Abstract: When selecting a business valuation expert, you may find that the least expensive candidate isn’t necessarily the most qualified one. This article summarizes a recent California Court of Appeals case. Although the trial court found a breach of fiduciary duty, the appellate court affirmed the decision to deny damages because the plaintiff had failed to provide credible evidence regarding the value of his business interest. A sidebar explains the challenges of valuing start-up companies, like the one in this case.
Zaffarkhan v. Domesek, No. G054604, Cal. App., May 18, 2018
Don’t cut corners on business valuation experts
When selecting a business valuation expert, you may find that the least expensive candidate isn’t necessarily the most qualified one. A recent California Court of Appeals case highlights how hiring an inexpensive or inexperienced expert can backfire, even if the opposing side fails to present expert testimony. Notably, this case involved a failed start-up software business with no revenue or earnings history — and no viable products.
Start-up shuts down
Prescription Diversion Solutions (PDS) was formed in June 2012. Two of the start-up’s founders had developed a prototype of a software application intended to help doctors manage patient medications and prevent fraud and prescription abuse. The developers invited the plaintiff to join their business venture as its third founding member because he had relevant experience: He was a doctor who claimed to have computer programming experience.
Within 14 months of forming PDS, the software developers discontinued working with the plaintiff. They claimed the doctor had misrepresented his programming ability and contributed little to the business. After dissolving PDS, the developers started a new company (ScriptGuard), which purchased some of PDS’s assets (primarily, the prototype software code).
The doctor sued, and the trial court found one of the defendants had breached his fiduciary duty as a PDS board member by participating as an interested director in the sale of PDS’s assets to his new company. However, the Superior Court of Orange County awarded no damages because the plaintiff’s expert wasn’t credible. On appeal, this decision was affirmed.
Expert testimony criticized
The plaintiff hired an expert to value his 30% interest in PDS. The expert testified at trial that the value of PDS ranged from $1.5 million to $8 million. He noted “many historical instances where nonrevenue generating companies, especially web-based companies, have sold for millions and millions of dollars on the expectation that they would begin to generate revenue and net profits related to the business.” However, the expert had never previously valued a technology or software company, start-up or otherwise.
Beyond his lack of experience, the expert based his opinion on inaccurate information. He believed ScriptGuard had run a pilot program to test its software in a large medical group with three offices, 12 physicians and two physician assistants, “responsible for more than 35,000 covered lives.” According to the expert, there were testimonials as to how well the product worked. In fact, no pilot tests had ever occurred, and PDS had never demonstrated any ability to interact with third-party prescription databases to guard against fraud and drug abuse.
The expert’s “misapprehension of basic facts” was one of several grounds supporting the trial court’s finding that the expert lacked credibility. The trial court also faulted the expert for relying on “speculation and wishful thinking on the part of [both] the plaintiff and the defendants” in their self-interested assessments of PDS’s value at different times.
California’s Fourth District Court of Appeals acknowledged that anticipated profits dependent on future events generally are objectionable because they’re speculative. Nonetheless, the court said, prospective profits are allowed where their nature and occurrence can be shown by reasonably reliable evidence. (See “The challenges of valuing start-ups.”)
Alternate arguments fail
In addition, the court rejected the plaintiff’s argument that, when the defendants dissolved PDS, they offered the plaintiff $110,000 to cover his $35,000 investment in the company and his 30% business interest, along with $15,000 in compensation. The plaintiff characterized this offer as the defendants’ admission that his interest in PDS was worth at least $110,000. The appeals court agreed with the trial court that it was, instead, an amount offered to the plaintiff by the defendants to “make him go away.”
The court also dismissed the plaintiff’s claim that the agreements the defendants entered into to raise $220,000 for ScriptGuard provided the best evidence of the company’s value. Those agreements, the court concluded, reflected investors making bets on the business’s success and said nothing about PDS’s intrinsic value.
Qualifications add value
This case demonstrates that unqualified experts can leave plaintiffs with valid claims holding an empty bag after a court rules in their favor. So, it’s important to vet the credentials of potential valuation experts before you hire them.
Sidebar: The challenges of valuing start-ups
The Zaffarkhan case (see main article) shows how valuing a new business — or one that never launched a real product — is challenging. But, for purposes of establishing lost profits damages, it’s not impossible, if your assumptions are reasonable and your sources of evidence are credible.
Much of the difficulty in valuing a start-up stems from the lack of historical financial data, which forces experts to turn to other types of evidence. The Zaffarkhan court faulted the plaintiff for making little use of the so-called “yardsticks” commonly used to value new or speculative businesses.
Under the Restatement (Second) of Contracts, a plaintiff can establish prospective profits damages for such businesses using such sources as:
- Expert testimony,
- Economic data,
- Market surveys and analyses, and
- Business records of similar enterprises.
Likewise, the Restatement (Second) of Torts provides that, where the defendant has specifically prevented the launch of a new business, a court should consider the factors relevant to the would-be business’s likelihood of success. Examples include general business conditions and the degree of success of comparable enterprises.