Peter Mahler wrote about the latest New York statutory fair value case in a recent post titled, “Threading the Fair-Value Needle: Court Finds Major Flaws in Arriving at Its Own Value.” The court in La Verghetta v Lawlor, et al took both appraisers to task and reached its own opinion, with the help of one of the experts. This case raises at least five valuation issues to discuss in this post:
- Reasonableness of valuation conclusions
- Reasonableness of normalization adjustments
- Reasonableness of projections
- Whether the earnings of tax pass-through entities should be tax-effected
- Appropriateness of a marketability discount
I have structured this post, the 8th in my Statutory Fair Value and Business Valuation Series, to focus on the valuation issues and not the drama that apparently played out in court on several fronts. You can read the 33-page, single-spaced decision report for that. Some of the drama will nevertheless bleed through.
Brief Background of the Case
Two brothers and a third owner got together at some point to own and operate Planet Fitness brand health clubs. By 2012, when JGJ Holding LLC (“JGJ”) was formed, the operation received 29 existing Planet Fitness franchises and the right to develop further franchises under an Area Development Agreement (“ADA”) with Planet Fitness. JGJ is a limited liability company (“LLC”).
Under the ADA, JGJ had the exclusive right to develop Planet Fitness franchises in New York City, two nearby counties, and portions of Long Island. Under the ADA, JGJ committed to develop 11 new clubs by December 2014, and at least six new clubs per year through 2018.
In addition, another LLC, JGJg Holding Company, LLC (“JGJg”) was formed in December 2013. A subsidiary of JGJg entered into an ADA in March 2014 to develop and operate Planet Fitness health centers in portions of Orange, San Bernardino, and Los Angeles, California (“CA ADA”).
This matter was commenced on June 12, 2014, or shortly after the CA ADA was signed. The plaintiff was Luigi La Verghetta (“La Verghetta”) and the defendants were Jeffry and James Innocenti (“the Innocenti’s”). They each owned one-third of JGJ’s member interests and one-third each of 95% of the member interests of JGJg, with the other 5% being granted to a senior employee.
Following litigation over several months, a statutory fair value proceeding was commenced, with each party to retain an appraiser to provide opinions of the fair value of La Verghetta’s interests in JGJ and JGJg. The valuation date was set at June 11, 2014, at which time, JGJ operated 35 Planet Fitness clubs in New York, Rockland, and Westchester. No stores had yet been opened by JGJg in California.
We know little about the financials of JGJ. The Court had access to a calculation of JGJ’s trailing twelve month GAAP EBITDA as of June 2014 of $11,295,936. There was debt (primarily with General Electric Capital Corporation) of $28,744,432. The rate on the financing was the 6-month LIBOR plus 5%, or around 5.6%, so annualized interest expense was on the order of $1.6 million.
With this background, we can focus on the valuation issues.
The plaintiff (La Verghetta) retained the services of a tax lawyer who held both a J.D, and an L.L.M in taxation. As the Court noted, “He does not have either formal training from, or certification by, any professional valuation organization or society.” The Court did not think much of this expert’s opinion:
While [Expert 1] purported to engage in a discounted cash flow analysis, he did not actually do so. Rather than project free cash flow, [Expert 1] developed projections of “net income”, which included depreciation, which is a non-cash expense. His analysis did not take into account capital expenditures and working capital.
Hence, the Court finds his entire approach to be flawed. While the Court was willing to allow [Expert 1] to testify as to his work and conclusions, the Court finds that his expertise in the area of valuations to be lacking and his analytical approach seriously flawed. But even assuming the validity of the approach, [Expert 1’s] execution of it is fraught with misjudgments and errors.
Expert 1 placed values on both JGJ and JGJg. The Court found that JGJg, which had only been recently formed and had no operations, had no value. Expert 1’s conclusions of fair value are summarized in the following table:
In a vacuum, these results don’t mean much. However, Expert 1 valued JGJg, which had no operations and only the CA ADA (for which $180 thousand was paid, which came from JGJ), at $23.3 million. As noted, the Court valued JGJg at zero. We will have to wait for further perspective on the $167.9 market value of total capital conclusion of Expert 1, but the Court has already supplied some color.
