Zan’s Kosher Deli has been serving up pastrami, corned beef and other traditional kosher deli fare at its Lake Grove, New York restaurant for over 20 years. The death last year of one of Zan’s two 50/50 owners — the brothers Anthony and Pasquale Ruggiero — sparked a most unkosher family squabble that landed in court in the form of a lawsuit by the deceased Anthony’s widow against Pasquale accusing him of cutting her and her family out of the business, which in turn prompted counterclaims by Pasquale accusing his late brother of systematic looting from the business.

The judge assigned to the case, Suffolk County Commercial Division Justice Emily Pines, after restoring health insurance benefits and salary for Anthony’s widow, persuaded the two sides to obtain expert appraisals and thereafter to conduct a hearing to determine the fair value of the shares of the business corporation that operates Zan’s, formally known as 784 8th Street Corp. Under the court-brokered arrangement, Justice Pines also was empowered to determine which side would buy out the other and, at a later stage of the case, to determine whether either party was entitled to any credits for amounts owed them other than their 50% share of the business value.

Following the exchange of valuation reports, and after conducting a hearing last month featuring testimony by the two expert appraisers, Justice Pines issued a 10-page decision valuing the business entity at slightly under $300,000 and directing that Pasquale purchase his late brother’s interest for half that amount. The court’s ruling in Ruggiero v. Ruggiero, 2013 NY Slip Op 31955(U) (Sup Ct Suffolk County July 29, 2013), includes detailed discussion of the conflicting valuation approaches used by the opposing experts, and for that reason alone is well worth the read.

Conflicting Approaches

The most striking difference between the opposing experts was their respective reliance on market and income approaches.

The report and testimony by the estate’s expert evaluator, Ronald Klein, used a market approach although he was unable to identify any businesses similar to Zan’s. Instead, he used what he termed a price-to-revenue method in which, based on normalized revenues and operating profits for years of operation and years left on the lease, he computed annual gross revenue of almost $2.7 million to which he applied a 0.4 multiple and then deducted a working capital deficit of about $360,000 to arrive at a fair value of the corporation’s equity of $709,000 as of Anthony’s date of death in August 2012.

Mr. Klein testified that he derived his multiple based upon his experience in the business valuation field. Mr. Klein also testified that his valuation did not take into account the company’s existing debt and shareholder loans because he was directed not to include them in his calculations. He also opined that the company’s inadequate records of income, expense, and accounts payable and receivable precluded reliance on income and cost valuation methods.

Pasquale’s expert appraiser, Russell Glazer, rejected the market approach due to insufficient transactions whose pricing multiples were applicable to a valuation of Zan’s. Instead he utilized a discounted cash flow analysis under the income approach based on a reconstruction of the company’s cash flows in which he compared tax return data with cash payments to vendors, payroll, invoices, cash register receipts, sales tax records, and the so-called “day book” which apparently recorded daily cash transactions. Unlike Mr. Klein, Mr. Glazer included the corporate debt and shareholder loans in his calculation of value.

The court’s decision does not set forth the details of Mr. Glazer’s cash flow analysis or discount rate. He ultimately determined a present value of the company’s equity as of Anthony’s date of death of $273,000, to which he applied a 20% discount for lack of marketability to conclude a fair value of about $240,000 after tax affecting for Subchapter S status.

The Court’s Determination of Value

Justice Pines agreed with the income approach used by Pasquale’s expert, Mr. Glazer, and largely agreed with his calculation of value, finding credible his testimony that he was able to review the “true revenues and expenses of the business for the period in question” based on his examination of the day book and other business records. She faulted Mr. Klein’s use of a 0.4 multiple in his price-to-revenue formula as lacking a sufficient explanation, and she also was critical of his failure to include corporate loans and debt in his valuation which, Justice Pines noted, “he admitted affected corporate value.”

The only issue the court had with Mr. Glazer’s valuation was his 20% marketability discount for which, according to Justice Pines, “he did not provide sufficient explanation.” Justice Pines instead agreed with Mr. Klein’s opinion that Zan’s “constitute[s] a somewhat unique niche business” and, on that basis, she excluded from Mr. Glazer’s calculation the deduction of almost $55,000 for lack of marketability, thereby arriving at a conclusion of fair value for 100% of Zan’s equity of about $295,000.

Finally, Justice Pines decided that Pasquale was the proper party to remain as the operator of the business and to purchase the shares owned by his deceased brother’s estate for 50% of the appraised value, or approximately $147,000. Justice Pines also ordered the parties to complete discovery and submit reports within 90 days calculating the amounts each side believes are due and owing, including any debt to a shareholder, outstanding shareholders’ loans, and any other claimed credits.

There are certain food service businesses such as pizza parlors that are bought and sold in sufficient numbers, often using business brokers, and whose operations and financial metrics are sufficiently uniform, for which the use of a market-based multiple of gross revenues can reliably establish fair value. In Ruggiero, the estate’s appraiser failed to convince Justice Pines that a market approach was suitable, first, because he failed to support his multiple and, second, because he could not convince her that the company’s business records were inadequate to perform a rigorous income and expense analysis as was undertaken by Pasquale’s expert using forensic techniques. It also strikes me that the estate’s argument for using the market approach in Ruggiero might have been inconsistent with its expert’s contention, accepted by the court, that Zan’s “unique niche business” weighed against a marketability discount.

Update October 26, 2016:  The Appellate Division, Second Department, today handed down a decision (read here) for the most part affirming Justice Pine’s valuation ruling but also increasing the award by about $155,000 on account of certain loan and insurance proceeds.