Drinkwater v Caddyrack Pty Limited [1999] NSWSC 851 | Case summary

1 MASTER: The substantive proceedings were heard before Mr Justice Young in 1997. His Honour made orders on 23 October 1997. His Honour made subsequent orders on 28 November 1997 (which were entered on 12 December 1997) to give effect to the essential items of relief claimed by the plaintiffs. That relief included a buy-back by the fifth and sixth defendants, Gedrot Pty Limited and Gavros Pty Limited of the shares held by the first plaintiffs Peter Westgarth Drinkwater and John Francis Drinkwater in the first defendant Caddyrack Pty Limited. Substantive relief in that regard was contained in orders 2 and 3, as follows: 2. The Fifth and Sixth Defendants purchase the shares which the Second Plaintiff (or in the alternative the First Plaintiffs) hold in the First Defendant (the "Shares") at a valuation to be agreed to assessed in accordance with orders 3 to 5 herein. 3. For the purposes of determining the value of the Shares in order 2 the appropriate date from which the Shares are to be valued is 25 September 1997. 2 In making order 2 His Honour invoked section 260 of the Corporations Law (now renumbered as section 246AA), which makes provision for the purchase of the shares of any member of a company by other members. That section does not provide the Court with any guidance or direction as to how the purchase price of the shares is to be determined. 3 However, the Court recognises that where, as here, its function is to determine the valuation of shares at a particular date, the overriding requirement is that the valuation should be fair on the facts of the particular case (Re London School of Electronics Limited [1985] 3 WLR 474 at 484; Dynasty Pty Limited v Coombs (1990) 14 ACSR 60 (von Doussa J) and (1995) 13 ACLC 1,290 at 1,307; 14 ACSR 60 at 120, where the Full Court of the Federal Court of Australia (Spender, O'Loughlin and Branson JJ) quoted with approval the foregoing passage from the judgment of Nourse J in Re London School of Electronics Limited, at 484). 4 The parties failed to agree as to the value of the shares, and, in consequence, the matter has come before me upon an inquiry to ascertain and thereafter certify the value of the shares (pursuant to order 6 made by his Honour). 5 Essentially, the inquiry before me concerned the evidence of the expert witnesses retained respectively by the plaintiffs and by the defendants. (It will be appreciated that, although I shall in this judgment speak of the defendants, that phrase will essentially encompass only the fifth and sixth defendants.) 6 The plaintiffs relied upon the evidence of Garth Warren Griffiths, a valuer, and Christopher Michael Hewitt, a chartered accountant; whilst the defendants relied upon the evidence of Steven Chamberlain Pritchard, an accountant. 7 Mr Griffiths is a registered valuer (since 1978), a licensed real estate agent and a licensed business agent. He is a Fellow of the Australian Society of Real Estate Agents and Valuers Ltd, a Fellow of the Australian Institute of Business Brokers Inc.; and the National President of that latter entity. He has been involved in the real estate and business sales industry for thirty-two years. 8 Mr Griffith's valuation dated 10 march 1998 is Exhibit GG1 to his affidavit of 24 November 1998. 9 The approach adopted by Mr Griffiths was to capitalise the maintainable earnings of what in his report he has compendiously described as "the business trading as Caddyrack" (the proprietorship and history of which are set forth in item 2 of his report). His starting point was the declared profit for the Caddyrack companies shown in the consolidated accounts for the year ended 30 June 1997. He then adjusted that figure to arrive at assumed maintainable earnings if the business had been effectively operated. That is to say, he took into consideration excessive production costs (such as the number of company vehicles and staff) and expenses that were caused by the owner's personal financial position, rather than costs caused by operating the business itself. In effect, what Mr Griffiths did was to value the business as a separate and distinct asset of the Caddyrack company. 10 Mr Griffiths' reasoning for his adjustments were all explained both in his report and in his oral evidence. In summary, he estimated what amount the maintainable earnings the business should be returning, and then capitalised that figure in order to give a purchase value for the business. 11 Mr Griffiths' report included (as Attachment 9 thereto) a report dated 20 March 1998 from Mr Hewitt. A supplementary report, dated 17 March 1999 from Mr Hewitt was also placed in evidence (Exhibit C). 12 Mr Hewitt then took the asset value of the business produced by Mr Griffiths, and adjusted it for the remaining assets and liabilities of the business. 13 The valuation methodology adopted by the plaintiffs was described in submissions prepared by their Counsel as an overall net asset valuation with the prime asset of the companies (the business) being determined on a capitalisation of maintainable profits. 14 The ultimate consequence of the reports of Mr Griffiths and Mr Hewitt was to give to each of the forty ordinary shares in Caddyrack Pty Limited a valuation of $41,495. 