The defentants (the Innocentis) retained the services of a nationally known business appraiser holding numerous professional credentials [Expert 2]. Although finding considerable fault with Expert 2, the Court was also complimentary:
Overall, the Court finds [Expert 2] to have a great deal more professional expertise and experience in valuation than [Expert 1].
We can compare the conclusions of Expert 2 and Expert 1 in the following table.
It is clear that there are substantial differences in the opinions provided to the Court by Expert 1 and Expert 2. Expert 2 applied a 35% marketability discount to his initial conclusion and found the fair value of the interest to be $2.2 million. Expert 1 applied no discounts and found the combined interests (JGJ and JGJg) to have a fair value of $54.1 million.
Recall that we know what GAAP EBITDA was for the last twelve months ending June 2012, so we can calculate the EBITDA multiples implied by the conclusions of the experts. Expert 1’s conclusion implies an EBITDA multiple of 16.9x. The Court found that conclusion to be unreasonably high and dismissed it.
Expert 2’s conclusion represents an EBITDA multiple, before DLOM, of 3.4x. The Court found that conclusion to be unreasonably low. The Court did not calculate EBITDA multiples, but I have placed them here for perspective.
So we have already dealt with the first valuation issue outlined above, that of reasonableness of conclusions. The Court found one conclusion to be unreasonably low and the other to be unreasonably high.
Observation 1. It is a good idea to provide a test of the reasonableness of valuation conclusions in expert reports.
The Other Valuation Issues
The four remaining issues relate to normalizing adjustments, projections, tax-effecting and the marketability discount. I should note that since the Court dismissed the conclusion of Expert 1 for the plaintiffs (the buyers), the focus on these issues pertained to the report and testimony of Expert 2.
The second valuation issue relates to normalizing adjustments as applied by Expert 2. The Court noted that he eliminated certain non-recurring expenses associated with legal fees and data processing without comment. He then normalized for officers’ compensation, because he found them to be “unreasonably low.” Finally, he made a normalizing adjustment related to rent expense.
The Court took issue with the adjustment for officers’ compensation, which were apparently about doubled by Expert 2. It does not appear that the Court was objecting to the fact of making normalizing adjustments. However, the Court was not convinced of the magnitude of what it described as unsupported adjustments. And the Court did not fail to notice that this large compensation adjustment served to lower value for Expert 2’s (buying) clients.
Observation 2. Normalizing adjustments in valuations are fairly usual. On can normalize for unusual or non-recurring items of income or expense. One can normalize owner compensation and other benefits to market levels. However, it is important to support the reasonableness of these adjustments in and of themselves and in terms of what they do to overall adjusted/normalized earnings.
The Forecast for the DCF Method
Expert 2 constructed a forecasting model based on all but 8 of the 35 existing stores. The Court noted that he gave reasons for omitting these stores, but it seems that the Court was wondering why it was appropriate to leave 8 stores, or more than 20% of the stores out of the forecast.
The Court was troubled by aspects of Expert 2’s forecast where revenues were projected to decline 10% in 2015 and a further 9% in 2016 and then 1% per year thereafter for the five year forecast period. Then, the forecast called for revenue growth of 2.5% per year thereafter. As the Court described:
It appears he developed a roller-coaster model with a major drop, followed by lesser drops and then a slight hill.
The clincher was that expenses were forecasted to increase, but the membership rate of $10 per month was never assumed to increase (it was controlled by Planet Fitness). There was an apparent margin squeeze in the forecast that the Court found troubling, perhaps in light of history, but the decision does not say.
The Court in AriZona Iced Tea matter, when faced with a projection that called for ever-increasing costs with no accompanying price increases did not find it credible. And the Court in this matter did not find the projection of Expert 2 credible either.
Observation 3. Forecasts should be shown to be reasonable from as many perspectives as possible. Reasonableness can be tested in comparison with a company’s history of operations, peer groups (in terms of margins, growth, working capital needs, etc.), industry performance and expectations, and more. The Court did not find either of the experts’ projections to be reasonable.
