Section 16701 Valuations

 

Section 16701 of the California Corporations Code is a relatively obscure fair value standard that applies to general partnerships. Whereas Section 2000 is a well know standard with some case law, this section remains in the shadows, as general partnerships are less common and there exists very little case law to provide guidance on this standard. I previously published a short article on Section 2000, which can be found here. Given the general understanding of Section 2000 that exists amongst valuation professionals, this article serves essentially as a compare and contrast between the two.

Section 16701 provides a statutory fair value standard for general partnerships. The statute reads:

The buyout price of a dissociated partner's interest is the amount that would have been distributable to the dissociating partner under subdivision (b) of Section 16807 if, on the date of dissociation, the assets of the partnership were sold at a price equal to the greater of the liquidation value or the value based on a sale of the entire business as a going concern without the dissociated partner and the partnership was wound up as of that date.

You are commanded to use the higher of the two values.

This standard has a similar feel to Section 2000, which similarly assumes a liquidation event, and demands the consideration of a “liquidation value” or a “going concern” sale of the entire business. The primary difference between the two is that this standard does not allow for a weighting of the two; it is an all or nothing situation. 

In specific, Section 16701 states that the “price shall be the greater of the liquidation value or the value based on a sale of the entire business as a going concern…” [Emphasis added.] In contrast, Section 2000 provides for a value “on the basis of liquidation … but taking into account the possibility of a sale of the entire business as a going concern.”  

It is generally agreed that under Section 2000, the appraisers may consider the “possibility,” or probability, of a sale under either a piecemeal liquidation or a going concern sale. That discretion does not exist under Section 16701, where the appraiser is demanded to use the higher of the two. 

In a liquidation, assume an investor will seek to maximize his or her return.

Although there is a dearth of case law on this statute, it is not a void. The best case on point is Rappaport v. Gelfand 197 Cal.App.4th 1213 (2011). In Rappaport, California’s Second District Court of Appeal provided that liquidation value under section 16701 is not intended to mean a distress sale of the partnership’s assets, but rather a hypothetical selling price that a willing and informed buyer would pay a willing and informed seller, with neither being under any compulsion to deal. “Thus, for purposes of section 16701 subdivision (b), ‘liquidation value’ does not incorporate the common definition of ‘liquidation,’ which generally implies some urgency for immediate cash.”

Transaction and liquidation costs and impairments must be considered.

In reaching a valuation figure, transaction costs and impairments should of course be factored in. These may be relatively minor or substantial, depending upon the situation. The costs will likely be different in each scenario, e.g., your costs under a piecemeal liquidation will not be the same as those under a going concern sale. 

As an example, if the subject company owns real estate, the first costs to consider are direct costs to sell such real estate. This includes at minimum brokerage commissions, transfer taxes, and escrow fees. Furthermore, any potential impairments ought to be considered. These impairments may consist of time value of money, being cognizant of the relationship between appreciation during a liquidation period, and diminution in value due to the nature of a piecemeal liquidation. 

For an example on the latter, it is not uncommon to have a facility which houses specialize equipment, which itself is specially located to serve a particular industry. In a piecemeal liquidation, the assumption is that the underlying equipment would be stripped out of the facility, and the remaining “shell” would be sold. The sale of a facility shell such as this usually impairs its value as compared to the value with its equipment in place. This impairment could be as high as 30% of the value with the equipment in place. This is a nuanced real estate issue to discuss with the real estate appraiser retained as a sub-appraiser.

Other costs directly associated with liquidating non-real estate assets must also be considered. This may include costs to sell machinery and equipment, which can add up fast. These costs may consist of an auctioneer’s fee, should that be the assumption. If the assumption is that the business will sell the machinery and equipment right off the yard, then labor becomes a substantial cost, as employees must manage the sale, including the negotiating of prices and executing sales, security, and record keeping. 

And in addition to these direct costs, the appraiser must consider the extraordinary costs associated with a dissolution and liquidation. These costs include legal fees and costs, accounting costs, labor during the liquidation period, and so on. One common assumption that many appraisers make is that operations during the liquidation period “break even,” such that these really are the extraordinary costs that result solely from the liquidation event (i.e., these are not normal operating costs, but in addition to them). 

As a final point, the appraiser needs also consider impairments to current assets, most notably accounts receivable. It will come as no surprise to learn that when a company goes out of business, it suddenly becomes more difficult for that company to collect on its accounts receivable. Thus, a thorough assessment of these assets need be undertaken to determine any collectability issues. 

Costs associated with a sale as a going concern.

Costs in this context are very different, as the transaction costs are not applied piecemeal to each asset class but are applied in bulk to the assets sold. A common method to calculate such costs is by reference to a Double Lehman. The Double Lehman formula usually results in lower liquidation costs as compared to a piecemeal liquidation.

Selecting your concluded value. 

As we know from the standard, a value is to be derived assuming both a piecemeal liquidation and a sale as a going concern. The concluded value must be the higher of the two. Unlike Section 2000, where an appraiser can weigh each value on the basis of probability, the analyst under Section 16701 must select the higher.