One of my favorite quotes from the realm of business valuation is found in a Delaware Chancery Court decision about 20 years ago in which, commenting on the vast disparity between the appraisals offered by two opposing experts — that for the seller making wildly optimistic assumptions about the subject firm’s business prospects while that for the buyer predicting doom and gloom — the court quipped, “In sum, one report is submitted by Dr. Pangloss, and the other by Mr. Scrooge.”
Dr. Pangloss and Mr. Scrooge were at it again in a decision handed down last week by Westchester Commercial Division Justice Alan D. Scheinkman, determining the fair value of a minority interest in two limited liability companies that, as franchisees, own and operate almost three dozen Planet Fitness health clubs in the New York City metro area and also own exclusive rights to develop additional clubs in New York and parts of Southern California.
The case is Verghetta v Lawlor, 2016 NY Slip Op 30423(U) [Sup Ct Westchester County Mar. 9, 2016]. The opening paragraph of Justice Scheinkman’s 33-page post-trial decision aptly sets the stage for the fair-value drama that follows, starring dueling appraisals over two thousand percent apart:
This Court is called upon to determine the value of two corporate entities for purposes of permitting the buy-out of a minority shareholder. It is not surprising, and rather in the nature of things, that the parties have a significant disagreement as to the value of the enterprise. The would-be seller relies on a valuation report that places the value of both corporations at over $162 million and the seller’s share at over $53 million. The would-be buyers rely on a valuation report that values one entity at $6.2 million, the other at $208,000, for a total for the two of approximately $6.4 million, and with the buyer’s share of the total being approximately $2.2 million. The Court must resolve the difference.
The case pits plaintiff Luigi Verghetta against defendants-brothers Jeffrey and James Innocenti. The three were partners in the health club business from at least 1995, and became Planet Fitness franchisees around 2004. In 2012, as one-third members each, they formed JGJ Holding LLC (“JGJ”) to serve as the controlling entity and holding company for 29 existing Planet Fitness franchises and to develop new clubs in accordance with an Area Development Agreement (“ADA”) with the franchisor. Under the ADA, JGJ committed to developing 11 new clubs by the end of 2014 and at least six new clubs per year thereafter through 2028.
In December 2013, the three partners formed JGJg Holding Company, LLC (“JGJg”) which, in March 2014, entered into another ADA to develop and operate Planet Fitness clubs in certain Southern California counties. Ownership was again divided equally among the three except a 5% interest was given to their in-house counsel, Gabrielle Lawlor.
In June 2014, Verghetta filed suit against the Innocenti brothers and Lawlor seeking judicial dissolution and asserting claims for various business torts. In October 2014, the parties agreed to stay the action pending a determination by Justice Scheinkman of the fair value of Verghetta’s interests in JGJ and JGJg as of June 11, 2014, and the terms and conditions upon which the two entities would acquire the interests.
The testifying expert for Verghetta was Paul Schaeffer, a tax lawyer with no formal training from, or certification by, any professional valuation organization or society. Mr. Schaeffer’s experience in valuation began in the context of estate planning and he became involved in franchise valuations.
The testifying expert for the companies was Gary Trugman, a nationally prominent business appraiser with accreditations from the top appraisal organizations, whom Justice Scheinkman referred to as “a true valuation professional.”
Notwithstanding their different levels of appraisal expertise, Justice Scheinkman found both their valuations “fraught with issues.” As described below, Justice Scheinkman dismissed entirely Schaeffer’s $53 million valuation of Verghetta’s interest as “unreliable,” and ultimately he increased four-fold Trugman’s “flawed” valuation of Verghetta’s interest in the two companies, from $2.2 million to $8.8 million. As Justice Scheinkman explained, the choice was not either/or:
If this were simply a battle of the experts and the Court’s task was simply to decide which of the two experts were more convincing, there is no doubt that Trugman was more persuasive and credible, while Schaeffer was utterly unreliable. However, the Court perceives significant issues with Trugman’s analysis and, therefore, the Court cannot simply just accept Trugman’s report on the ground that it is the better of two evils.
Schaeffer’s “Unreliable” Valuation
Justice Scheinkman discounted completely Schaeffer’s valuation report and testimony which concluded a combined enterprise value of JGJ and JGJg over $160 million. Here are just some of the reasons given by Justice Scheinkman:
- Schaeffer valued JGJg at $23 million by assigning a net present value to non-existent California health clubs slated for later development under the ADA. Justice Scheinkman found that Schaeffer’s methodology “defies economic reality” by increasing JGJg’s value from $180,000 (the amount paid to the Planet Fitness franchisor for the development rights granted by the California ADA) in March 2014 to $23 million only three months later, particularly where the ADA prohibited JGJg from reselling its development rights at a profit.
- As to JGJ, instead of developing enterprise value Schaeffer valued each of the 32 existing health clubs and a computed a present value for future clubs, from each of which he allocated one-third as Verghetta’s share. “[A]s a matter of economic reality,” wrote the judge, “a hypothetical buyer would be looking for the value of an integrated enterprise to be acquired as a whole, not . . . a purchase of club-by-individual club.”
- Justice Scheinkman faulted Schaeffer’s discounted cash flow analysis, inter alia, for not taking into account capital expenditures and working capital.
- Schaeffer “engaged in a number of adjustments, which seriously inflated the value of the clubs” including artificially capping returns and allowances for club members who don’t pay their monthly fees, and ignoring certain royalty payment obligations.
- “Schaeffer baked in increases in net revenue to certain clubs and carried those increases forward into subsequent years, which increases are inconsistent with the historical trends in those clubs.”
- Schaeffer’s valuation of “future clubs” did not account for the costs to build and equip each new club or for the operating expenses incurred for new clubs prior to opening.
In sum, Justice Scheinkman wrote,
The Court finds that Schaeffer’s analysis is not worthy of being relied upon in evaluating JGJ. That Schaeffer’s analysis was presented not as a genuine effort to place a fair value on JGJ, but as an effort to extract as maximum a recovery as could be viewed as remotely plausible, is shown by the fact that Schaeffer found an “enterprise value” for JGJ of approximately $139 million, which excluded the $29 million in debt outstanding as of the Valuation Date. . . . In other words, Schaeffer presented the Court with an argument for valuing Verghetta’s interest as if JGJ had no debt. Such an approach is not professional. And this is without regard to $6.8 million in uncorrected math errors.
Trugman’s Valuation: Better But Still Flawed
As to JGJg, the court agreed with Trugman that it should be valued as an early stage development company using an asset-based approach. JGJg’s only assets were about $28,000 cash and the California ADA valued at $180,000.
Trugman relied exclusively on the income approach in arriving at an enterprise value for JGJ of about $9.6 million, to which he applied a 35% marketability discount before adding non-operating assets to reach a final equity value of $6.6 million, or $2.2 million for Verghetta’s one-third interest.
Justice Scheinkman’s opinion is significantly more accepting of Trugman’s analysis relative to Schaeffer’s, but it nonetheless takes a number of hits. Here are some of them:
- Justice Scheinkman disagreed with Trugman’s normalization of historic income statements by doubling officer compensation, for which Trugman presented no comparative data.
- Trugman’s $6.6 million enterprise value for JGJ was just over half of the company’s unused credit facility. Were the credit line to be fully untilized, Justice Scheinkman observed, “under Trugman’s value, the entire equity in the company would be depleted. It does not make economic sense that the value of the equity in the company would be so low in relation to the existing, and the additional, foreseeable, debt.”
- The court found a “major analytical flaw” in Trugman’s discounted cash flow analysis insofar as he used a contra-factual 2.5% terminal growth rate after five years of declines. “The Court perceives,” wrote Justice Scheinkman, “that Trugman added a level of revenue growth arbitrarily as he did not provide any rationale for why revenue would grow again after years of significant decline.” Trugman’s “roller-coaster model” instead was designed to avoid showing “every one of these clubs [going] out of business at some point in time.”
- Justice Scheinkman criticized Trugman’s assumption that the Planet Fitness franchisor, which sets member fees, would freeze fees indefinitely notwithstanding the certainty of franchisees facing increased expenses over time, which assumption would render “irrational” the Innocentis’ avowed refusal to sell their interests in JGJ and JGJg “at any price.”
- Trugman tax affected JGJ’s earnings by 18.5% to reflect its pass-through taxation as an S corporation, which Justice Scheinkman rejected as “speculative” and as “unduly focusing on the buyer’s side of the equation and effectively ignor[ing] the seller’s side.” Justice Scheinkman also credited Schaeffer’s testimony that the Innocentis could elect under IRC § 754 to step up the basis of JGJ’s assets and to deduct, over time, the cost of the buy-out.
- Justice Scheinkman also was critical of Trugman’s 35% discount for lack of marketability, which Trugman conceded was “towards the high end,” primarily on the ground that much of it was based on consideration of a potential tax liability to the sellers which, Justice Scheinkman, found, “does not inhibit them from selling” any more than “the prospect that the owners would face a capital gains tax on a profit they make on sale is an impediment to a sale.”
The Court’s Valuation Conclusion
Justice Scheinkman initially concluded that JGJg should be valued as a stand-alone entity and, as such, that it had no value. The court accepted Trugman’s asset-based approach but, instead of treating the $180,000 paid by JGJ for the California ADA and the cash on hand as a capital contribution, treated it as a loan payable to JGJ and added both to the value of JGJ.
The court’s valuation of JGJ utilized Trugman’s basic approach but made several, major modifications that increased Trugman’s $2.2 million conclusion of value by a factor of four, to $8.8 million equal to one-third of $26.4 million composed of Trugman’s non-tax impacted value of JGJ ($26.1 million) plus another $300,000 on account of JGJg.
First, Justice Scheinkman disallowed Trugman’s 35% marketability discount which, as noted above, was based in part on tax considerations and failed to set forth how much discounting would be appropriate solely by reason of transfer restrictions. “Moreover,” the court continued, “even if the Court could determine an appropriate discount level, the Court would nevertheless conclude that no discount for lack of marketability is appropriate in this situation.” The Innocentis as buyers “made clear in their testimony that they did not intend to sell JGJ and that no amount of money would tempt them to do so,” consequently, as in the Zelouf case from which Justice Scheinkman quoted at length, “Verghetta should not recover less due to possible illiquidity costs in the event of a sale that is not likely to occur.” Applying a marketability discount, the judge wrote, “would be the economic equivalent of imposing an impermissible minority discount . . ..”
The second major adjustment was Justice Scheinkman’s refusal to tax impact JGJ’s future earnings as computed by Trugman, for two reasons: (1) there is no New York appellate authority for tax impacting and the out-of-state cases reach no consensus on its propriety, and (2) as an offset to Trugman’s “understatement of the value of the future revenue stream.” As Justice Scheinkman further explained:
Had Trugman 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.
Buy-Out Terms and Conditions
The October 2014 stipulation that set in motion the valuation hearing gave the defendants the option to pursue a buy-out or not. Justice Scheinkman accordingly gave the defendants 20 days to notify Verghetta as to their determination either to pursue buy-out or resume litigating the underlying complaint.
Assuming defendants pursue the $8.8 million buy-out, Justice Scheinkman ordered payment in four installments between May 2016 and November 2017 with interest at the 9% statutory rate from the valuation date of June 11, 2014.
Finally, Justice Scheinkman ordered the defendants to secure Verghetta’s release from any and all personal guaranties that he gave for the indebtedness of JGJ and JGJg and any affiliated entities, and that pending completion of the buy-out, Verghetta continue to exercise his rights as a co-manager of JGJ and as a member of JGJg, including the requirement of his consent to all Major Decisions enumerated in JGJ’s operating agreement. “If Defendants find that uncomfortable or inconvenient,” the judge added, “they may complete the buy-out.”
Historically, New York case law hasn’t exactly been rife with highly detailed, comprehensive, carefully reasoned decisions in contested valuation proceedings, as one routinely finds in the Delaware Chancery Court, which is why I’m so grateful when a magnum opus decision like Verghetta comes along to provide valuable insights and guidance for lawyers and business appraisers in future cases. Other recent decisions of like caliber include Cortes (Justice Demarest), Zelouf (Justice Kornreich), and AriZona Iced Tea (Justice Driscoll). Let’s hope it’s a trend and that it continues.