The Issue of Tax-Effecting
Expert 2 used an 18.5% tax rate against projected earnings, which further dampened the forecast. JGJ is a tax pass-through entity for tax purposes, so ordinarily we might have used a blended corporate rate to tax-effect earnings. The issue wasn’t so much the tax-effecting, but the apparently low projected earnings.
The discussion of the tax-effecting issue in the decision reflected some confusion regarding when or if tax-effecting is appropriate. The Court cited cases suggesting both for and against on the issue. We normally would tax-effect the earnings of a tax pass-through entity at blended effective corporate rates. The Court noted:
…[T]he Court does not accept the tax-impacting that [Expert 2] imposed in calculating JGJ’s future earnings. There is no New York appellate authority for such tax impacting. The only New York case on the subject cited by the parties is Ferolito v. AriZona Beverages. But in that case both experts agreed that, in the extent of the valuation of that business, tax-impacting was appropriate. All that the trial court was required to decide was the applicable tax rate.
I testified in the AriZona case, so I am familiar with the experts’ and that Court’s treatment of tax-effecting.
In this matter, there was apparently some confusing testimony regarding the issue of tax-effecting. In any event, the Court asked Expert 2 to run his DCF model without tax-effecting and to report the resulting impact on the value of JGJ. In the Court’s mind, this model run at not tax-effecting offset some of the downward pressure in Expert 2’s conclusion by the problems noted above in the DCF forecast. We will report that result below.
Observation 4. Business appraisers should be familiar with the issue of tax-effecting income of pass-through entities in valuation. When tax-effecting, it is appropriate to indicate why and also how the effective tax rate used was developed.
The Marketability Discount
As we saw above, Expert 2 applied a 35% marketability discount to his initial indication of value to reach his conclusion. Expert 2 apparently included consideration of a potential tax liability for sellers of JGJ related to a deferred tax issue resulting from a mismatching of accounting and cash rent expense. If that deferral is a liability of the company (that flows through to its members), it would seem that a preferable treatment would have been to quantify the amount as a liability in the valuation. In any event, the Court did not view the tax issue as reflecting an impediment on marketability.
Expert 2 also noted that restrictions on transfer from an assumed two year holding period (under SEC Rule 144) were part of his 35% marketability discount. However, fair value is a cash concept and assumes that a transaction in the interest occurred on the valuation date. The Court noted:
While [Expert 2] refers in his report to Securities Rule 144 (17 CFR 230:144) which impose[d] a two year holding period on the sale of unregistered securities, there is no indication that the interests in JGJ are subject to any holding period would not be met. [Expert 2] only “assumed” that there was such a holding period.
And a bit further in the opinion:
The Court declines to impose 35% discount for lack of marketability on the ground that the Court does not accept two of the three reasons given by [Expert 2] for such a discount have any factual validity: the deferred tax issue and the assumed holding period. While the Court would have given consideration to an entity-level discount for lack of marketability based upon the transfer restrictions imposed by the Franchisor, [Expert 2] does not provide a basis for calculating the appropriate amount of discount. Stated differently, [Expert 2] does not set forth how much discounting would be appropriate solely by the reason of the transfer restrictions. Indeed, he testified that he did not even attempt to quantify such a discount. Since Defendants seek to impose such a discount, their failure to establish what the appropriate level of discount would be results in the discounting of the discount. [Expert 2] only “assumed” that there was such a holding period. [emphasis added]
Expert 2’s discounting was not entity-level discounting, but discounting that might have been applicable to the one-third interest in JGJ that was being valued.
And finally, the Court found that the Innocenti brothers had emphasized that they never intended to sell JGJ and then referred to the recent Zelouf case:
…The Construct is that La Verghetta will receive his fair value and the Innocentis can move on with JGJ free of him. The Innocentis made clear in their testimony that they did not intend to sell JGJ and that no amount of money would tempt then to do so. Thus, while they correctly contend that [Expert 1’s] valuation for JGJ and JGJg is widely inflated, they refuse to sell at [Expert 1’s] value.