15 Mr Pritchard upon whose evidence the defendants relied, was a Certified Practising Accountant. He was a director of Rees Pritchard Pty Limited (described as "a firm of Certified Practising Accountants"), which had been the professional accountants for Caddyrack Pty Limited since November 1996 and for Caddyrack International Pty Limited since its incorporation. Mr Pritchard's report was Annexure A to his affidavit of 17 March 1999. Mr Pritchard's professional qualifications and expertise are set forth in Exhibit 1. He holds the degree of Bachelor of Commerce from the University of Newcastle, and a Diploma in Applied Finance and Investment from the Securities Institute of Australia; he is a Certified Practising Accountant, and Associate of the Securities Institute of Australia, a member of the Stock Exchange of Newcastle Limited, and is also a Fellow of the Taxation Institute of Australia. Mr Pritchard is a director of the Stock Exchange of Newcastle Limited, and a past chairman of the Australian Society of Certified Practising Accountants, Newcastle and Hunter Valley Branch. He has had more than fifteen years' experience as a director of Rees Pritchard Pty Limited, Certified Practising Accountants, and Pritchard & Partners Pty Limited, Stockbrokers and Investment Advisers. 16 At the outset, there was objection by the plaintiffs to Mr Pritchard being allowed to give opinion evidence. After a hearing on the voir dire on this objection and on the status of Mr Pritchard as an expert witness, I allowed Mr Pritchard to give opinion evidence. That ruling, of course, did not pre-empt any ultimate conclusions concerning the qualifications and experience of Mr Pritchard or the weight to be attached to his opinion evidence. 17 Mr Pritchard, in item 6 of his report, referred to what he described as "two generally accepted methods" of valuing shares in a company such as the first defendant, those methods being (i) capitalisation of future maintainable profits; and (ii) net tangible assets per share at current value. 18 Mr Pritchard proceeded to explain each of those bases. In regard to future maintainable profits, he listed the operating profits before tax of the first defendant in the period since it commenced business in 1994, and adjusted those profits by eliminating legal costs. 19 He arrived at a result disclosing the average profit/loss of the first defendant before tax as being a loss of $154,458. He then expressed the following conclusion. 20 Since Caddyrack Pty Limited had incurred an operating loss in every year except one since it commenced business, and since it did not have any legally enforceable right to the use of the intellectual property which underpins its business, Mr Pritchard was of the view that it was not possible to predict with any certainty what its future maintainable profits would be. 21 Mr Pritchard then proceeded to apply his alternative basis of valuation, that based upon net tangible assets at current values. That approach, based upon the consolidated balance sheet of Caddyrack Pty Limited and Caddyrack International Pty Limited (which disclosed a deficiency on shareholders' funds of $562,965) led Mr Pritchard to the conclusion that there would be no funds available for distribution to the shareholders of Caddyrack Pty Limited in the event of its ceasing to trade, and that its ability to continue as a going concern was dependent on the continuing financial support of its bank and other creditors, and in particular, of the Drinkwater and Kyrwood families. In that regard Mr Pritchard noted that both the Drinkwaters and the Kyrwoods had served upon Caddyrack Pty Limited demands for repayment of their respective loans. 22 He expressed the view that the preparation of a consolidated balance sheet on a basis other than that as a going concern would merely result in an increased deficiency on shareholder's funds, and would not affect his opinion of the value of the shares in Caddyrack Pty Limited. 23 Mr Pritchard expressed his opinion that, in consequence, the shares in Caddyrack Pty Limited had no net tangible asset value. 24 Each of Mr Griffiths, Mr Hewitt and Mr Pritchard was cross-examined during the course of the hearing. I have had the benefit of receiving written submissions from each Counsel who appeared at the enquiry before me. Those submissions will be retained in the Court file. 25 In conducting the present enquiry the Court is reliant upon evidence. In the instant case, that evidence has been given by witnesses who, having been put forward as expert witnesses (and having established at least prima facie qualifications as such), have been allowed to offer opinion evidence. 26 It must be appreciated, however, when approaching the concept of value, that a valuation is the means by which the worth of an item is determined; it is a process involving a valuer's personal judgment and opinion rather than the strict application of accounting principles or arithmetic rules. For that reason, the value of an item might be assessed differently by different persons. Further, the value of an item may vary depending on the purpose for which the valuation is required. There is, therefore, no standard definition of value for all purposes and in all circumstances. (See, generally, Steven Sirianos, "Problems of Share Valuation Under Section 260 of the Corporations Law" (13 Company and Securities Law Journal, March 1995, 88, especially at 90.) 