1115038 Alberta Ltd. Plaintiff - v. -, 2012 ABQB 334

Court of Queen ’ s Bench of Alberta Citation: 1115038 Alberta Ltd. v 1163256 Alberta Ltd., 2012 ABQB 334 Date: 20120518 Docket: 1003 07979 Registry: Edmonton Between: 1115038 Alberta Ltd. Plaintiff - and - 1163256 Alberta Ltd., Asian Concepts Franchising Corporation, 409389 B.C. Ltd., and Scott Bender Defendants _______________________________________________________ Reasons for Judgment of the Honourable Mr. Justice J.J.

Gill _______________________________________________________ Introduction: [ 1 ] The corporate Defendant, Asian Concepts Franchising Corporation ( “ ACFC ” ), is the owner of a restaurant franchise called the Wok Box. [ 2 ] The Wok Box started as a single store in Edmonton in 2004. It began to open franchises in 2008, and as of November 30, 2010 it had grown to 53 franchises across Canada.

[ 3 ] The parties agreed that the Defendants will buy out the Plaintiffs ’ interest in ACFC and the Wok Box business enterprise. [ 4 ] The issue in this case to be decided is the value of ACFC as of November 26, 2010 (the valuation date). Background [ 5 ] The Parties agreed to the following facts: 1. The Plaintiff 1115038 Alberta Ltd. (Newton Co.) is a duly registered Alberta Corporation belonging to Roger Newton, who is the sole Director and Shareholder of the company. 2. The Defendant ACFC is a Canada Corporation registered and carrying on business in British Columbia, Alberta, and elsewhere. 3.

ACFC is the current corporate entity used as the franchisor of a chain of restaurants called “ Wok Box, Fresh Asian Kitchen ” . ACFC essentially succeeded the Defendant 1163256 Alberta Ltd. (116 AltaCo.) in approximately early 2008 as the corporate entity through which the Wok Box business enterprise is run, such that the value of the Wok Box business enterprise effectively resides in ACFC. 4. Roger Newton, through Newton Co., was one of three founding shareholders who opened the first Wok Box restaurants in the greater Edmonton area in approximately 2004.

The shareholder group eventually grew to include a fourth shareholder, Mr. Bender, in what would be a new company, when 116 AltaCo. was incorporated, and that entity took over the Wok Box business enterprise. 5. Over time, the four shareholders determined that Mr. Bender would be the executive manager of the Wok Box business enterprise, and agreements among the four shareholders were made to give Mr. Bender ’ s company, the Defendant 409389 B.C. Ltd. (Bender Co.) more shares in 116 AltaCo. Mr.

Bender has remained as the executive manager of the Wok Box business enterprise through to the present, with ACFC having succeeded 116 AltaCo. as the corporate entity owning the Wok Box franchising operation. Mr. Newton has not been involved in any active day-to-day management or decision making with ACFC, while Mr. Bender and one of the other two shareholders have been. 6.

A dispute arose between Newton Co., Bender Co., and ACFC about, among other things, the amount of shareholdings that Newton Co. and Bender Co. hold in the Wok Box business enterprise, comprising ACFC, 116 AltaCo. and any related companies, based on certain past agreements. 7. Newton Co. commenced this Action on May 13, 2010. 8.

On October 28, 2010, the parties entered into a Limited Settlement Agreement with respect to a significant portion of the Action, whereby ACFC must buy-out Newton Co. ’ s interest in ACFC at 26% of the total value of the Wok Box business enterprise if it were to be sold as of November 30, 2010. The Limited Settlement Agreement is attached as

Schedule “ 1 ” hereto. 9. Because the parties have been unable to agree on the valuation of ACFC/Wok Box, the Limited Settlement Agreement requires the Court to determine the value. 10. On November 4, 2011 the Parties entered a Consent Order to proceed with this trial to determine the share valuate and buy-out

issues. [ 6 ] The following additional facts were agreed to during trial: 1. The management development agreement for the Middle East shows the price to be $250,000, but in fact it was reduced to $45,000. This is the amount paid to date. 2. Mr. Bender took a voluntary salary pay cut commencing mid-December 2010, reducing his salary to $120,000. 3. Mr. Bender owns other companies, including Famoso and the Rock. [ 7 ] The Consent Order entered into between the parties outlines the relief requested from this Court: 1.

This court shall hear a trial to determine the following issue: What is the total value of the Defendant Asian Concepts Franchising Corporation and the Wok Box business enterprise if it were to have been sold as of November 30, 2010 (the “ Business Value ” )? 2.

Based on the Business Value determined by the Court, the Court shall issue a judgement against the Defendants in this Action in favour of the Plaintiff awarding the Plaintiffs a sum equal to 26% of the Business value (the “ Purchase Price ” ), in accordance with the settlement agreement between the parties. [ 8 ] The Settlement Agreement between the parties provides: 2. For the purpose of the Buy-Out, Newton Co. will be considered to be the owner of 26% of all outstanding shares in Asian Concepts and Wok Box generally. 3.

The amount paid to Newton Co. in the Buy-Out will be 26% 0f the total value of Wok Box if Wok Box were to be sold as of November 26, 2010. The Issues [ 9 ] There are two issues to be decided.

A) What is the appropriate Valuation Approach to use? [ 10 ] The parties disagree as to the appropriate method to use to determine the “ Business Value ” of ACFC. The Plaintiff submits that ACFC should be valued as a “ going concern ” . The Defendants argues that it should be valued using a “ liquidation ” approach.

B) What is the value of ACFC if it had been sold as the valuation date?

[ 11 ] The Plaintiff calculates a fair market value of the issued and outstanding shares of ACFC at the valuation date to be in the range of $2.1 million to $2.7 million, with a midpoint of $2.4 million. [ 12 ] The Defendants concluded the fair market value of the issued and outstanding shares of ACFC at the valuation date is $NIL. Evidence [ 13 ] The Plaintiff and the Defendant both called business evaluators who were qualified at trial as experts. [ 14 ] The Plaintiff called Mr. Paul Sharpe, a Chartered Accountant and Chartered Business Valuator from the firm of Ernst and Young in Calgary.

