A lesson from AriZona: Standard of Business Valuation in New York

Corey Lederman and Elena Volkova, Esq. on February 5, 2016

When a business gets to the point of dissolution, or when a shareholder wishes to depart, the ultimate question is…

How much will a shareholder walk away with?

In order to answer that question, the business’s value must be determined.

If shareholders don’t see eye-to-eye and cannot come to an agreement themselves, it will be up to the courts to assign a value to the business.

Unfortunately, there is a lack of a definition of “fair value” in the New York Business Corporation Law, and New York courts have had to approach valuation of businesses in a myriad of ways.

So, how can shareholders prepare for this process if there’s no standard?

Thankfully, the epic case of Ferolito v. AriZona BeveragesUSA (AriZona), provides important insights into many of the issues that New York courts are confronted with in valuing a business.

A business once founded on a decades-long friendship between its co-owners, AriZona Iced Tea eventually became “the business that killed the friendship” and cost its owners millions of dollars in litigation fees.

By taking a look at what happened during this case, shareholders can find various elements to take into consideration when considering valuation.

1. What will someone pay for the business?

Deciding the “fair value” of a corporation requires a determination of “what a willing purchaser in an arm’s length transaction would offer for petitioners’ interest in the company as an operating business.”

Thus, the value will be a completely objective assessment based only on the finances and relevant business considerations.

Finding the “fair value” of a business is a fact-intensive investigation, which relies on (often numerous) expert opinions, affidavits, and evidence to fairly and accurately decide on the value.

Additionally, there are several different approaches that courts have used in the determination, including looking to net asset value, investment value, and/or market value. However, all three need not factor into the ultimate valuation.

In the case of the feuding co-founders of AriZona Beverage Corp., the valuation dispute lasted several years.

The case began when when 50% owner and co-founder John Ferolito filed a petition for judicial dissolution of the collection of companies under the AriZona umbrella.

Ferolito valued AriZona at $3.2 billion, while Domenick Vultaggio, the current managing partner, valued it at a distant $426 million.

2. Expression of interest must be wholly non-speculative to factor into the court’s valuation.

For a court to place credence on an existing valuation (even from a reputable company), a thorough investigation must be made.

And proper due diligence must be conducted by a likely buyer.

In AriZona, the Court rejected valuations by Tata, Nestle, and Merrill Lynch, which estimated the value of AriZona as high as $4.5 billion.

All of those figures were discredited because they were contingent on due diligence which had not yet been conducted, a lack of approval from the very top of those corporations, and accordingly, no actual binding offers.

3. The Financial Control Measurement

After rejecting the offered valuations, the Court moved on to its own valuation for AriZona.

It do so by using the “financial control” measurement, which is “the value of a company exposed to a representative group of buyers who are not expecting synergies, who are looking at the value of the business on a standalone basis.”

The parties attempted to determine the value by calculating the company’s Discounted Cash Flow (“DCF”). DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate.

The DCF analysis in this case included…

  • examining anticipated revenues and costs
  • the company’s terminal value
  • he existence of a tax amortization benefit for a potential buyer
  • the anticipated tax rate on AriZona’s income
  • and the discount rate

One major contention in AriZona was on the weight to be provided to the DCF in determining AriZona’s value.

Ultimately, the Court agreed with Vultaggio that the value should be 100% of the value, instead of 80% of AriZona’s value plus 20% based on comparable merger or acquisition transactions which Ferolito pressed for.

New York courts generally reject valuations which incorporate comparable merger or acquisition transactions unless it can be demonstrated that there actually are comparable companies engaged in similar transactions.

Here, the Court found that the comparable companies offered were distinguishable due to a “lack of similarity in size, timing, products…and are also synergistic market transactions.”

The Court found that to compare AriZona to other companies was too speculative because AriZona is unique in its position in the tea market and holds a “significant plurality of market share.”

4. The Marketability Discount

The discount for lack of marketability (DLOM) “reflects the notion that shares in privately held companies may be less marketable because those shares cannot be readily liquidated for cash.”

New York courts typically apply a 25% DLOM for large and growing companies, like AriZona, and did exactly that in this case.

The 25% DLOM, Justice Timothy S. Driscoll of the Nassau County Commercial Division said, reflected the reality that “shareholders in a closely held company cannot readily liquidate their shares.”

Ultimately, as Driscoll would value AriZona at approximately $2 billion before prejudgment interest, this 25% DLOM reduced the value of AriZona by $500 million and reduced the price to be paid to the 50 percent shareholder by approximately $250 million.

5. Rejection of the hypothetical “Synergistic Buyer”

Synergistic buyers acquire companies that belong in the same or a related industry in order to take advantage of economies of scale and create synergies with their existing businesses.

However, courts almost unanimously reject incorporating this hypothetical buyer into business valuations.

In the case of AriZona, the Court concluded that a valuation that incorporates such a “strategic” or “synergistic” element would not rely on actual facts that relate to AriZona as an operating business and instead would force the Court to speculate about the future.

6. If the parties don’t settle…

Ultimately, the parties in the AriZone case settled.

Had they not though, it looks as if the Court would’ve eventually entered a judgment which relied solely on the Discounted Cash Flow method (which at the time of this decision valued AriZona somewhere around $1.4 to $1.5 billion after applying the 25% marketability discount).

The fact that the Court completely rejected the potential offers for acquisition and focused solely on the DCF method is instructive for those who may be in negotiations.

At the very least, this case study provides valuable perspective for shareholders considering the value of their shares.

How to avoid AriZona-like litigation

The AriZone litigation cost its owners millions of dollars in legal fees.

We all like to believe that we’ll always have strong relationships with our shareholders, especially if those shareholders are friends or family.

Unfortunately, shareholder disputes are incredibly common.

The best way to protect yourself against expensive litigation is to have an iron-clad business prenup.

This comes in the form of a well-crafted and negotiated buy-sell shareholder agreement – an absolute “must have” for any privately owned company.

If you are ready to tackle your thorny shareholder issues, please email elena@volkovalaw.com to set up a confidential consultation.

This material may be viewed as attorney advertising and does not constitute legal advice. This information does not create an attorney-client relationship between you and the author. This article strictly represents the personal views of the author on the date it was written and such views are subject to change without notice.

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