27 It is appropriate to pay heed to the salutory admonition of Gallen J in the New Zealand case of Lusk v Archive Security Limited (1991) 5 NZCLC 66,979 at 66,992, There is ample authority to establish that valuations are not a matter of exact science and not infrequently mathematical calculations produce an authoritative result which is in fact totally dependant upon bases which are not capable of mathematical demonstration. 28 In approaching the opinion evidence of the expert witnesses in the instant case, especially that of Mr Pritchard, it is important to bear in mind that here the purpose of the valuation is to attribute a value to shares in Caddyrack Pty Limited which will be the subject of a buy-back by the fifth and sixth defendants from the plaintiffs, and will thus give to those defendants and to the Kyrwood interests a 100 per cent shareholding in the first defendant. 29 The respective reports of Mr Griffiths and Mr Pritchard were the subject of criticisms by the expert of the opposing parties. The defendant submitted that the methodology adopted by Mr Griffiths in his assessment of the "fair value of the shares" was flawed, especially in the assumption (which underlies the assessment of a "open market value") that each party is assumed to be fully informed about all relevant details concerning the share sale transaction and the market in which it is to take place. It was submitted on behalf of the defendants that this assumption is important in circumstances where the "overriding requirement is that the valuation should be fair on the facts of the particular case" (Re London School of Electronics Limited, supra). The defendants challenged Mr Griffiths' valuation of the company being based upon the ownership of an asset (being the exclusive licence of the patent to the golf club holder known as a "Caddyrack"), in circumstances where there was no evidence that the company owns that asset. 30 It seems to me, however, that in circumstances where, as in the instant case, the first defendant, whilst not the owner of the patent, has for a number of years been permitted to manufacture and deal with that patent without any restraint from the legal owner, it should not be assumed (as the defendants would have the Court assume) that there will be some challenge by that legal owner to the dealing of the first defendant with that patent, or some attempt to restrain the first defendant from continuing to deal with it. Where, as here, a private company is essentially controlled by two families and the activities and assets of that company and the intellectual property which is the substantial asset of that company are also controlled by those two families, it would be in my view a quite artificial approach to assume that the owner of the intellectual property (also controlled by those two families) would prevent Caddyrack Pty Limited from continuing to deal with that intellectual property in the manner in which it has been dealing with it for a number of years. The company is continuing to produce the golf club holders, and there is no suggestion that it will cease to do so. 31 The second criticism of the Griffiths report was that, so it was submitted on behalf of the defendants, that report adopted two inappropriate methods of valuation. The first method adopted in the Griffiths report is the capitalisation of future maintainable profits. The defendants submit that the adoption of that method was not appropriate in the instant case for the following reasons: (a) The average profits/losses of Caddyrack Pty Limited before tax for the period 1994 to 1997 were a loss of $154,458 a year. (b) Since Caddyrack Pty Limited has incurred losses in every year except one since it commenced operations, it is not appropriate to use the capitalisation of "future maintainable profits" as the appropriate method of valuation of the shares in the company. (c) Moreover, since Caddyrack Pty Limited does not have any legally enforceable right to the use of the intellectual property rights which underpin the business, it is not possible to predict what the "future maintainable profit" will be. (d) In light of the factors outlined above the defendants rely on the following comments of W. Lonergan, The Valuation of Businesses, Shares, and Other Equity , 2 ed. (1994) (Longman), 20, While the capitalisation of FMP [future maintainable profits] is the most commonly used valuation method, there are some situations where it is not appropriate. This method should not be used where there is · a history of losses; · rapidly declining profits in an industry with poor prospects; · profitable trading but severe liquidity problems; or · a single year's profit in a high risk market. 32 The defendants, in adopting the foregoing opinion that the capitalisation method as a valuation technique where the business has a history of losses is wholly inappropriate relied also upon Dynasty Pty Limited v Coombs (1995) 13 ACLC 1,290 at 1,307 (a decision of the Full Court of the Federal Court of Australia) and Ledesma v Nobule Pty Limited (Master McLaughlin, 11 December 1997, unreported). 