in acquiring the Company. 

That PE firm continued its due diligence throughout the Summer of 2016.  But every additional step toward the PE deal raised the temperature of the dispute between Schochet and Wilhelm—who were anxious to proceed with the deal—and Farro—who insisted that the proposed PE deal was not rich enough. 

In October 2016, as the PE deal was on the verge of closing, Farro filed a lawsuit asserting direct and derivative claims against Schochet and Wilhelm.  Upon seeing that lawsuit, the PE firm—perhaps already spooked by LMEG’s declining performance during the second half of 2016—predictably terminated its negotiations with LMEG, costing the Company and its owners millions.

The Appraisal Proceeding

In a last-ditch effort to save the PE deal, Schochet and Wilhelm, who collectively held 2/3 of the ownership interests in LMEG, orchestrated a cash-out merger of Farro.  The merger extinguished Farro’s ownership interest in the Company in exchange for his statutory right to receive a cash payment for the fair value of his interest.  The appraisal proceeding to determine the value of Farro’s cashed-out interest was stayed for years while the parties litigated whether Farro had the right to unwind the cash-out merger (again, here), but was ultimately filed (LMEG v Farro, 501508/2021 [Sup Ct. Kings County]) and set down for a hearing in November of 2023.

Farro’s DCF Analysis and Reliance on the PE Projections

In advance of the valuation hearing, Farro offered the expert opinion of a well-known business appraiser who concluded that as of the valuation date, Farro’s cashed-out 1/3 interest in LMEG was worth more than $24 million.

To reach that number, the expert relied on a discounted cash flow analysis, which involves forecasting the company’s future cash flows, then discounting those future cash flows back to their present value. 

The expert based his DCF analysis on a set of five-year revenue and income projections prepared by the PE firm that considered acquiring LMEG in the summer prior to the cash-out merger.  A confidential, internal slide deck from the PE firm contained hockey-stick growth projections: from approximately $9.5 million EBITDA in year 1 to more than $23 million EBITDA in year 5.  When plugged into the DCF analysis, the PE firm’s projections resulted in an indicated value of LMEG at a staggering $96 million.

LMEG’s Motion to Preclude Farro’s Valuation Expert

Weeks prior to the valuation hearing, LMEG moved to preclude the expert’s DCF analysis.  Adoption of the “PE projections” into the DCF, LMEG contended, was a methodological failure that required exclusion of the entire DCF calculation.  LMEG argued:

  • Using the PE projections was improper because the PE firm contemplated a company overhaul.  LMEG pointed out that in the same slide deck containing the projections, the PE firm outlined exactly what it intended to do with the Company upon its acquisition: it would spend millions on hiring a new management team, designing a new operations center and hub, moving the company from Brooklyn to Texas, overhauling and leaning out operations, and standardizing the refurbishment process.  The PE plans were so extreme, LMEG argued, that their projections essentially valued a different, hypothetical company—what LMEG could be.  Therefore, LMEG argued, by using the PE projections, the expert ran afoul of the requirement that LMEG be valued as a going concern.
  • The PE projections were inadmissible hearsay on which the expert could not rely.  Under New York law, a testifying expert can rely on hearsay as a basis for his opinion only where (1) the out-of-court material is of a kind accepted in the profession as reliable as a basis in forming a professional opinion, and (2) there is evidence presented establishing the reliability of the out-of-court material referred to by the witness (Hambsch v New York City Tr. Auth., 63 NY2d 723 [1984]).  Reliance on the PE projections, LMEG argued, met neither of those requirements.  For one, while valuation experts often rely upon projections prepared by the Company, Farro could not demonstrate that third-party projections are “of a kind accepted in the profession as reliable.”  Second, LMEG argued that Farro could not point to any other evidence establishing the reliability of the PE projections.
  • The expert failed to perform any documented testing of the PE projections.  The expert did not compare the PE projections to the Company’s actual performance in the years following the cash-out merger.  This failure was critical, argued LMEG.  Any such testing of the PE projections against the actual performance of the Company would show that the PE projections were grossly overstated even in year 1. By year 3, the projections and the actuals were miles apart.

In opposition, Farro argued that any flaws in the expert’s projections were grist for the mill at trial, not grounds to exclude the DCF calculation altogether.  And no one could deny that the PE firm’s projections apparently were based on an “extraordinary amount” of due diligence.

The “Decision”

The week prior to the hearing, the Court advised the parties via email that it would grant LMEG’s motion to preclude the DCF analysis.  Rather than issue a written decision, the Court would put that ruling on the record at the start of the hearing.  But, alas, (and no doubt motivated by that decision), the parties settled the dispute before the valuation hearing ever got started.  Thus, the motion to preclude remains only informally decided.

Lessons Learned

Whatever the “decision” lacks in precedential utility, it makes up for in exhortatory value.  And the briefing and research are as comprehensive as I’ve seen on the issues of the admissibility of a DCF analysis, the ASA Standards, and the Uniform Standards of Professional Appraisal Practice.  Here are my favorite takeaways:

  • Garbage in; Garbage Out. Though I know the business appraisal community will remind me that every company is different, and there is no one-size-fits-all valuation approach or methodology, in my experience the DCF methodology is a continued favorite among business appraisers.  The LMEG motion should be a poignant reminder that the projections utilized in the DCF calculation are at best fertile grounds for cross examination, and perhaps grounds for exclusion altogether.  As Delaware Vice Chancellor Slights colorfully remarked in In re PetSmart, Inc., “Garbage In; Garbage Out” (CV 10782-VCS, 2017 WL 2303599, at *32 [Del Ch May 26, 2017]; Ramcell, Inc. v Alltel Corp., 2019-0601-PAF, 2022 WL 16549259, at *11 (Del Ch Oct. 31, 2022) (“Without a reliable estimate of cash flows, a DCF analysis is simply a guess.”).
  • Consider the Evidentiary Rules at Every Stage of the Case.  Early in the appraisal proceeding, Farro subpoenaed the PE firm for documents associated with their due diligence—that’s how he uncovered the PE projections in the first place.  Those projections became the cornerstone of Farro’s DCF analysis, but Farro never obtained a business records certification, nor any testimony from the PE firm about those projections.  So when it came time for the hearing, Farro found himself up against a major evidentiary problem: no one could lay a non-hearsay foundation for the out-of-court PE projections (the PE firm was outside of the Court’s jurisdiction and could not be subpoenaed for trial).  The harsh lesson there is that it’s never too early to think critically about how key documents will be admitted into evidence over any potential objections.