He works exclusively in the business valuation area and has done many types of business valuations over the last ten years. He has been accepted as an expert witness in the Alberta Court of Queen ’ s Bench and for the Alberta Utilities Commission. [ 15 ] Mr. Sharpe testified that he was retained to provide an estimate of the fair market value of the shares of this company as of November 30, 2010. His mandate was to value the entire company, not a particular group of shareholdings. [ 16 ] Mr. Sharpe ’ s valuation report, dated December 21, 2011, used a “ going concern ” approach to valuation.

Such an approach is appropriate when you have an operating business that can earn income into the future and is economically viable. [ 17 ] Another way to approach a valuation is to use the “ liquidation approach ” . It is an asset-valued approach based on the sale of each individual asset, sold separately. This is used when one is not dealing with a viable business and is interested in selling assets individually. [ 18 ] Mr.

Sharpe selected the “ going concern ” approach because he believes this business, while it is a relatively new entity, will be solvent in the future and will be in a position to continue to operate. After normalization of the financial statements, it will generate a positive cash flow. [ 19 ] In his valuation analysis, Mr. Sharpe used a discounted cash flow to calculate the value. Future cash flows were discounted to present value to reflect the time value and the risk involved. As November 30, 2010 was the agreed upon valuation date, all prospective cash flow in the future were discounted back to that date.

He looked at historical forecasts and achievements and built in a growth factor. [ 20 ] The Defendant ’ s valuator Mr. Mynatt used a liquidation approach. Mr. Sharpe disagrees with using this approach because without considering potential growth as part of the valuation analysis, there will likely not be any value in this type of company. [ 21 ] Mr. Sharpe prepared growth forecasts even though management would not, or could not. He believes by not forecasting growth, the Defendant forced a valuation based on a historical pattern of financial losses, inherently ruling out using a “ going concern ” approach.

This did not make sense when one took into account the history of growth and the plans the company had made to grow. [ 22 ] In preparing his evaluation, Mr. Sharpe requested and received a significant amount of financial information from the company. Much of this information was in response to several questionnaires that he provided to the company. He also conducted interviews with management. He estimates that he had about half a dozen meetings with the CEO and CFO. [ 23 ] One of the documents reviewed included a company document entitled “ Landlord Information ” dated 2009 and a franchise

information kit. In the Landlord Information kit the company predicted having 50 plus locations across Canada. Mr. Sharpe noted that in November 2010 they actually had 53 locations. He also referred to an email from the CEO Mr. Bender, dated June 24, 2009, containing a number of growth projections up until 2019. He reviewed email correspondence dated September 30, 2009 where the principal shareholder valued ACFC at approximately $2.8 million. [ 24 ] Mr.

Sharpe did not rely on any of the information that post-dated November 30, 2010. [ 25 ] The background information on business operations that he accepted as fact for the purposes of his analysis and valuation is set out in paragraph 9 of his report dated December 21, 2011: 9.0 Background Description of business operations 9.1 For the purposes of our report and analysis, we have accepted the following background information as fact. 9.2 ACFC was incorporated in 2008 to house the operations of the Wok Box brand.

Operating assets were formerly held in Wok Box Co. 9.3 ACFC conducts franchisor activities for the Wok Box brand. Wok Box is a quick service restaurant brand that serves Asian-inspired stirfry and other meals. 9.4 ACFC receives initial franchise fees from its franchisees for each new location. Management maintains that these fees are not a profit-generating activity; but rather, they are required to recoup certain costs incurred upon the initiation of the new location.

The costs include, among other things, the portion of the franchise fee paid to the master developer, travel costs, legal costs and certain construction management costs. 9.5 ACFC receives royalty fees from Wok Box franchisees. Exceptions are made in certain instances where the franchisee requires financial relief. In addition, ACFC sells ‘ master developer rights to various geographic areas. These rights give the master developer the exclusive right, in his or her respective region, to market franchises for sale.

In exchange for these rights, ACFC receive 50% of royalties and initial franchise fees earned by the master developer. Other, less material sources of revenue include revenues received from the direct operation of Wok Box stores and sub-lease fees. 9.6 ACFC conducts advertising activities on behalf of its franchisees. Funds, specifically dedicated to the promotion of the Wok Box brand, are collected from each franchisee. ACFC is responsible for the planning and execution of the promotion campaigns. 9.7 From time to time, ACFC engages in the operation of certain Wok Box locations.

Where certain franchisees are enduring financial hardship or are in breach of the terms of their franchise agreement, ACFC may take over operational control of the location. Management may also pay rent on behalf of a troubled franchise. Through discussions, management maintains that these activities are only carried out in specific circumstances where ACFC ’ s intervention at the franchise level has been deemed necessary. 9.8 As at the Valuation Date, ACFC had 53 stores, including four corporately-run locations operating under the Wok Box brand.

Stores are located in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario and the Maritimes.

Asian Concepts Franchising Corporation Geographic Distribution of Locations Locations at Valuation Date British Columbia Alberta Saskatchewan Manitoba Ontario The Maritimes Total 11 29 3 3 2 5 53 9.9 Two of the four stores that were operated by the Company at the Valuation Date were re-franchised to a new operator on 1 December 2010 (Lethbridge South and Lethbridge West). On 1 December 2010 one of franchises not corporately controlled was closed and on 2 December 2010 the operations of the Vernon location were assumed by the Company. It is assumed that these events were all known at the Valuation Date.

Historical Growth 9.10 Seven new stores were opened in the six months ended 30 November 2010. Individual stores were added in Saint John, NB; Airdrie, AB; London, ON; St. John’s, NE; Mississauga, ON; Fort Saskatchewan, AB; and Calgary, AB. During this six month period, 2 stores closed (Port Moody, BC and Surrey BC) for net growth of 5 stores. 9.11 In the twelve months ended 30 November 2010, the number of franchises grew by 14, and in the twelve months ended 30 November 2009, 16 net stores added. In 2008 and 2007, there were 13 and 10 net locations added, respectively.