33 Since Mr Griffiths under cross-examination agreed that both Caddyrack Pty Limited and Caddyrack International Internation Pty Limited had a history of losses, as well as a single year's profit in a high risk market, it was submitted on behalf of the defendants that the capitalisation of future maintainable profits should not be the valuation method adopted by the Court in the instant case. 34 It was submitted on behalf of the defendants that the failure of Mr Griffiths to recognise the problems inherent in the valuation method which he adopted further undermined his objectivity in the assessment of the "fair value" of the shares; that the methodology adopted and applied by Mr Griffiths demonstrated his lack of expertise, and his basic lack of understanding of the nature of the methodology which he applied. The defendants in this regard referred to the editorial comment made by Mr. Justice Young on "The Role of Experts" (1996) 70 ALJ 108. 35 The second method of valuation relied upon by Mr Griffiths was headed "Assessment of Real Profit" (pages 12 to 14 of his report). It was submitted on behalf of the defendants that this was not a recognised method of valuation, and that, in any event, the relevance of the other entities referred to by Mr Griffiths in that part of his report, and the evidence about those other entities (being Caddyrack Inc., Clubrack Pty Limited, and Golf Products Promotions Limited) had not been proven and were not the subject of any part of his Honour's orders. The defendants submitted that it was impossible to sever those parts of Mr Griffiths' report which refer only to Caddyrack Pty Limited and Caddyrack International Pty Limited from those parts of the report which refer only to the other entities. 36 The third major criticism directed by the defendants against the Griffiths report was that it contains a large number of assumptions which are entirely speculative and the factual basis for which has not been proved. Those matters which the defendants assert to be purely speculative are: the existence of an implied consent of the owner of the intellectual property, in the absence of an express licence agreement, to allow the first defendant to produce a golf club holder; that the right to manufacture such a golf club holder rests with Caddyrack Pty Limited, Caddyrack International Pty Limited and Caddyrack Inc.; that the rights of those companies to manufacture the golf club holder has the consequence that the shares of Caddyrack Pty Limited have significant value by virtue of the income produced; and that "the business" (as defined by Mr Griffiths under the heading "Proprietorship" at pages 3 - 4) has manufactured and sold many thousands of units and has generated a substantial income in its infancy. Further, it was submitted that the Griffiths report assumes that the real profit can only be ascertained by consolidating the trading results of a number of different entities; and further, that it assumes a figure of $100,000 to service trade debtors and stock levels of all five entities. 37 It was submitted on behalf of the defendants that the methodology adopted by Mr Griffiths was the ability of the subject business to generate future maintainable profits (and that in this regard a price-earnings ratio of 2.5 was considered appropriate, with the consequence that the return on the investment became 40 percent), whilst, so it was submitted, there was no evidence as to the determination of the price-earnings ratio, or the appropriateness thereof by reference to what was considered to be an appropriate return on investments. 38 It was also submitted on behalf of the defendants that there was no evidence upon which Mr Griffiths was entitled to proceed upon the basis that the combined value of the group of entities was $3 million, that the value to be attributed to Caddyrack Pty Limited and Caddyrack International Pty Limited at 25 September 1997 was $1,839,000, or that calculating the combined value of those two companies by deducting from the pre-tax profit a proportionate cost of servicing stock and debtors in an amount of $60,000 and then capitalising the balance of $735,748 at 40 percent was appropriate. 39 The fourth major criticism addressed by the defendants to the Griffiths report was that, upon the assumption that the capitalisation of future maintainable profits is an appropriate method of valuation in the instant case, nevertheless the Griffiths report makes a number of errors in the application of that method. In particular, so it was submitted, the Griffiths report make a determination of real pre-tax profit for the business generated from the golf club holder, as a consequence of a significant number of add-backs to profit. Most of those add-backs were, as it was submitted by the defendant, totally inappropriate, and had the consequence of artificially inflating the Griffiths estimate of real pre-tax profit by a very large margin. 40 The defendants also submitted that the calculations of Mr Hewitt (being Attachment 9 to the Griffiths valuation) were defective for a number of reasons which are set forth in the submissions of Counsel. 41 In summary, it was submitted on behalf of the defendants that the Griffiths report should be disregarded for the following reasons; (i) The valuation purports to include in the valuation of shares of Caddyrack Pty Limited a value for a whole range of unrelated entities.

