Breaking Up Is Hard to Calculate: Recent Case Clarifies How to Value a Terminated Member’s Interest in a Tennessee LLC
June 14, 2021 | Sherrard Roe Blog I Ryan T. Holt
Disputes between members of a Tennessee limited liability company (LLC) can come and go. Disagreements between business partners are often like those between spouses; inevitable and uncomfortable, but ultimately resolved with minimal consequence. Some conflicts, however, render the relationship between LLC members untenable and threaten the enterprise’s ongoing viability. When that happens, and a member must leave the company and sell their interest, how to value that interest can lead to even more internal warfare.
In its 2020 decision in Raley v. Brinkman, the Tennessee Court of Appeals brought much-needed clarity to the issue of how to calculate the “fair value” of LLC membership interests when a member’s interest is terminated and the entity needs to purchase it.
Termination of LLC Interests Leading to Forced Sale
Raley and Brinkman each held a 50 percent interest in a Tennessee LLC that owned and operated a successful Nashville restaurant. The relationship between the two deteriorated and led to litigation in which Raley alleged that Brinkman failed to make agreed-upon capital contributions. Brinkman counterclaimed, accusing Raley of breach of contract, breach of fiduciary duty, and the misappropriation of funds.
Based on Raley’s alleged misconduct and the pair’s inability to effectively run the business together, Brinkman asked the trial court to terminate Raley’s membership interest. The Tennessee Revised Limited Liability Company Act (LLC Act) provides that an LLC or one of its members can ask a court to expel a member if they “engaged in wrongful conduct that adversely and materially affected the LLC’s business” or “engaged in conduct relating to the LLC’s business that makes it not reasonably practicable to carry on the business with the member.” (Tenn. Code. Ann. § 48-249-503(a)(6)(A) and (C)).
The trial court found in Brinkman’s favor on his claims of misconduct by Raley and terminated Raley’s interest in the LLC. Brinkman, in turn, advised the court of his intent to continue operating the LLC as an ongoing business. Under the LLC Act, if:
[T]he existence and business of the LLC are continued following the termination of a membership interest under § 48-249-503(a)…., then, regardless whether such termination of membership interest was wrongful, any member whose membership interest has so terminated… is entitled, subject to the offset provisions of § 48-249-504(2), to receive from the LLC the fair value of the terminated membership interest as of the date of termination of such membership interest.
“Fair Value” v. “Fair Market Value”
The trial court determined the fair value of Raley’s interest after receiving competing appraisals and other evidence from the two men. On appeal, Brinkman challenged the factors used—and not used—by the trial court in making its assessment.
In affirming the trial court’s assessment of the fair value of Raley’s interest, the Court of Appeals noted that neither the LLC’s operating agreement nor the LLC Act defined the term “fair value.” It then set about defining what constitutes “fair value” in such circumstances and what should and should not be considered when calculating “fair value.”
Specifically, the court held that:
- “Fair value,” not “fair market value,” is the valuation benchmark when the entity is an ongoing concern since the seller “is not in the same position as a willing seller on the open market,” because the company is purchasing the membership interest according to a judicially-ordered sale
- Any alleged wrongdoing by the selling member should not factor into the valuation of their interest
- No discounts should be applied for the lack of marketability or control of the member’s interest when the purchaser is the LLC “because discounts for lack of control and marketability are premised on a theoretical sale to a third party”
- No entity level tax should be applied in the valuation analysis for a non-controlling interest in an electing S corporation, absent a compelling demonstration that independent third parties dealing at arms-length would do so as part of a purchase price negotiation
Given there are more limited liability companies in Tennessee than all other types of entities combined, and given how frequently relationships between LLC members deteriorate to the point of no return, this decision is an impactful one. With this new clarity as to what “fair value” means, quarreling members and their respective attorneys can better assess the outcome of a member’s termination, whether voluntary or otherwise.