9.12 Total royalty revenues for the year ended 31 May 2010 grew by 69% over 2009. Annualized revenues at the six months ended 30 November2010 were 14% higher than fiscal 2010. Forecast Growth 9.13 In documents provided to the shareholders of ACFC on 24 July 2009, a

schedule entitled ‘Future Store Potential by Market’ was included. The

schedule proposed a hypothetical franchise growth scenario, for various regions through to 2019. A

summary of this document is included at

Schedule 10. The

schedule proposes 491 potential locations by the end of 2019, including 160 locations in Ontario, 132 in the United States and 52 locations in other countries. Per the schedule, there were 30 existing locations at the time the

schedule was prepared. 9.14 We understand that, at 31 May 2010, management intended to have over 150 locations operational across Canada within five to seven years. 9.15 At the Valuation Date, we understand that the Company had 11 planned new locations. Nine of these locations had executed both franchise and lease agreements, while two of the locations had an executed franchise agreement but no lease agreement. Three further locations were identified that had quite serious potential franchisees, however no franchise or lease agreements had been executed.

[ 26 ] This background information was not challenged by the Defendants. [ 27 ] One of the key methods used by ACFC to grow were Master Development Agreements (MDA). The purchaser under a MDA paid an up-front fee, usually between $200,000 and $220,000. The purchaser was given exclusive control to develop up to five franchises in a particular geographic area (eg; southern Alberta).

The royalties from these new franchises were shared equally between the ACFC and the master developer. [ 28 ] Under an MDA, ACFC also received a new franchise fee of $25,000 for each new franchise, 50% of which would be returned to the purchaser under the MDA. There was an obligation on ACFC under the MDA to spend certain amounts for advertising to promote the franchises. [ 29 ] Mr. Sharpe ’ s valuation took into account that stores close and, on occasion, the ACFC was required to take over a store that was not performing, and then run it until it was resold or closed.

When that happens, the company does not make as much money. [ 30 ] Mr. Sharpe used historical income statements. Royalties had increased from 2008 to 2010. He took into account that the company had not turned a profit as of the valuation date. He did not consider it unusual or unexpected that the company had not made a profit as at the valuation date. A franchisor required a certain level of stores to pay the fixed costs.

Whether it has 15 or 100 stores, there is still a certain number of fixed costs. [ 31 ] He assumed that the franchise fees was not a profitable side to the company, as these were offset by construction costs. There was also income from the sale of the Wok Box boxes, which he assumed would continue into the future. [ 32 ] Mr. Sharpe testified that it is important to not just consider profit in determining value. The value lies in the company ’ s prospects. That is, what does the valuator think will happen in the future, particularly as regards to future cash flows.

Future cash flows, however, must reflect risk, the time value of money, and inflation. [ 33 ] In the six-month period before the valuation date, ACFC failed to achieve its projected goals, and lost money. However, while a six-month financial snapshot is relevant to the long-term (five year) projection, a purchaser would not just focus on that period as it is only six months in the potential life of the company. Premise of Value [ 34 ] Mr.

Sharpe used a going concern approach and a capitalization of cash flow technique to value ACFC. [ 35 ] At paragraph 12.5 of his June 29, 2011 report under the heading “ Premise of Value ” he states: Considering the nature of the business and it ’ s economic viability we concluded that it was appropriate to value the operating assets and liabilities of that business on a going concern basis. While historically the Company has not generated positive cashflows, it is a relatively young entity that has been focused on growth. It now has over 50 franchises, many of which were added in the recent year.

After normalisation adjustments, the Company appears to be generating positive historical EBITDA and positive forecast EBITDA. It also appears to meet it ’ s near-term obligations. These factors lend themselves to valuing the business on a going concern basis rather than on a liquidation basis. [ 36 ] The valuation approaches and methodologies used are set out on paragraph 12.8:

Considering the nature of the business and the available information, we selected two income based approaches to determining value, specifically:

a) An income approach utilising a capitalised EBITDA methodology.

b) An income approach utilising a discounted cash flow ( “ DCF ” ) methodology. [ 37 ] “ EBITDA ” is a calculation of a company ’ s earnings. It is net income with interest, taxes, depreciation, and amortization added back to it. [ 38 ] Mr. Sharpe prepared a valuation based on those 3 scenarios. Each scenario contained different assumptions as to the future growth path of ACFC over a 4 to5 year period based on varying assumptions.

He assigned a probability factor of 33.3 % to each scenario. [ 39 ] At paragraph 13.1 of the report: Given the relatively short history of ACFC and the significant revenue growth we calculated value under three scenarios, each reflecting a different forecast of future growth. In determining the fair market value we have applied a different weighting to each of the three scenarios. The combined weightings applied to the scenarios sums to 100%. [ 40 ] Scenario 1 is a conservative estimate of growth. It assumed ACFC would limit franchise growth and not carry out any of it ’ s assumed growth.

Present operations would continue and t assumed that the only franchises actually under contract (signed up to franchise and lease agreements) would be added. Royalties and profit from sale of Wok Box boxes would continue. Franchise Fees ($25,000) from MDAs would not continue. Built into this estimate are stores that already have potential difficulties. [ 41 ] Because management had previously been focussed on growth, under this scenario there would likely be excess managerial capacity. Operational issues such as advertising etc. would have to continue.

Management would also continue to work with the management developer agreements and be responsible for the day to day involvement with any troubled franchises that were not covered by territorial territorial agreements. [ 42 ] Because this scenario anticipates no growth in the future that is not already specifically contracted, a more conservative EBITDA calculation was used. Under this scenario he calculated the fair market value to fall within the range of $700,000 and $900,000. [ 43 ] Scenario 2 is a “ low growth ” scenario. Mr.