(iv) The respective qualifications of Mr Griffiths and Mr Pritchard entitling them to offer opinion evidence concerning the valuation of the shares in the first defendant are such that, so it is submitted, Mr Pritchard's opinion should be preferred to that of Mr Griffiths, since Mr Pritchard, as the accountant of Caddyrack Pty Limited and of Caddyrack International Pty Limited, is better qualified to comment on the value of the shares, because he is the person best able to know the true state of the company's affairs. 42 The report of Mr Pritchard was the subject of a number of criticisms on behalf of the plaintiffs. Concerning the conclusion drawn by Mr Pritchard from the losses experienced by the first defendant in two of the last three years of trading, to produce a negative profit figure, and Mr Pritchard's conclusion that, in consequence, there were no maintainable profits of the first defendant, Mr Griffiths said that such a method gave a distorted picture of a company's earning capacity, because it failed to take into consideration "start up" costs and "extraordinary expenditure" and the question of whether the company's profitability was improving or deteriorating. Mr Griffiths offered by way of example three hypothetical companies. The first had earned profits of $0, $50,000 and $100,000 in three consecutive years; the second had earned $50,000 for each of three years; and the final company had earned $100,000, $50,000 and $0 in its last three years of trading. By adopting Mr Pritchard's method (it was submitted on behalf of the plaintiffs) the maintainable profits would be the same for each of the three companies. Yet clearly there is likely to be a considerable difference in the value of those three companies. 43 It was submitted on behalf of the plaintiffs that Mr Pritchard did not explain upon what basis he claimed that this averaging process gave a more reliable process of present earning capacity. 44 Mr Griffiths also pointed out that if the extraordinary expenditure of $1.2 million was removed from the 1996 accounts, that year would have shown a net profit of over $500,000, rather than a loss. 45 It was also emphasised in the submissions of the plaintiffs that the chief difference between the net assets value technique adopted by Mr Pritchard and the basis adopted by the plaintiffs was that Mr Pritchard refused to allow anything for the goodwill of the business, asserting that this was not proper valuation methodology. 46 The plaintiffs submitted that firstly Mr Pritchard had not explained why goodwill should not be included as an asset of the company. Further, they relied upon the decision in Re Golden Bread Pty Limited [1977] QR 44 at 61 - 62, where the trial judge had valued the principal assets of a bakery company, namely the property at which the bakery business was conducted and the goodwill of that business, on a going concern basis, despite the unprofitability and insolvency of the company. The Full Court of the Supreme Court of Queensland (by majority) dismissed an appeal from that decision and affirmed the approach taken by the trial judge. 47 It seems to me that it is not appropriate to value only the tangible assets, and disregard the intangible assets of a company (as appears to have been done by Mr Pritchard). 48 Generally speaking, courts favour a two stage process in determining the fair value of shares. That two stage process is briefly explained by Fulton J in Diligenti v RWMD Operations Kelowna Limited (No. 2) (1977) 4 BCLR 134 at 165 - 166. 49 The first stage involves the determination of the value of the company's assets (both tangible and intangible) and the value of the business carried on by company. The first stage actually involves the Court in determining two separate issues, namely: (i) what method of valuation should be employed in determining the company's worth in terms of assets and earning potential; and (ii) on what date should the valuation be treated as being made? 50 In the instant case I do not need to concern myself with the question of the date upon which the valuation should be treated as being made, since the date 25 September 1997 was designated by Mr Justice Young, in order 3, as being the appropriate date from which the shares are to be valued. 51 The second stage involves the determination of the actual price for the applicant's shares, which is based upon the applicant's proportionate share of the company's total worth. 52 I have already observed that valuations are not a matter of exact science. To the extent that it is appropriate that I should do so, it seems to me that I should prefer the opinion evidence of Mr Griffiths to that of Mr Pritchard. There are a number of reasons for that preference. Firstly, on the basis of experience and qualifications alone the evidence of Mr Griffiths should be preferred to that of Mr Pritchard (see Kizquari Pty Limited v Prestoo Pty Limited (1993) 10 ACLSR 606 at 608; Sapir v Sapir (1989) 13 FamLR 362 at 364. Further, it seems to me that the approach adopted by Mr Griffiths towards the valuation was much more realistic than that adopted by Mr Pritchard. 