A couple of months ago, my colleague Vince Sliwoski wrote Oregon Cannabis Dispensary Sales: What We Are Seeing on Valuation, which focused on the secondary market for cannabis licenses and businesses. Vince explained that the retail market, i.e. the purchase and sale of dispensaries, is still mostly done on multiples of revenue. But what is a less than 100% interest in an Oregon marijuana dispensary worth?
The answer depends on several factors that extend beyond the mere revenues or profitability of the store. These include:
- how the dispensary is organized
- what the organizing documents say or don’t say about the methodology for calculating the value of partial interest
- whether there is a right of first refusal for other owners
- the amount of control the interest holder has over the operations of the business
- whether the question is being asked in the context of adverse hostile litigation, and
- whether certain discounts apply.
How the Type of Entity Selected at Formation May Affect the Value of an Ownership Interests
This post discusses how the the type of entity selected at formation and its governing documents may affect the value of an ownership interest in a marijuana dispensary.
Take the common litigation scenario where one or more members of a limited liability company seek to expel another member from the company for malfeasance. Since 1997, a withdrawing or expelled member of an Oregon LLC has not been entitled to any distribution of that member’s interest (i.e. a buyout) unless the articles of organization or operating agreement expressly provide otherwise. Instead, the member who withdraws or is expelled becomes an assignee of their interest.
The member/assignee status distinction is critical. An assignee is not a member and cannot vote, but they remain entitled to interim distributions, allocations of profits and losses, etc. This means that unless the Operating Agreement includes buy-sell provisions specific to expulsion and withdrawal, an expelled or withdrawing member is not entitled to a buyout of her interest, and the other members may be stuck sharing profits with that person.
The lesson here is to make sure your organizing LLC documents include buy-sell provisions. Most do. Although I have encountered several operating agreements in the cannabis context that do not – usually because the persons involved did not retain a lawyer and downloaded a form from the internet.
The law governing closely-held Oregon corporations, on the other hand, includes so-called “dissenters’ rights” provisions and, in some circumstances, permits the corporation to compel a shareholder to sell her shares back to the corporation. In 2001, Oregon adopted the Oregon Business Corporation Act (the Act”) to encourage courts to use the buyout remedy in certain kinds of proceedings brought by shareholders of closely-held corporations.
Before 2001, the statutory remedy for addressing oppression or misconduct was the dissolution of the corporation, though courts often exercised their equitable powers to order buyouts instead of dissolving the corporation. The Act permits a court to order a corporation to purchase a dissenter’s shares for “fair value” in some circumstances. The shareholder must commence an action against the corporation and establish one of the following: (a) director deadlock; (b) that the corporation’s directors have acted or are acting in a manner that is illegal, oppressive, or fraudulent; (c) shareholder deadlock; or (d) corporate waste.
Alternatively, after such an action is commenced, the corporation or another shareholder may respond with an election to purchase all of the shares of the shareholder who filed the proceeding and proceed to acquire those shares. The corporation may make such election at any time within 90 days after the filing of a proceeding and the corporation must state in writing the amount it will pay for the shares. If there is a dispute over the amount the shares are worth, a court may decide the question usually with the help of valuation experts.
“Fair value” and “Fair market value”
Oftentimes, when the dispensary is formed as a limited liability company (LLC), the operating agreement will include provisions governing the purchase and sale of membership interests. One common provision is a right of first refusal – i.e. the selling member must first offer to sell her interest to the other members before selling to a stranger. A good operating agreement — and we see many poor ones in cannabis — should also specify how the members will value the interest and the procedure for doing so. An initial key concept is whether the value of a member’s interest will be appraised at its “fair value” or “fair market value” and whether discounts for lack of control and/or lack of marketability will apply. These concepts should be included in governing corporate documents to avoid litigation.
Standard of Value
A primary consideration of any appraisal is what standard of value applies. Business appraisers must ascertain and apply a “Standard of Value.” According to the AICPA, the Standard of Value is the “identification of the type of value being utilized in a specific engagement; for example, fair market value, fair value, investment value.”
