The Delaware Court of Chancery recently issued an opinion in Domain Associates, LLC v. Nimesh S. Shah. Vice Chancellor J. Travis Laster ruled that an expelled member of Domain Associates, LLC (“Domain” or the “company”), the management company of a venture capital firm, was owed the fair value of his member interest as opposed to the book value of his capital account. This decision followed a detailed review of the relevant provisions of the company’s operating agreement, which failed to support the plaintiffs’ argument that the expelled member was owed only the book value of his capital account. In this case, the default provisions of Delaware law were in play, and they supported the defendant’s claim for the fair value of his interest. The case thus provides a cautionary tale to members of limited-liability companies (LLCs) and their legal counsel regarding the need for specific and precise language in an LLC agreement. Regarding the value of Shah’s interest, the court heard from two experts that both relied on a discounted cash flow (DCF) analysis but with disparate outcomes. Ultimately, the court directed the experts to recalculate the value of the interest using a DCF model with inputs selected by the court.
Domain is a venture capital firm that was formed in the 1980s and had raised nine investment funds (“Funds I through IX,” respectively) through 2014. The company and its funds struggled during and after the Great Recession and the size of its funds fell from a height of $700 million in committed capital in its sixth fund (“Fund VI”) to a low of $80 million for its ninth fund (“Fund IX”). Nimesh Shah joined Domain in 2006 at its height, right around the time the company was raising Fund VI. His focus at the company was medical-device businesses, a sector that fell out of favor following the Great Recession and which limited partners cited as a reason for not investing with Domain in Fund IX. Amid this downturn, and even with the negative sentiment toward the sector that Shah focused on, Shah was offered membership in the company in January 2015, which he accepted.
In less than one year, in December 2015, the members of Domain other than Shah decided they no longer needed a partner with expertise in medical devices and they asked Shah to depart. They formally unanimously voted for his withdrawal in April 2016, and the company wired him a payout of his capital account in June 2016. Following months of back and forth over the proper severance package for Shah, the company and its remaining members (the plaintiffs) filed suit against Shah seeking a declaratory judgement that Domain’s LLC agreement specified the payment that Shah was to receive. Shah counterclaimed for breach of contract and that under the Delaware Limited Liability Company Act (the “LLC Act”) he was owed the fair value of his member interest. Both sides hired experts that employed a DCF analysis to determine the value of Shah’s interest. Shah’s expert determined a value in the range of $4.3 million to $6.1 million and the plaintiffs’ expert determined a value of $531,000.
As noted in the court’s opinion, procedurally, the company filed the initial suit seeking a declaratory judgment that its LLC agreement specified the payment to Shah to be the book value of his capital account. Shah then counterclaimed for breach of contract, asserting that he was owed the fair value of his member interest. The decision then focused on Shah’s counterclaim for breach of contract as he was the natural claimant in the case. The first step taken by the court was to examine the relevant sections of Domain’s LLC agreement. Article VII of such agreement stated that it “permitted the members to force any particular member to withdraw, as long as the nonwithdrawing members voted unanimously … A member also could retire voluntarily or could be deemed to withdraw … in the event of insanity, bankruptcy, or death.” Based on this provision, the court found that the plaintiffs were not at fault in forcing Shah’s withdrawal under the terms of the LLC agreement. The court next turned its attention to whether the LLC agreement specified the payment to be made to a member who was forced to withdraw. The court found that the LLC agreement was silent on the required payment to an expelled member. Specifically, the court again analyzed Article VII of the company’s LLC agreement, which stated:
“If the remaining members continue the business of the Company, the Company shall pay to any retiring member, or to the legal representative of the deceased, insane or bankrupt member, as the case may be, in exchange for his entire interest in the Company, an amount equal to (A) such member’s capital account, to be determined as of the date of a member’s death or retirement, or his withdrawal from the Company (such date of death or withdrawal being referred to herein as the “Withdrawal Date”), which capital account, for purposes of such determination, shall be computed on the cash and disbursements basis of accounting …”
The court then stated that “under the plain language of this provision, the payout mechanism does not apply to a forced withdrawal … The concept of 'withdrawal' in this formula … is used generically as a catchall for the forms of withdrawal where the payout formula applies. Notably, the formula specifies two of the triggering means of withdrawal (death or retirement) but not two others (insanity or bankruptcy).” The court went on to say that another paragraph in the same Article VII “refers to only ‘the retiring member, or to the legal representative of the deceased, insane or bankrupt member.’ It does not address a forced withdrawal."
The court thus found that the company’s LLC agreement did not specify the payment to be made to Shah. Instead, the court looked to Section 18-1104 of the LLC Act, which the court noted “states that ‘the rules of law and equity … shall govern.’” The court then indicated this section of the LLC Act was analogous to Section 17-1105 of the Delaware Revised Uniform Limited Partnership Act (“LP Act”). In Hillman v. Hillman the court concluded that under Section 17-1105 an expelled partner was owed the fair value of his interest in the absence of more specific requirements in the governing limited partnership agreement. Noting that Domain’s member-managed model allows for analogies to partnership law, the court found that the default rule of Section 17-1105 applies in this case. Finally, the court noted that Delaware Law in general “does not favor interpretations that result in forfeitures. Section 18-1104 does not vary the fundamental principle under Delaware law that a majority of the members (or stockholders) of a business entity, unless expressly granted such power by contract, have no right to take the property of other members (or stockholders).”
Based on the above analyses, the court concluded that Shah was owed the fair value of his member interest. The individual members of the company, besides Shah, were held jointly and severally liable for not paying Shah the fair value of his member interest while at the same time benefiting by the elimination of his interest. Members of an LLC typically have limited liability to third parties. In this case, however, Shah is not a third party, and the liability arose out of the actions taken by the other members.
Citing the Court’s decision In re Petsmart, Inc. from 2017, the court noted that the “first key to a reliable DCF analysis is the availability of reliable projections….” Domain prepared 10-year projections on an annual basis, and these were deemed reliable given they were not prepared specifically for the litigation at hand or some other business purpose besides general corporate planning. Shah’s expert was faulted for deviating from these projections while failing to provide adequate justification for altering the forecasts. Similarly, some of Shah’s expert’s adjustments to the forecasts were disregarded because they were not “known or knowable” as of the valuation date.
Upon establishing the projections to be relied on in the DCF analysis, the court turned its attention to the experts’ calculations of the DCF’s terminal value at the end of the 10-year discrete projection. Citing Glob. GT LP v. Golden Telecom, Inc. from 2010, the court noted that “a company will grow at a steady rate that is roughly equal to the rate of nominal GDP growth” once an industry reaches a mature stage of growth. Also, citing the same precedent, it noted that “the rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.” The plaintiffs’ expert unconvincingly applied a perpetual growth of 0%, and the court favored the 3% growth rate applied by Shah’s expert.
Turning its attention to the weighted average cost of capital (WACC) used to discount the cash flows to present value, the court accepted a 3% company-specific risk premium. Citing Hintmann v. Fred Weber, Inc. from 1998, the court noted that such premiums are “largely a matter of the analyst’s judgement, without a commonly accepted set of empirical support evidence.” However, given that both experts put forth the same 3% premium, the court accepted the 3% premium in this case. The court, however, refused to include an additional 0.6% premium added in the plaintiffs’ expert’s analysis to account for “liquidity risks.” The court believed any such risks to be adequately accounted for in the previously accepted 3% premium and excluded any additional premium.
Within the calculation of the WACC, the court quibbled over the experts’ analyses of the beta to be used in the WACC calculation, which were based on the betas of a peer group. In particular, the plaintiffs’ expert called for one company to be excluded on account of its beta being an outlier, while Shah’s expert used the entire peer group. Alluding to the court’s decision in Merion Capital, LP v. 3M Cogent from 2013, the court noted that “when a party does not justify the use of the companies it selected as comparable, the court will not accord weight to the analysis.” The experts were thus directed to recalculate their original conclusions excluding the noted outlier.
As a final point of contention, the court highlighted the experts’ treatment of the company’s cash balance. Citing the court’s decision In re AOL Inc. from 2018, the court noted that “excess cash on hand is a nonoperating asset that should be added after a DCF valuation has been performed.” The plaintiffs’ expert’s contention that the company’s entire cash balance was necessary to fund future cash deficits was not convincing given that the same expert showed positive cash flows in its valuation model. Shah’s expert’s treatment of the cash included treating all but three months’ worth of operating expenses as excess cash, which the court accepted as persuasive.
In the end, the plaintiffs were held jointly and severally liable to pay Shah the fair value of his member interest in the company. The court’s decision does not address the value of Shah’s ownership positions in Domain’s funds, though the case highlights the fact that he had an ownership interest in certain securities and certain general partner entities of Domain’s investment funds. The court ordered that the fair value of Shah’s member interest in the company be recalculated in accordance with the court’s decision. This case highlights the need for valuation experts to take care to provide well-supported, reasonable, and persuasive arguments to justify the key inputs into their valuation analyses.