53 I consider that it is here appropriate (despite the criticisms of Mr Pritchard) to adopt the capitalisation of future maintainable profits as the proper valuation method. I appreciate the opinion expressed by Lonergan, op. cit., 20, that this method should not be used where there is a history of losses. However, where, as here, only three years of a company's activities are being considered, and in one of those years a profit was made, whilst losses were made in the other two (and in one of those other two years the loss was the result of an extraordinary item, without which a substantial profit would have resulted), it is both inaccurate and misleading to state that the company has a history of losses. In my view the valuation method of future maintainable profits adopted by Mr Griffiths is the appropriate method of valuing the business of the first defendant, and the adoption of this method is not precluded by an asserted (but not substantiated) history of losses. 54 In approaching this valuation (not only the method of valuation, but also the application of that method to the facts of the instant case), the Court should not lose sight of the fact that Mr Justice Young, in ordering the buy-back and in directing the enquiry, proceeded upon the basis (at least implicit throughout his Honour's reasons for judgment) that the subject shares were of some value, indeed of a significant value, to the two competing family interests which were the protagonists in the proceedings before his Honour. 55 To adopt the approach now advanced by the defendants (for example, by asserting a lack of any legal entitlement to produce the golf club holder) seems to me to introduce into the enquiry a degree of artificiality which is entirely inconsistent with the manner in which the contested proceedings were conducted before his Honour, and entirely inconsistent with the underlying basis of his Honour's decision and the reasons why his Honour ordered a buy-back of the shares in the defendant. 56 Further, reasons of practicality and common sense suggest that the approach of Mr Pritchard was flawed by such matters as his denial that when valuing shares in a company it was necessary to value that company's assets, or his assertion that in the instant case he was required to value the shares in the first defendant, not the underlying assets of the first defendant. The denial that the phrase "future maintainable earnings" was equivalent to "goodwill" seemed to me to indicate a basic misunderstanding of the concept of goodwill. 57 The approach adopted by Mr Griffiths was far more realistic and far less artificial than that adopted by Mr Pritchard. 58 To approach the valuation of the shares in the first defendant by disregarding the assets of the first defendant seems to me to fly in the face of reality and common sense. 59 Since the Drinkwater interests and Kyrwood interests in the first defendant were equal, this is not a case where the principles relating to what is sometimes referred to as a "minority discount" have application (see Sirianos op. cit., 113 - 115). 60 Accordingly, I summarise as follows my foregoing conclusions. I regard the expertise and qualifications of Mr Griffiths as preferable to those of Mr Pritchard. I prefer the approach of Mr Griffiths to the valuation, rather than that of Mr Pritchard. In my view Mr Pritchard's approach totally disregarded the implicit basis upon which Mr Justice Young considered that there should be a buy-back of the shareholding of one of the protagonist families in the first defendant by the other protagonist family. One queries whether the defendants would have propounded the expert evidence of Mr Pritchard, if it had been the Drinkwaters who were purchasing the interests of the Kyrwoods in the first defendant. (I note that his Honour at page 33 of his judgment of 25 September 1997 contemplated that the short minutes to give effect to his reasons for judgment should include an order that "within a certain time after the publication of the valuation the Drinkwaters (or perhaps the Kyrwoods) be at liberty to purchase the opposing party's shares at that valuation".) 61 It follows from the conclusions which I have expressed that each of the forty ordinary shares in Caddyrack Pty Limited should be valued at $41,495. 62 I make the following orders: 1. I certify the value of the shares in Caddyrack Pty Limited at $41,495 a share.

Drinkwater v Caddyrack Pty Limited

At a glance

Court

Decision date

Before

Catchwords

Source

Catchwords

Judgment (11 paragraphs)

Parties

Cases Cited (1)

Cited By (1)