MEMBER ENTITLED TO FAIR VALUE OF INTEREST UPON FORCED WITHDRAWAL

By Scott E. Waxman and Annamarie C. Larson

In Domain Associates, L.L.C. et al. v. Nimesh S. Shah (C.A. No. 12921-VCL), Vice Chancellor Lastor held that, in the absence of clear language in the limited liability company agreement, a withdrawn member of a venture capital fund’s management company is entitled to the fair value of his or her member interest, not simply the amount of the member’s capital account.

Domain is a venture capital firm founded in 1985 and focused on the biopharmaceutical, diagnostic, and medical device sectors. Like most venture capital funds, Domain organizes a new general partner entity to receive carried interest from each fund it raises, and it uses one management company (the “Company”) to act as the investment manager of all of its funds and to receive the management fee.  The Company is a Delaware limited liability company.

Defendant Nimesh Shah joined Domain in 2006 as an employee specializing in medical devices. Effective January 1, 2015, Shah became a member of the Company by signing the Company’s limited liability company agreement (the “LLC Agreement”).  Domain’s financial situation began to decline, and the members discussed exiting the medical device space.  In January 2016, two of the members told Shah that the other members had decided that Shah should leave.  On several occasions, the members tried to have face-to-face discussions with Shah regarding his severance package, and a member sent a few drafts to Shah for his approval.

The Company held a member meeting in April 2016. All of the members except for Shah voted to require Shah to withdraw from the Company.  At that time, Shah owned a 12.1% membership interest in the Company, as well as interest in the Company’s ownership of securities and a share of the guaranteed distributions the Company made to its members.

The other members argued that Shah was only entitled to his capital account balance ($438,353). Shah argued that he was entitled to 12.1% of the Company’s cash on hand ($1,533,667).  Shah initiated mediation, and the Company and the other members initiated this lawsuit to determine how much Shah was entitled to receive.

Using a breach of contract analysis, the Court of Chancery found that the LLC Agreement was a binding contract, and that Domain breached the LLC Agreement when it failed to pay Shah the fair value of his membership interest. The LLC Agreement provides five means by which a member’s status can be terminated: retirement, death, insanity, bankruptcy, and forced withdrawal.  A member can be forced to withdraw at any time upon written demand signed by all of the other members and approved at a meeting of the members.  However, the LLC Agreement does not provide a payment method for a member forced to withdraw.  Because the members could have drafted the LLC Agreement to include a payment method upon forced withdrawal (but did not), the court found the LLC Agreement unambiguous and concluded that the members chose the default provisions of Delaware law.

Unfortunately, the Delaware Limited Liability Company Act only addresses the payment method for a resigning member (i.e., fair value of the member’s interest). Therefore, Vice Chancellor Lastor relied on the law regarding expulsion of partners under the Delaware Revised Uniform Partnership Act, which requires payment equal to the fair value of such partner’s economic interest as of the date of dissociation.

As damages, the court found that Shah was entitled to the fair value of his member interest. To calculate the fair value, the court reviewed both parties’ discounted cash flow (“DCF”) models and made several changes.  The court agreed with using Domain’s management projections, but made adjustments for directors’ fees, future GP distributions, and gains on Company securities.  The court also agreed with using a perpetuity growth rate of 3% and adjusting the weighted average cost of capital by a 3% company-specific risk premium.  Finally, the court found that the Company’s “massive cash balance” had been earmarked for the member’s compensation and should be added to the Company’s value (less three months of operating expenses).

The court also held the individual plaintiffs jointly and severally liable. Through their votes as members, they expelled Shah and gave rise to the obligation to pay him the fair value of his interest.  The court dismissed the plaintiffs’ argument that, pursuant to the LLC Agreement, the members did not agree to be obligated personally for the obligations of the Company, because the liability at issue here is not to a third party but to another member.

Domain Associates, L.L.C., et al. v. Nimesh S. Shah CA No. 12921-VCL (Del Ch. August 13, 2018)