PECO Logistics v. Walnut Investment Partners
Recently, a Delaware Court of Chancery case demonstrates how courts give substantial weight to valuation provisions in owners’ agreements, especially when the experts follow the terms of these agreements and maintain their independence. Even though the investors objected to the purchase price determined under an owners’ agreement, some minority investors were forced to sell their units after exercising a put option. Here are the details.
LLC agreement valuation provisions
Two minority investors acquired preferred equity units in PECO Logistics, a limited liability company (LLC), in 2011. The company’s sole asset was an interest in a pallet rental company. The investors became parties to an LLC agreement, granting them a voluntary “put option” to sell their preferred units back to PECO Logistics over a three-year period.
The LLC agreement required the company to “retain a nationally recognized valuation firm to determine the fair market value of the preferred units in accordance with a specified formula” if the investors exercised the put option. The value of the investors’ units would be based on the pro rata value of the entire company, expressly excluding discounts for lack of control or marketability.
The agreement required the company to repurchase the preferred units at the appraised value within 45 days of the completion of the valuation. The LLC agreement also stated that both the company and the investors “shall be bound by the determination” of the valuation firm. A potential shortcoming was that the LLC agreement included no mechanism that allowed the owners to review the determination of value.
Lawsuits over appraised value
In 2014, the put option was exercised by investors and the board hired a nationally recognized valuation firm to value their interests. When the company attempted to repurchase their interests at the appraised value, the investors objected, and the company sued the investors for the right to purchase their units.
The investors subsequently filed counterclaims that PECO Logistics had breached the implied covenant of good faith and fair dealing. The investors also claimed that the letter of intent unilaterally “reserved their rights” to participate in the valuation process and review the determination of value.
Reasonableness and independence
The valuation expert used the discounted cash flow and merger and acquisition methods to determine a total enterprise value of approximately $275 million. Because this value exceeded the prescribed cap under the EBITDA collar, as defined by the LLC agreement, the total enterprise value was reduced to approximately $209 million. The total equity available for distribution to owners, after adjusting for debt, cash and cash equivalents, and hypothetical transaction, legal and accounting fees, was approximately $93 million.
This methodology was not questioned by the court, because:
- The appraisal firm maintained its independence from both the company and its investors, and
- The assumptions underlying the valuation were reasonable.
The court concluded, “When parties to a contract agree to be bound by a contractually established valuation methodology, this Court will respect their right to order their affairs as they wish and refrain from second-guessing the substantive determination of value.” Accordingly, the court ordered the investors to sell their units to PECO Logistics at the appraised value.
Lessons from this case
Typically courts will defer to agreements that owners enter into before disputes arise, as shown in this case. So, it’s important to be detailed and comprehensive when drafting valuation provisions for owners’ agreements. For instance, if the parties expect to participate in the selection of a valuation firm or in the valuation process, or if they want to retain the right to review the appraised value before initiating a buyout, the agreement should specifically provide for those rights.
Contact a valuation professional when you’re writing or reviewing an owners’ agreement to help cover all the appraisal-related bases. If you wait until a dispute arises to define or test the valuation provisions, it may be too late.