The definitions of “fair value” and “fair market value” used by CPAs are technical. In layperson’s terms the key difference in most circumstances is whether discounts apply. For example, an appraiser may conclude that a 33% interest in a dispensary has a “fair value” of $300,000. This would mean the appraiser believes the entire dispensary is worth $900,000 and so 1/3 of that is $300,000. But determining “fair market value” the appraiser may apply discounts for lack of marketability and lack of control to conclude that the 33% interest is worth only $150,000. This represents a 50% discount from the “fair value” of the interest to arrive at the “fair market value.”
“Fair market value” is supposed to express the price at which the interest would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms’ length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. In simple, when an appraiser gives an opinion as to the “fair market value” of an interest, the appraiser is giving an opinion as to what price the appraiser believes a reasonable buyer would pay for the interest in an open market.
So do your corporate documents provide for a “fair value” or “fair market value”? Or . . . shudder … do they say nothing at all, leaving the members to disagree about what standard and discounts apply?
Discounts for Lack of Control and Lack of Marketability
There are two primary discounts to consider in determining the value of a minority interest. The discount for lack of control (“DLOC”), and the discount for lack of marketability (“DLOM”). The DLOC considers that the lack of control negatively impacts the value of the subject interest. Continuing with the example above, if the 33% interest-holder lacks any meaningful control over the management and operations of the company because, for example, the majority rules, the interest is less attractive to a potential purchaser as she or she is buying into a business with no ability to run the business. Consequently, an appraiser may apply a DLOC that reduces the value of the interest.
The DLOM considers the difficulty and cost of finding a buyer of a private interest. The AICPA defines DLOM as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.” For example, typically there is no DLOM when appraising the value of stocks in a publicly traded company. That is because a ready market exists in which to purchase and sell ownership interests in the company. (e.g. Gamestop, Apple, Google, Tesla). But finding a market for an interest in a privately-owned company for which data is not publicly available is much different. In such circumstances, an appraiser may apply a DLOM.
Factors affecting the DLOM include a company’s profitability, earnings, revenue and growth, the product it sells, and the industry risk. One significant risk for marijuana dispensaries is that the business remains federally illegal. This narrows the pool of potential investors significantly, making the interest less marketable, and translates to a higher DLOM – and lower value of any particular interest. Courts and commentators tend to agree that what percentage discount applies in any given situation is more art than science. In a leading case, Mandelbaum v. Comm’r, 69 T.C.M. 2852, 2865 (1995), one expert proposed a 70-75% discount and the other a 30% discount based on studies of restricted stock transactions. In other cases, courts have approved of discounts ranging from 15% to 70% depending on the factors listed above.
All of this adds up to significant uncertainty in the context of a marijuana dispensary. Uncertainty means risk. The seller of an interest may find her interest significantly discounted and worth much less than she thought, or perhaps the interest is discounted only minimally, causing the other members to pay more than they believe is reasonable. Despite the uncertainty, the fair market value approach is more commonly found in corporate documents than the fair value approach. That is because the goal of the fair market value approach is to arrive at a value conclusion that closely tracks what the interest is actually worth in the marketplace.
Readers may recall from my prior post that one difference between corporations and limited liability companies is the existence of “dissenters’ rights” in the former business structure. Typically, dissenters’ rights statutes provide for a “fair value” determination. But there is significant variation across jurisdictions and some jurisdictions that specify “fair value” may permit the application of discounts in some circumstances. See Columbia Mgmt. Co. v. Wyss, 94 Or. App. 195 (1988). So even if you and your partners decide upon a “fair value” approach, there is no reason not to specify whether discounts apply.
Along with deciding how to value a membership interest, the operating agreement may also specify how the valuation is performed. This is no small matter, particularly if later business separation becomes contentious. The kinds of questions that should be resolved in the operating agreement include: Will the company retain an independent third-party appraiser when a member desires to exit the company? Will that appraiser’s determination be deemed binding on the members? Can a member retain her own appraiser? How are disputes between appraisers resolved? What is the timeline for the purchase of the exiting member’s interest? How are capital accounts and contributions handled? Does it matter if the exiting member is forced out for some breach of duty?
For relevant posts on buying and selling Oregon cannabis businesses, check out the following:
- Oregon Cannabis Company Acquisitions
- Oregon Cannabis Company Acquisitions, Part 2: Term Sheets
- Oregon Cannabis Company Acquisitions, Part 3: Due Diligence
- Oregon Cannabis Licenses: No Seller’s Market
For posts addressing valuation in detail, here are some more: