Neil Smith v. Promontory Financial Group, LLC, C.A. No. 11255-VCG (Del. Ch. Apr. 30, 2019) (Glasscock, V.C.)
In this memorandum opinion, the Court of Chancery rejected the use of a DCF analysis and the asset accumulation method, instead relying on the parties’ shared valuation in an unconsummated debt-forgiveness transaction to determine the value of Promontory Growth and Innovation, LLC (“PGI”).
PGI is a Delaware LLC founded by Neil Smith, a longtime management consultant, and Eugene Ludwig, a former Comptroller of the Currency. Ludwig was also the founder of Promontory Financial Group, LLC (“Promontory”), which provided working capital to PGI. PGI’s LLC Agreement provided that if Smith withdrew as a member, he would receive one-half of the value of PGI, valued without Smith’s continuing service to the company. Smith withdrew in 2013, the parties could not agree on the amount Smith would receive, and litigation ensued.
Before it could render an opinion as to the value of Smith’s interest, the Court had to determine the validity of a proposed transaction in which Smith would transfer a twenty percent interest in PGI to Promontory in exchange for Promontory forgiving a substantial debt PGI owed (the “Debt/Equity Deal”). The Court concluded that the parties had not consummated that transaction, because Smith never agreed to be bound by that agreement. Therefore, Smith was entitled to fifty percent of the value of PGI without him.
The Court then turned to PGI’s value. PGI relied on an unusual business model. It provided consulting services to financial institutions on a one-time basis, which the Court compared to a “mining or hunting operation,” that resulted in deals that were “episodic, variable in size and included one enormously profitable unicorn.” That business model posed significant complications for the valuation of PGI.
First, the Court considered the Defendants’ use of the asset accumulation method. That methodology produced a value of $0, because PGI’s liabilities were greater than its assets. The Court rejected that approach, noting that because PGI’s sole business was providing consulting services, it had few tangible assets, and that the episodic nature of PGI’s cash flows could result in such a method missing significant value.
Second, the Court considered the Plaintiffs’ use of a discounted cash flow methodology, which produced a $37.5 million valuation. The Court considered that PGI’s “erratic and sparse” cash flows created “boom and bust economics” that were not suitable for a DCF. The Court also had concerns with the projections that the Plaintiffs used for their DCF. Plaintiffs used a set of projections Promontory created in August 2013 by moving a set of projections from March 2012 forward. But those March 2012 projections had proved to be inaccurate, and Promontory did not reconsider them in light of that inaccuracy. Moreover, Smith created those projections based on experience at previous firms, not PGI, and the projections included a number of deals that exceeded the maximum annual deals PGI touted in marketing materials. The Court rejected Plaintiffs’ argument that the projections were credible because PGI shared them with banks and found that a DCF valuation of PGI was not appropriate.
Third, even though the Court had decided that the parties did not consummate the Debt/Equity Deal, it still looked to the Debt/Equity Deal to determine PGI’s value. As part of the Debt/Equity Deal, Smith valued PGI at $16.25 million. The Defendants agreed to that proposal. The Court decided that the $16.25 million valuation in the Debt/Equity Deal represented the best indication of the value of PGI.
The Court then determined the value of PGI without Smith. The Court agreed with Plaintiffs’ expert that the value without Smith was $8.125 million, half of the value with him. The Court rejected Defendants’ arguments that the loss of Smith would reduce PGI’s value by more than half, noting that PGI still had five managing directors who could perform Smith’s responsibilities and that Defendants wanted to continue to operate PGI after Smith left.
Finally, the Court reduced the award to Smith by $3,133,184, the amount he owed to PGI to settle the negative balance in his capital account.