Sharpe assumed a net store growth of only seven stores per year, producing a total of 85 franchises by 2015. This growth rate represents only about 50% of the average annual store growth from the proceeding four years. Before November 30, 2010 the company was actually adding more than seven stores a year. On average the ACFC was adding about nine to eleven stores per year (14, 16, 13, and 10 stores were added in the previous years.) [ 44 ] Scenario 2 assumes that growth would stop as of May 31, 2015.

It is also assumed no income growth on the cash flow after that, except inflation, and used a discounted cash flow method to determine the present value of prospective cash flows and the terminal value. [ 45 ] Under scenario 2, Mr. Sharpe calculated the fair market value to fall in the range of $1.6 million and $2.2 million.

[ 46 ] Scenario 3 can be described as a “ high growth ” scenario. It assumes a growth of four (net) stores to May 31, 2011. Then a growth of 25 percent over four years. ACFC would stop growing in May, 2015 with 139 stores. This scenario represents higher growth, but it is still discounted substantially from ACFC ’ s own growth forecasts. [ 47 ] Scenario 3 also uses a discounted cash flow method to determine the present value of prospective cash flows and the terminal value. Under this scenario, Mr. Sharpe calculated the fair market value to fall in the range of $4.0 million and $4.9 million. [ 48 ] Mr.

Sharpe assumed that these three scenarios were three business paths the company could follow and that there was a one- third chance that each of these scenarios would occur. Therefore, the probability is one-third chance of each of them occurring. Since the company could not, or would not, forecast, he did not pick one scenario as being the most likely. [ 49 ] Based on his three scenarios the value of the company was between $2.1 million and $2.7 million. He set the value at $2.4 million as the midpoint. [ 50 ] Mr.

Sharpe was referred to Exhibit 15, a document prepared by the company, showing projected store growth for fiscal 2011, 2012 and 2013. It describes, on a monthly basis, the number of stores the company projected would be added in each region. This information was provided to Mr. Sharpe two months before the valuation date and was effective as of the sale date. He notes the company ’ s projections were higher than those he used in his valuation in Scenarios 1 and 2. In Scenario 3 Mr.

Sharpe was higher by 10 stores on the 2013 prediction than the ACFC ’ s projection, but otherwise his predictions were the same or lower than the company. [ 51 ] It is also reasonable to assume that the company, (ie. the seller) would want to maximize their value as of November 30, 2010. [ 52 ] Wok Box Canada website has new stores in 2012. Wok Box Lebanon has a projected number of 70 stores. Wok Box U.S.A. shows stores opening in 2012. Mr. Sharpe was not aware of that about this information. It would not have been known as in November 2010 and he would not have considered it. Cross Examination of Mr.

Sharpe [ 53 ] Mr. Sharpe had not prepared a valuation of a franchisor previously. His report was reviewed by two senior valuators in his office. The company said they could not forecast future revenue and expenses, and therefore provided no projections. The company told him that they had planned to grow stores over time. [ 54 ] He understood the financial condition of the franchises as of November 30, 2010. The company operated four stores, and two of these were re-franchised the day after November 30, 2010.

He had discussions with the company concerning the financial health as of November 30, 2010, and it provided information of negative events after the valuation date. The performance in the six-month period afterwards was not as strong as he predicted. He noted the company controls the information that it provided. [ 55 ] He used marketing documents to get an understanding of the business. In reviewing these documents, he was conscious that someone creating marketing documents are careful not to provide negative information to potential franchisees. [ 56 ] He reviewed the e-mails and comments from Mr.

Bender and Mr. Bender ’ s comments of June 23 and September, 2009 concerning the value of the company. He gave limited weight to these because it was 2009 information and there was no analysis attached. It is, however, to be noted that somebody was willing to pay $2.8 million for the company.

[ 57 ] Mr. Sharpe did not recall taking the Wok Box trademark into consideration. He acknowledges that its ownership could potentially affect the value of the company. He made written requests to the company for that information, and proceeded under the assumption that ACFC had access, or continued, access to the trademarks. It was not really raised as an issue as to whether or not they had exclusive rights to use the trademarks. He acknowledged that valuation is premised on access to the trademarks and lack of access could have a negative impact.

However, he noted that the company that owned the trademarks is owned by Mr. Bender, the president of ACFC. [ 58 ] Mr. Sharpe indicated that he assumed that the salary for the CEO of Wok Box would be paid market rate, and he did not consult as to what an appropriate salary would be and he did not request the management contracts.

He concluded that it was not necessary that the same management remain on, and he assumed that it could be replaced and that there would be a continuation of competent management making decisions in the best interests of the company. [ 59 ] Information about what happened after November 30, 2010 was not part of his opinion. His opinion was based on what was happening as of November 30, 2010. He considered both the good and the bad debts. He assumed the royalties would continue to be paid. He calculated a contingency at 7.5% for bad debt (Mr. Mynett used 5%) based on historical analysis.

He also took into account the potential of the management having to take over closed stores. [ 60 ] In Exhibit 10 the company said it would stop selling Wok Box “ Boxes ” . He ignored this statement because the company had made a profit from the boxes in the past. It could be assumed that any potential purchaser would continue to sell them if profitable. A purchaser with a competent management team would not disregard profit. [ 61 ] As regards litigation against the company he noted the response from the company that the only litigation as of November 30, 2010 was considered to be frivolous.

He did not take into account allegations that came to light after the valuation date. [ 62 ] Mr. Sharpe based future revenue from the MDAs on an average of the five that had been sold previously – $220,000. He acknowledged that while there was one fee of $600,000 for a Northern Alberta Agreement, other fees paid were less (between $45,000 and $110,000). Scenario 2 assumed one new Master Development Agreement and Scenario 3 assumed three more Master Development Agreements. [ 63 ] He was not surprised that some franchises were in difficulty.