Consequently, the imposition of a lack of marketability discount would be inappropriate in this context. As the Court observed in a similar context in Zelouf, since the Innocentis are not likely to sell JGJ, La Verghetta should not recover less due to possible illiquidity costs in the event of a sale that is not likely to occur…Hence, applying a discount for lack of marketability would be the economic equivalent of imposing an impermissible minority discount — that is, La Verghetta will [realize] less for his interest while the Innocentis get to realize their full value by staying in control.
The Court concluded that the appropriate marketability discount was effectively zero percent (0%) and declined to apply such a discount.
Observation 5. The issue of whether (or not) to apply a marketability discount in a statutory fair value determination in New York is not yet settled. There are, however, a growing number of cases in which New York justices have declined to apply marketability discounts. And courts are noting that there is no requirement that a marketability discount be applied. The Court in this matter recognized that any such discount should relate to the entity and not to the interest. If this recognition becomes more pervasive, there could be a growing consensus that marketability discounts in New York fair value determinations should be zero or fairly small.
The Court’s Conclusion
The Court in La Verghetta did not pick the conclusion of either Expert 1 or of Expert 2. Expert 1’s valuation was totally discounted and numerous issues were noted regarding Expert 2’s valuation. Nor did the Court split the baby, although its conclusion was between the two opinions.
Had [Expert 2] not so significantly underreported the future earnings of JGJ, perhaps tax impacting would have been appropriate. But since the Court has no present means of correcting for the undercounting of future revenue than to eliminate the tax impacting, the Court believes that fairness requires that it do so rather than apply a formalistic adjustment for taxes.
To value JGJ, the Court will take [Expert 2’s] non-tax impacted value of JGJ and add to it consideration of $180,000 paid by JGJ for the California opportunity and the $180,000 paid to the Franchisor and the $28,282 cash on hand provided to JGJg.
Thus, the Court arrives at a fair value of JGJ of $26,400,000. La Verghetta’s share thereof is 1/3 or $8,800,000….
We compare the valuations of Expert 1 and Expert 2 with the conclusion of the Court below:
We calculated the implied multiples of EBITDA for the respective conclusions. The Court’s “valuation” based on Expert 2’s report as adjusted (and no marketability discount) implies an EBITDA multiple of 4.9x for JGJ. At least that conclusion is within the rule of thumb range of 4x to 6x times EBITDA, plus or minus, that is often noted by market participants.
Almost certainly, the conclusion would have been higher had Expert 2’s projections been reasonable to the Court. However, the Court believed that valuing JGJ in this manner came closest to an equitable result.
The Court also valued JGJg effectively at zero. And the Court concluded terms for any buyout of La Verghetta’s 1/3 interest in JGJ and interest on the note determined appropriate by the Court. Interest was at the statutory rate of 9% in New York, which should encourage a rapid payoff of the note.
There is a chink in the armor of automatically applying big marketability discounts in statutory fair value determinations in New York. But the armor is still there. On the recent side of zero or very small marketability discounts, we have La Verghetta, Zelouf, Chiu, and even Giamo (which started at zero at trial and ended at 16% on appeal).
On the other hand, the Court in AriZona, where the subject, AriZona Beverages (or Iced Tea), was a highly attractive business that was actively sought out for purchase by a number of strategic buyers, the Court concluded that the appropriate DLOM was 25%, which reduced the concluded fair value by $478 million.
Where is New York headed on the issue of the marketability discount in statutory fair value determinations? I don’t know, but we will see. I’m guessing that over time, there will be a gravitational pull towards nil or small marketability discounts. Logic doesn’t work for large discounts. And the trend in other jurisdictions is clearly toward no marketability discounts at all.
At the very least, given this case and Chiu, where proffered 35% marketability discounts were dismissed and replaced with no (or zero) discounts, appraisers will need to make better arguments than applying dated restricted stock studies based on minority trading in public companies to whole companies to justify such discounts.
As with the case of AriZona just mentioned, and even with the much smaller JGJ in the present matter, the DLOM is a big money issue in New York fair value determinations. It needs to be resolved so that appraisers, attorneys and clients can have a clear understanding of New York judicial guidance on the issue.
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