In this appraisal proceeding pursuant to 8 Del. C. § 262, the post-trial issue addressed by the Court was whether the “fair value” of the company was worth more than the $40 million acquisition price.
In an unusual twist, the Court found that the “fair value” of the company for appraisal purposes was only $34 million – – $6 million less than the cash acquisition price.
This appraisal action was pursued by minority shareholders which included the founder and former CEO of the company, who voted in favor of the merger as a director, but later voted against it as a shareholder. The case was filed in January 2010 and the trial was held in July 2011, followed by extensive post-trial briefing and oral argument. Petitioners contended that the fair value of the company was $55 million. By comparison, the respondent company claimed that the company was only worth $33 million, even though the cash acquisition price was $40 million. The major difference between the valuations by the experts for each of the parties was twofold: (1) whether cash flow projections for new planned facilities should be included in the valuations; and (2) “the appropriate small company size premium to be applied to the Company’s cost of equity.” The Court explained that those two areas of dispute accounted for most of the differences between the parties’ respective valuations.
The Court began its analysis with the basics, and described the fundamental purpose of an appraisal action as a limited legislative remedy intended to provide stockholders who dissent from a merger asserting the inadequacy of the offering price, with “an independent judicial determination of the fair value of their shares.” See footnote 10. The DGCL entitles petitioners to their pro rata share of the “fair value” of the companies in question as of the merger date. See 8 Del. C. § 262(h) (acknowledging that the fair value of the shares is “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value”).
Determination of Fair Value
In connection with the broad discretion given to the Court to determine fair value, it takes into account all relevant factors known or ascertainable “as of the merger date that illuminates the future prospects of the company.” However, the Court must determine the fair value of the company as a going concern which requires the Court to “exclude any synergistic value, that is, the amount of any value that the selling company’s shareholders would receive because the buyer intends to operate the subject company, not as a stand-alone going concern, but as part of a larger enterprise, from which synergistic gains can be extracted.”
Both sides in an appraisal proceeding have the burden of proving their respective valuations by a preponderance of the evidence, and the Court may consider “proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in Court.” Acceptable techniques that have been recognized in Delaware include “the DCF approach and the comparable transactions approach.” The Court will use its own independent judgment to determine the fair value of the shares if neither party satisfies its burden. See footnotes 15 through 19.
Relevance of Fiduciary Duty Claims
The Court noted in footnote 26 that where a company relies on the merger price as evidence of fair value, allegations of breach of fiduciary duty or other improper actions during the sales process are relevant to whether the merger price is credible evidence of fair value. However, where evidence of fair value is supplied by expert analyses, allegations of improper conduct by the Company’s fiduciaries are relevant only to the extent that they relate to some assumption or input to the expert’s valuation, affecting in turn the credibility of the challenged valuation. See also footnote 27 (citing Cede & Co. v. Technicolor, Inc., 2003 WL 23700218, at *7 (Del. Ch. Dec. 31, 2003) aff’d in part rev’d in part, 884 A.2d 26 (Del. 2005) (referring to Chancery decision holding that when management projections are made in the ordinary course of business, they are generally deemed reliable)).
Each of the parties’ experts relied primarily on their DCF analyses to value the Company and the Court spent considerable time focusing on the “disputed inputs and assumptions” regarding the projected cash flows, capital structure and costs of capital for the Company.
Value as of the Date of Merger
The Court determined that the projected new facility in Georgia was too speculative to be included in the valuation of the Company as of the merger date, based on Delaware appraisal law which provides that “the corporation must be valued as a going concern based on the “operative reality” of the Company as of “the time of the merger” and the Court is limited to factors known or knowable as of the merger date that relate to future prospects of the Company, but should avoid including speculative costs or revenues. See footnotes 35 and 36. The Court distinguished the decision in Delaware of Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290, 315 (Del. Ch. 2006), which included in an appraisal valuation certain proposed new facilities which the Court likened to a Starbucks or McDonald’s as part of a standardized business model – – which was substantially different from the business model involved in the instant case.