When one takes into account that there are 53 separate businesses, it is foreseeable that a couple of them would be in difficulty. In terms of growth, Management had projections to 2013, and the growth that Mr. Sharpe predicted was less than the historical growth. [ 64 ] He was then asked to refer to the financial statements for the whole of 2011 which included the last six months. He acknowledges he did not predict that financial decline in the first six months after November 10. His projections were based on the information available as of November 30, 2010.

Under Scenario 1, he predicted income of $199,000 to $206,000, on Scenario 2 - $77,000 to $154,000 profit, on Scenario 3 - $75,000 to $150,000 profit. He acknowledges the projections were not borne out in reality, but he also said that conclusion was based on the financial statements which he has not normalized. [ 65 ] A valuation of a business is always at point in time. The value of a business changes daily similar to the value of shares in the stock market. Mr.

Sharpe ’ s valuation was based on a particular day – November 30, 2010 – and based on the assumption that the business was sold on that date. [ 66 ] His valuation as of November 30, 2010 was a theoretical evaluation, not an open market evaluation. A six month loss after November 10, 2010 does not mean that the company would continue in the future in a loss position. All that is known is that for the first six months his projections were not borne out, but the information as of May 31, 2011 was not something the buyer and seller would have known as of November 30, 2010. Mr. Gary Mynett

[ 67 ] Mr. Gary Mynett was called as an expert witness by the defence. He is a CA and CBV (Chartered Business Valuator). He has been exclusively a business valuator since 1992. He has valuated all types of businesses, including many restaurants and franchise restaurants, including a company that had 44 franchises in British Columbia and one based in Edmonton that had 60 franchises. As a valuator he has dealt with numerous fast food restaurants. [ 68 ] He authored the report that was entered as Exhibit 19. He was assisted by another CA, CFA, CBA who was a former CFO of the franchisor Red Robin.

He was retained to determine the fair market value of the Wok Box as of November 30, 2010. His report lists the documents and other sources he used. [ 69 ] After attempting to do an income based approach he decided to use the liquidation approach. It is appropriate to use an income based approach when a company is generating income and is expected to continue to generate income in the future.

ACFC had not generated any income, even with adjustments, and so an income approach was not possible. [ 70 ] Since it was a new company in a growth stage he considered using projections but previous projections had been unreliable. Supportable projections were not available. Using projections also did not show any value in the company. [ 71 ] It is important to have confidence in management projections. One looks at the previous projections. Often they are much more optimistic than the results achieved. He did not have much confidence in their predictions. Some stores were not performing.

Sales were declining and management predictions in the past were not achieved. Therefore he could not have confidence in their predictions. [ 72 ] With established companies you can use track record history as a good starting point. In this type of situation with a company losing money and where there is so much uncertainty, the purchaser might take a “ wait and see ” approach. The purchaser would typically agree to an arrangement with a payment up front and the balance of the purchase price being paid based on future performance and results.

In this case this was not an option as the valuation was to be based on immediate payment of the full purchase price. [ 73 ] While a buyer would consider the opportunity for future growth, he would not pay for potential future cash flows. If the purchaser believes he could generate more profit, it would take that into account, but if the company has not achieved profitability, it will not be paid for. [ 74 ] A going concern valuation is applicable where a company is meeting its financial obligations as they come due.

If a company can only meet its obligations by cash injections from the shareholders, the business is probably not a going concern. It needs to generate sufficient cash flow. If it is generating a cash flow, but all it can do is pay its debt, it may arguably be a going concern, but from a purchaser ’ s perspective there is no point buying if all the company can do is pay its debt and not provide a financial return. To be a going concern. a company must not only pay its obligations, but provide a reasonable rate of return on the money invested. [ 75 ] Mr.

Mynett concluded that he could not use a valuation based on income, as there was no reasonable possibility of positive cash flow. [ 76 ] An alternative was to assume the status as a model and assume no further growth (ie: 53 franchises). He could not generate a positive cash flow, even after removing growth expenses. Using a growth model, with growth expenses built in, there was a negative income. [ 77 ] He concluded that the liquidation approach was appropriate to use since the company was not generating a sufficient rate of return. He assumed that it would be better to wind up the company.

This method of evaluation does not mean that the company will actually be liquidated [ 78 ] The liquidation approach did not generate any value because the company did not own significant tangible assets such as trademarks or copyright.

[ 79 ] Mr. Mynett commented on Mr. Sharpe ’ s evidence in regards to using a “ going concern “ approach. He had a number of concerns with that assumption. First, the projections used by Mr. Sharpe were not consistent with the advice he received from management. Second, a purchaser would not pay to take on the risk of growing the company. [ 80 ] Mr. Mynett considered the financial statements of the company would be problematic to a purchaser as they indicated that the company was going deeper into debt. Management salaries were not paid in 2010.

The 2011 financial statement (May 31, 2011) showed a default position of $519,000, suggesting the financial health of the company was deteriorating. The unaudited internal financial statements for 2012 show continued deterioration of the financial situation. The financial forecasts were meaningless, and he did not think a financial turnaround was possible. [ 81 ] Usually one can project no more than five years because projections become much more uncertain each year into the future.

If a vendor was trying to sell a company they would prepare five years of projections; a prudent purchaser would assess how accurate these would be. [ 82 ] A prudent buyer would not consider the company a going concern because it was not capable of generating returns for investors based on the historical performance and the projections. With the background here, a purchaser would not have confidence in the financial projections of management.

No purchaser would pay for something not achieved because the purchaser would have to put in all the effort and take all the risk. [ 83 ] A purchaser might pay if the ground work had been laid for future growth. However, one would need to see positive financial statements with positive cash flow, and a track record of profitability. If, as in this case, a company needs a financial subsidies, the purchase price would be reduced by the subsidy. One needs to see a positive cash flow to motivate a purchaser to inject capital. [ 84 ] He had reviewed Mr. Sharpe ’ s report and prepared a critique (Exhibit 21).

