The first and last time I wrote about the AriZona Iced Tea dissolution case — likely the biggest ever of its kind in New York — was four years ago, when 50% owner and co-founder John Ferolito filed his petition under Section 1104-a of the Business Corporation Law for judicial dissolution of the collection of companies that produce beverages and food products under the popular AriZona Iced Tea brand.
Since then, there’s been a multitude of trial and appellate decisions in that and several related lawsuits between Ferolito and the other co-founder and 50% shareholder, Domenick Vultaggio, all of which eventually were consolidated for trial starting last May before Nassau County Commercial Division Justice Timothy S. Driscoll, to whom the task fell of determining the fair value of the Ferolito shares pursuant to AriZona’s BCL Section 1118 buyout.
As you might expect, this was no ordinary valuation trial. Ferolito valued AriZona at $3.2 billion versus Vultaggio’s $426 million. For over a month, Justice Driscoll heard the testimony of 34 lay and expert witnesses, many of whom supplemented their in-court testimony with affidavits totaling about 1,000 pages, in addition to tens of thousands of pages of exhibits introduced into evidence. The parties filed post-trial memoranda last August, followed by oral summations in September, followed by more post-trial memoranda.
The wait is over. In a 42-page decision dated October 14, 2014 (2014 NY Slip Op 32830(U)), relying solely on the Discounted Cash Flow method, Justice Driscoll valued the entire enterprise somewhere around $1.4 to $1.5 billion after applying a 25% marketability discount. The number’s fuzziness reflects post-decision adjustments that will have to be calculated based on certain findings made by Justice Driscoll that departed from some of the assumptions made by the parties’ experts. According to Justice Driscoll’s self-described “back-of-the-envelope” calculations, the value of Ferolito’s 50% stock interest currently “approaches” $1 billion when pre-judgment interest is added at the rate of 9%. Justice Driscoll also left to future proceedings the critical question of AriZona’s ability to pay the fair value award, and its impact on the terms and conditions of any payout.
The decision’s findings of fact and conclusions of law offer a heightened level of detailed analysis concerning a cornucopia of valuation issues that not only reflects the high stakes of this blockbuster case, but also is rarely seen (with some notable exceptions) in fair value decisions issued by New York courts. The scale and profitability of AriZona’s category-leading business — on a par with, if not larger than, many public companies — also teed up issues rarely if ever seen in New York fair value contests, such as consideration of synergistic value and multi-billion dollar expressions of interest from international beverage conglomerates.
The following, numbered paragraphs, in which I’ll briefly summarize the salient issues addressed in the decision, more or less conform to the order in which they’re laid out in the decision.
- AriZona’s Adjusted EBITDA (pp. 4-7). Justice Driscoll credited the testimony of one of Ferolito’s experts in determining the proper measure of AriZona’s EBITDA (earnings before interest, taxes, depreciation and amortization), including normalizing adjustments to the company’s financial statements for management fees, officer compensation, and non-recurring expenditures. With these and other normalizing adjustments, the expert concluded that AriZona’s EBITDA for the 12 months ending 9/30/10 was approximately $173 million. On the other hand, Justice Driscoll did not credit the EBITDA conclusions derived from AriZona’s post-litigation financial statements, which he found were not “relied upon by the company in its normal course of business.”
- Expressions of Interest in Acquiring AriZona (pp. 7-11). Justice Driscoll found that since at least 2005, AriZona’s success attracted expressions of interest from other companies, including global conglomerates Tata and Nestle, interested in acquiring all or part of AriZona, with preliminary estimates as high as $4.5 billion. The court further found, however, that none of the interested companies performed due diligence or sought board approval, much less made a binding offer. Justice Driscoll also discounted Ferolito’s $2 billion offer during trial to acquire Vultaggio’s shares, finding “insufficient evidence . . . to conclude that this offer was any more than bluster or had appropriate financial backing.”
- Non-Operational Challenges Faced by AriZona (pp. 12-13). Justice Driscoll further based his reluctance to credit potential third-party acquirers’ expressions of interest on several “non-operational challenges” faced by AriZona, including the effect of the company’s S-Corporation status, the lengthy history of litigation between the two owners, and the company’s lack of audited financial statements. “[A]ll of these issues,” he wrote, “help explain why the preliminary expressions of interest discussed above never resulted in a consummated deal.”
- Synergistic Value (p. 15). A strategic buyer is one who’s willing to pay a premium to acquire a company that will integrate product lines, achieve cost savings, and create other synergies with their existing business. After summarizing general valuation principles, Justice Driscoll concluded that “[t]hese principles make clear that the Court may not consider AriZona’s ‘strategic’ or ‘synergistc’ value to a hypothetical third-party purchaser, as Ferolito urges.” Describing hypothetical synergies as “too speculative to quantify with any certainty,” Justice Driscoll declared that, “[i]nstead, the Court will value AriZona using the ‘financial control’ measurement” absent any expectation of synergistic value.
- Valuation Date (pp. 15-16). BCL Section 1118 specifies a valuation date as of the day before the filing of the dissolution petition which, in regard to the voting shares held by Ferolito, the parties agreed was October 5, 2010. The parties differed, however, as to the valuation date for the non-voting shares held by a Ferolito family trust, which had commenced on February 1, 2011, a separate lawsuit for common-law dissolution for which there is no statutorily-mandated valuation date. Ferolito argued for a January 31, 2011, valuation date for the trust’s shares. Vultaggio sought a December 31, 2012, valuation date. Justice Driscoll sided with Ferolito on this issue, reasoning that “adopting any date . . . later than January 31, 2011 would, in effect, impermissibly permit Vultaggio to use the Trust’s own dissolution action to dilute the value of the Trust’s shares.”
- DCF Analysis (pp. 16-32). In this, the heart of Justice Driscoll’s valuation decision, he agreed with Vultaggio that the Discounted Cash Flow (DCF) method “should be the full measure of AriZona’s value,” and he rejected Ferolito’s position that DCF should be weighted 80% as against 20% for “comparable” transactions. Essentially, Justice Driscoll concluded that “AriZona is truly an ‘incomparable’ company” and that Ferolito’s proposed “comps” were distinguishable in size, timing, products and were also synergistic market transactions. The court then proceeded to address a number of variables affecting the DCF analysis, including anticipated revenues and costs; AriZona’s terminal value; existence of a tax amortization benefit for a potential buyer; anticipated tax rate on AriZona’s income; and discount rate. Among the highlights of the court’s findings in this section are: a compounded annual growth rate (CAGR) of 10.2%; terminal growth rate of 4.5%; rejection of Ferolito’s position advocating inclusion of a tax amortization benefit; adoption of a 43.5% tax rate as advocated by Vultaggio, versus Ferolito’s 38% rate; and a 10.8% discount rate.
- “Key Man” Discount (pp. 30-31). Justice Driscoll found that a “key man” discount to AriZona’s anticipated cash flow used for the DCF analysis was “appropriate” to reflect “the presence, charisma, work ethic, leadership and talent” of its co-founder and sole managing partner, Vultaggio, whose “efforts at the company are legion” and who “is immersed in all aspects of the company’s business, including product development, packaging, marketing, and celebrity endorsements.” One of Vultaggio’s experts, Shannon Pratt, testified that a “key person discount can be reflected in adjustment to a discount or capitalization rate in a DCF.” Ferolito’s expert, Chris Mercer, “quantified Vultaggio’s role in the company” and incorporated that calculation into his discount rate, which the court accepted.
- Marketability Discount (pp. 33-36). The discount for lack of marketability “reflects that shares in privately held companies may be less marketable because those shares cannot be readily liquidated for cash.” So begins Justice Driscoll’s analysis of so-called DLOM, an issue that continues to play an out-sized role in fair-value contests as illustrated most recently in the Zelouf case featured in my last two posts. In the AriZona case, Ferolito argued for zero DLOM because the company was successful and had attracted interest from potential acquirers. Vultaggio asked for a 35% DLOM. Justice Driscoll agreed that DLOM was appropriate for a number of reasons, including the company’s lack of audited financial statements, but lowered it to 25%, in part based on Pratt’s testimony that “smaller discounts are often appropriate for large and growing companies” which, Justice Driscoll added, “certainly describes AriZona.” He also referred to 25% as “the DLOM typically applied” by courts, citing to commentary by yours truly in a blog post I wrote on the subject some years ago. He also distinguished Justice Kornreich’s rejection of DLOM in Zelouf on the ground that, unlike in Zelouf, the liquidity risk associated with AriZona was “real” as evidenced by Ferolito’s inability to sell his shares prior to the dissolution proceeding.
- Effect of Ferolito’s “Bad Acts” (pp. 36-38). Vultaggio alleged by way of counterclaim that Ferolito engaged in certain “bad acts” that reduced any payout to him, including interfering with company operations, delaying prosecution of the case, and “steering money” from the Ferolito family trust to himself. Justice Driscoll disagreed, finding that the complained-of actions were “due to Ferolito’s frustration with his inability to sell his shares in the company,” and that in any event, the alleged bad acts did not cause damage to Vultaggio or to the company.
- Pre-Judgment Interest (pp. 38-40). BCL Section 1118 (b) provides that, “[i]n determining the fair value of the petitioner’s shares, the court, in its discretion, may award interest from the date the petition is filed to the date of payment for the petitioner’s share at an equitable rate upon judicially determined fair value of his shares.” After noting that the Appellate Division, Second Department, in its 1985 Blake decision declared that “justice requires” payment of interest in Section 1118 buyouts, Justice Driscoll awarded interest at the statutory rate of 9% which he found “appropriate and equitable” based on case precedent, the absence of bad faith on Ferolito’s part, and on the evidence that “AriZona pays Vultaggio 10 percent interest on the loans that he makes to the company.” Assuming a fair value award of around $725 million for Ferolito’s shares, 9% simple interest computes to about $65 million per year.
- Risk of Insolvency from Award (p. 41). Justice Driscoll declined AriZona’s invitation to factor into his valuation the risk of insolvency from an award in excess of that proposed by the company. Any such adjustment, Justice Driscoll wrote, “could provide Vultaggio with a windfall he could easily exploit if he decided to sell the shares he acquires from the Ferolito parties.” Instead, the risks posed by the award to AriZona’s financial health may be considered in the court’s future determination of the terms and conditions of the payout.