Unlike Mr. Sharpe, Mr. Mynett would never substitute his judgment for that of management in relation to future opportunities available to the company. The role of an valuator is to deal with the company ’ s stated intentions. A valuator does not substitute his judgment for that of the business decisions of management. [ 85 ] Mr. Mynett also disagreed with Sharpe ’ s three scenario approach. The scenario analysis does not represent fair market value. It is incumbent on a valuator to establish the most likely assumptions and prepare a valuation accordingly.

If that cannot be done, then one uses an asset based appraisal. He was also critical of a number of Mr. Sharpe ’ s assumptions and of the use of probability for the three scenarios. [ 86 ] EBITDA is a formula used in the public market sector; it is a mathematical conversion that makes it easy for investors to determine profitability. It is not a rigorous valuation technique and is not the primary way to carry out a valuation analysis because it has a number of shortcomings. In Scenario 1, Mr. Sharpe made some assumptions that took some of the shortcomings into account. [ 87 ] However, in Mr.

Mynett ’ s opinion Mr. Sharpe overstated income in Scenarios 2 and 3, as he assumed the continued use of MDAs. Management had said that they would not use an MDA agreement again and so those revenues would not be generated. Valuators should never substitute their opinion for management as regards items that generate potential cash flow. Information used in a valuation must come from management. [ 88 ] Mr. Mynett also disagreed with the discount rates used by Mr. Sharpe. He used the same discount rates in all three scenarios. Scenario 3 is much riskier and he should have used a higher discounted rate.

He also has a problem with the level of debt financing used by Mr. Sharpe. The company could not get the level of debt financing assumed by Mr. Sharpe because it did not have positive cash flow. No prudent lender would lend, therefore an assumption of debt was not appropriate. Mr. Sharpe should have removed the debt financing from his calculations and assumed 100% equity financing. Further, the cost of finance used by Mr. Sharpe was too low. Start up companies such as ACFC would require much higher rates of return than he assumed.

This resulted in the discount rates he used being too low. [ 89 ] In his valuation Mr. Sharpe used large companies as comparables resulting in an over valuation. A public company should never be used as a comparable for this type of evaluation.

[ 90 ] Mr. Sharpe ’ s opinion was based on a projection of future earnings which was very speculative. A prudent purchaser could not rely on these projections as there was no history of a positive cash flow. Cross Examination [ 91 ] Mr. Mynett did not prepare an alternative “ going concern ” valuation. He acknowledged that the company has substantial royalties (ie: about $855,000) and that from a percentage perspective, the royalties have grown very significantly. The company had also grown to 53 locations in three years.

He further acknowledged that five MDAs had been sold which demonstrated that people were prepared to buy into the company, even when the company was not making any money. [ 92 ] Mr. Mynett did not take into account that several of the loans owed by the ACFC were to entities owned by Mr. Bender, the CEO of ACFC, who could presumably decide whether to call in these loans. [ 93 ] In regard to selling Wok Box containers, he did not know that as of November 30, 2010 management had not yet made the decision not to sell those anymore.

In fact this plan developed in March 2011, and therefore was not relevant to the valuation. [ 94 ] He acknowledged that Mr. Sharpe had taken into account the size of the companies he used for variables and had removed companies with the large revenues from the valuation analysis. He acknowledged it was useful to look at big companies as comparables for a reality test. He further noted that Mr. Sharpe assumed that the trademark was owned, but did not assess any value to the trademark.

He also acknowledged it is not unusual for young companies to have low cash flows, but low cash flows and losses do not mean no value. [ 95 ] Mr. Mynett acknowledged that he knew that the management wanted to grow the company but said this was just a wish list not a plan. He needed specific details of each location. [ 96 ] He was then asked to compare his May evaluation report and his Exhibit 9 most recent one. It was noted that he redacted information concerning growth and he replaced it with information that was not available on the November 30, 2010 evaluation date.

He redacted one positive and highlighted a negative. When he prepared his December 21, 2010 evaluation, there was information concerning plans to expand to 150 stores. He redacted this information based on other information received from management. There is no reference to the expected growth in his most recent report.

His most recent report does not mention/note that ACFC reached 50 locations by 2010 which was a prediction made by the company in 2009. [ 97 ] He acknowledged a purchaser will pay for the opportunity to grow a company, but he believes that in this case there was no such opportunity. [ 98 ] ACFC did not advise him February 2011 about the expansion to India (see Exhibit 23). Issues 1 . What is the appropriate Valuation Approach to use? 2. What is the total value of ACFC if it were to have been sold as of November 30, 2010?

1. What is the appropriate Valuation Approach to use? [ 99 ] The parties agreed that this Court will decide following the issue: 1. What is the total value of the Defendant Asian Concepts Franchising Corporation ( “ ACFC ” ) and the Wok Box Enterprise if were to have been sold as of November 30, 2010? (the Business Value). [ 100 ] The two expert witnesses defined “ fair market value ” . Mr.

Sharpe at para. 3.0 of his report dated December 21, 2011: Fair market value ( “ FMV ” ): the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell, and when both have reasonable knowledge of the relevant facts. FMV is an estimate of the price which could be obtained in the market at a given point in time under an assumed set of conditions.

The price that might be obtained for the subject interests, if sold in an actual transaction, could be different from our value conclusion for a number of reasons, including the terms of sale, changes in values since the valuation date, the method of sale, and the characteristics and motivations of the acting parties. [ 101 ] Mr.

Mynett in his reports dated December 21, 2010 and June 29, 2011 used the following definition of fair market value, See para. 4.01: Fair market value, is defined as the highest price available in open and unrestricted market between informed and prudent parties acting at arms length and under no compulsion to act, expressed in terms of cash. [ 102 ] Both

definitions contain essentially the same key elements: informed parties under no compulsion to act. [ 103 ] This sale transaction assumed the sale of all the issued and outstanding shares and Mr. Sharpe provided a definition in relation to “ en bloc value ” at para. 3.02 : The FMV of the assets or ownership interest of a business viewed as a whole, i.e. 100% of the issued and outstanding shares/units of an entity. Valuation Approaches [ 104 ] In

summary, Mr. Sharpe recognized that the company had not generated positive cash flows but took into account that it was a relatively young entity that had been focused on growth and had added many franchises during it ’ s short life. He adjusted the historical and forecasted cash flow using the EBITDA method and concluded that the going concern approach was the appropriate method to use. [ 105 ] Mr. Mynett used the liquidation approach because the company had not been profitable and because the owners had not been accurate in their forecasts for either future income or future number of franchises. Mr. Sharpe

[ 106 ] Mr. Sharpe in his report dated December 21, 2011 set out his valuation approach and methodology at paras. 12.2 to 12.6: 12.2 When measuring FMV, it is appropriate to adopt the premise of value, going concern or stand alone, that will maximize the value of the subject entity.

In determining the highest and best use of the component assets and hence the appropriate valuation premise for each, it is necessary to consider whether the overall entity value is maximized by measuring each assets value on a stand alone ( “ in exchange ” ) basis or as part of a going concern ( “ in use ” ) asset grouping. 12.3 Given the valuation premise adopted, the values of individual assets or combination of assets and liabilities may be estimated through one or more of the cost, market and income approaches. . . . 12.4 The selection of appropriate valuation methodologies and the value conclusions drawn after their application are matters of professional judgment.

Premise of Value 12.5 Considering the nature of the business and its economic viability, we concluded that it was appropriate to value the operating assets and liabilities of that business enterprise on a going concern basis. While historically the company has not generated positive cash flows, it is a relatively young entity that has been focused on growth. It now has over 50 franchises, many of which were added in the recent year. After normalization and adjustments, the company appears to be generating positive historical EBITDA and positive forecast EBITDA.

It also appears to be able to meet its near term obligations. These factors lend themselves to valuing the business on an on going concern rather than on a liquidation approach. 12.6 Assets and liabilities that were redundant to business operations were valued on a stand alone basis under an in-exchange premise. Mr. Mynett [ 107 ] Mr. Mynett in his June 29, 2011 report at para. 7.01 described two valuation approaches: 7.01 There are two basic approaches to the determination of fair market value: (

a) the going concern approach which assumes that the company under consideration will continue to operate in future years; (

b) the liquidation approach, which assumes that the company under consideration will be wound up and the funds realized will be distributed to the shareholders for use in a more profitable operation. This does not necessarily mean that the company under review is suitable only for liquidation.

It simply suggests that a prudent person would not sell the company as a going concern for any less than could be realized by winding it up. [ 108 ] At para. 7.13 he set out criteria to use in choosing which valuation approach was appropriate: 7.13 Where a company is not a going concern either because it is in financial distress or because it is not earning a reasonable rate of return on the net assets employed in its operation a liquidation approach is appropriate.

[ 109 ] At para. 7.14 Mr. Mynett described the two types of liquidation scenarios that were possible. Firstly a forced liquidation where the sale of the assets arises from an immediate cessation of the business and disposition of the assets is assumed on a “ as is/where is ” basis. The second alternative is a voluntary liquidation where the sale of the assets and the wind up of the operation is controlled by the owners of the business and where residual value normally is expected to be realized by the owners. [ 110 ] At para. 7.18 of his November 30,2010 report Mr.

Mynett provided his conclusion as which valuation approach to be used: 7.18 After reviewing the nature and history of the operation of ACFC, we concluded that the appropriate valuation approach was a voluntary liquidation approach. Analysis and Conclusion [ 111 ] I have concluded that the “ going concern ” approach is the appropriate valuation method to use to for a number of reasons. [ 112 ] I accept as reasonable the premise of valuation used by Mr.

Sharpe at paragraph 12.2: When measuring FMV, it is appropriate to adopt the premise of value, going concern or stand alone that will maximize the value of the subject entity. In determining the highest and best use of the component assets, and hence the appropriate evaluation premise for each, it is necessary to consider whether the overall entity value is maximized by measuring each assets value on a stand alone (in exchange) basis or as part of the going concern (in use) asset grouping. [ 113 ] This approach is supported by logic and the evidence.

Using a “ going concern ” valuation approach would result in a maximization of the value of this entity. [ 114 ] A “ going concern ” approach is consistent with my

interpretation of the intention of the parties in their settlement agreement. The wording of the Consent Order refers to the total value of the Defendant “ ACFC and the Wok Box business enterprise ” (emphasis added). The use of the word “ enterprise ” suggests a corporate entity that would continue to operate into the future and had value, as opposed to an entity that was on no value to be wound up immediately as suggested by the Defendant. [ 115 ] The concept of ACFC as “ a going concern ” is consistent with the track record of the company leading up to November 30, 2010.

It had grown rapidly both in terms of the number of franchises and cash flow. [ 116 ] The evidence presented at trial strongly suggests that ACFC was planning to and had the capability to continue to operate beyond November 30, 2010 ( “ the valuation date ” ) and was by any definition a “ going concern ” . [ 117 ] This evidence included: (

a) As of the valuation date ACFC had 53 franchise stores; (

b) In the 12 months ending November 30, 2010 the number of franchises grew by 14, with seven new stores opened in the 6 months ending November 30, 2010; (

c) In the 12 months ending November 30, 2009, 16 net stores were added;

(

d) In 2008 and 2007 there were 13 and 10 net locations added respectively; (

e) At the valuation date the company had 11 planned new locations, nine of these locations had executed both franchise and lease agreements while two had an executed franchise agreement, but no lease agreement. Three further locations were identified that had quite serious potential franchisees, however no franchise or lease agreements had been executed. (

f) At May 31, 2010 management intended to have over 150 locations operational across Canada within 5 to 7 years; (

g) Total royalty revenues for the year ended May 31, 2010 grew by 69% over 2009; (

h) Annualized revenues of the 6 months ending November 30, 2010 were 14% higher than fiscal 2010; (

i) In documents provided to the shareholders of ACFC on July 24, 2010 a

Schedule entitled “ Future Store Potential by Market ” was included. The

schedule proposed a hypothetical franchise growth scenario for various regions through to 2019. [ 118 ] The success of the Master Developer Agreements (MDAs) also supports the use of a “ going concern ” approach and completely undermines the use of a “ liquidation approach ” . The company has been selling “ fractions ” of itself through MDAs for years even while ACFC was not showing a profit. Through MDAs purchasers had been buying exclusive rights to develop franchises in geographic territories and then sharing expenses and royalties with ACFC.

The average price for a MDA was $200,000 (eg: Northern Alberta $600,000). Why would purchasers have invested in these MDAs if they did not have a “ value ” ? Simple business logic and common sense suggest that the purchasers of MDAs anticipated a return on their investment. [ 119 ] It is also logical to assume that prudent, informed parties under no compulsion to act, would not adopt a valuation approach (ie: the liquidation approach) that would essentially eliminate any “ value ” .

One could also assume that a vendor will try to maximize value and that the buyer would not be purchasing the company if there was no value. [ 120 ] It is also illogical to assume the vendor and purchaser would ignore the history of the company, the development that had occurred, and the future plans, and assume that ACFC would be liquidated. Would a reasonable vendor use or accept a liquidation approach? The company had few hard assets.

Clearly any value arose from the fact that the business had been operating in a growth mode, was still operating at the time of the valuation, and had concrete plans to continue to grow. For parties to use a valuation approach that minimises or eliminates value makes no business sense in these circumstances. [ 121 ] While a liquidation approach may be technically or theoretically defensible, it is inappropriate and implausible to use it in the circumstances of this case. The idea of liquidating or closing the company was not even being considered.

As described previously, the evidence is that ACFC grew the number of franchises, gross revenues, and gross profit margins right up to the valuation date of November 30 th , 2010. [ 122 ] While not relying on it for my decision the evidence also indicates that ACFC has, since the valuation date, continued to expand and has ambitious plans (some underway) for the future, including plans to open stores in Lebanon, India, the United States which reinforces the absurdity of using the liquidation approach. [ 123 ] In

summary to use a “ liquidation approach ” is contrary to both the evidence and to common sense. A “ going concern ” approach is the appropriate valuation method.

2. What is the total value of ACFC if it were to have been sold as of November 30, 2010? [ 124 ] Mr. Mynett concluded that the en bloc fair market value of the issues and outstanding shares of ACFC was $NIL. He acknowledged that there may be perceived value based on the future cash flows that may be generated by ACFC but concluded given a number of factors, including the uncertainty of those future cash flows and the historical negative cash flow that any perceived value would be speculative in nature and not a type of value which is contemplated in the definition of fair market value. [ 125 ] Mr.

Mynett did not prepare a valuation based on a going concern approach. [ 126 ] What is the value of this company using the going concern approach? [ 127 ] I accept Mr. Sharpe ’ s conclusion on valuation. His evidence was detailed and very credible. He conducted a thorough investigation into the financial history and business operations of the company, which included a review of all types of documentation and numerous personal interviews. [ 128 ] In his evidence Mr. Sharpe displayed an intimate knowledge and understanding of the financial history and operations of the business.

His analysis and use of the financial data to prepare the growth projections followed accepted accounting practices and methodology. His analysis and his conclusions were not undermined on cross examination. [ 129 ] The three scenarios of growth used by Mr. Sharpe are supported by the evidence. They take into account a reasonable range of likely outcomes; ie: no growth (pessimistic), low growth and high growth (optimistic). Giving equal weight to each scenario provides a reasonable estimate as to probability. [ 130 ] Mr. Mynett was critical of the of use of three weighted scenarios.

I find this criticism to be without merit. The approach taken by Mr.Sharpe is recognized as appropriate in a leading textbook on valuation, The Valuation of Business Interests , by R. Campbell and Howard E. Johmson (Canadian Institute of Chartered Accountants, 2001) at p. 183: It is often useful to conduct sensitivity analysis on the forecast. Frequently several scenarios may be prepared reflecting pessimistic, most likely, and optimistic assumptions with respect to key economic drivers.

These sensitivity tests not only may assist in meaningful forecast development, but also may contribute significantly to risk assessment, and hence to the determination of appropriate discount rates. [ 131 ] Mr. Sharpe ’ s valuation analysis concludes with a range of values (after discounting) from $2.1 to $2.7 million dollars. The mid point value is $2.4 million. [ 132 ] Based on the information available on the valuation date, this mid point value of $2.4 million is a credible and acceptable valuation.

It represents a reasonable trade-off between the growth factors and other positives that a reasonable seller would likely emphasize and the risk factors and discounting that a reasonable purchaser would raise during any hypothetical negotiation. [ 133 ] It is also noteworthy that this mid point valuation involves an assumption that ACFC ’ s growth would be less successful in the four years following November 30, 2010 than it was in its first four years of operation. In my opinion the evidence would suggest more success, not less success.

Conclusion [ 134 ] I find the total value of ACFC if it were to have been sold as of November 30, 2010 to be $2.4 million.

[ 135 ] Based on this valuation the Plaintiff shall have a judgment against the Defendants in a sum equal to $624,000 (26%) in accordance with the settlement agreement between the parties. [ 136 ] If the parties are unable to agree on costs they may speak to them with 60 days. Heard on the 15 th ,16 th and 24th days of February, 2012. Written argument concluded on the 20 th day of March, 2012. Dated at the City of Edmonton, Alberta this 18 th day of May, 2012. J.J. Gill J.C.Q.B.A. Appearances: Geoffrey M. Hope Field LLP for the Plaintiff Glenn Laughlin Laughlin & Company #710, 2755 Lougheed Highway Port Coquitlam, BC V3B 5Y9 for the Defendants