The Court spent a substantial part of the opinion addressing the weighted average cost of capital (WACC), in order to discount the cash flow projections for the company.
The Court determined that the approach taken by the expert for the petitioner was inappropriate, in part, because the capital structure applied by the expert for the petitioner arose directly out of the expectation of the merger. The Court of Chancery has previously rejected the proposition that changes to a company’s capital structure in relation to a merger should be included in an appraisal. The Court cited to a case at footnote 54 in which it had previously refused to include debt incurred as part of the merger in the company’s capital structure because to do so would contravene the valuation statute’s command to appraise shares “exclusive of any element of value arising from the accomplishments or expectation of the merger.” Instead, in that cited case, the Court determined that because the Company had no debt before the merger and because the petitioner had introduced no evidence of non-speculative plans to incur significant debt, (that is not due to the accomplishment of the merger), it was inappropriate to include the actual additional debt for purposes of an appraisal. Thus, the Court determined in this case that the correct capital structure for an appraisal of Just Care is that “theoretical capital structure it would have maintained as a going concern.”
In discussing the cost of equity, the Court determined that neither side seriously contested the beta calculation of the other. The Court found that the relevant beta was equal to 0.82. Beta has been defined as follows:
“Beta (β) of a stock or portfolio is a number describing the volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500.
An asset has a Beta of zero if its returns change independently of changes in the market’s returns. A positive beta means that the asset’s returns generally follow the market’s returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset’s returns generally move opposite the market’s returns: one will tend to be above its average when the other is below its average.”
Equity Risk Premium
The Court’s discussion of this point also provides a practice tip regarding the Court’s current approach on this issue.
Regarding the equity risk premium, the Court determined that the supply side equity risk premium of 5.73% was the appropriate metric to be applied in valuing the Company. The Court explained that despite the historical equity risk premium applied by the Court, “the academic community in recent years has gravitated toward greater support for utilizing the supply side equity risk premium.” See Global GT L.P. v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010). The Chancery decision in Global v. Golden was highlighted here, and the Supreme Court’s affirmance was summarized here.
The Court explained that in smaller companies, “an equity size premium” generally is added to the company’s cost of equity for the higher rate of return demanded by investors to compensate for the greater risk associated with small company equity. Small company premiums are empirically estimated and both experts utilized the Ibbotson size premiums in performing their analysis.
No Liquidity Discount Allowed
The Court emphasized that: “Although a liquidity discount related to the marketability of a company’s shares is prohibited, that does not mean that the use of any input that is correlated with a company’s illiquidity is per se invalid.” (emphasis in original.) The reduced liquidity of smaller companies which results in their equity being riskier and investors demanding higher returns, increases the cost of capital and it is that type of liquidity circumstance that is captured in the Ibbotson size premium. See footnotes 77 and 78.
That is, the liquidity effect that arises in connection with transactions between a company and its providers of capital, which is part of the value of a company as a going concern, and which impacts its ability to obtain financing and influences the overall risk and return profile, needs to be distinguished from the liquidity effect that is prohibited under Delaware appraisal law and relates to transactions between shareholders and other market participants.
Therefore, the Court explained that where the effect of the company’s illiquidity relates only to the ability of an investor to exit his investment by selling his shares in the market, such a transaction relates more to the structure of the market than to the company’s ability to generate profits. As a result, such a discount rightly is excluded in an appraisal because it does not relate to the intrinsic value of the company.
By contrast, the liquidity effect at issue in this case relates to the ability of the company to obtain capital at a certain cost and this effect is related to the intrinsic value of the company as a going concern and should be included when calculating its cost of capital.
The Court rejected the adjustment by the expert for the petitioner because the Court explained that “small company size premiums regularly are applied in appraisal proceedings in Delaware” without the type of adjustment performed by the expert for the petitioner. See D.R.E. 702 (an expert’s report must be based on reliable principles and methods).
The Court addressed the general rule that an award of interest is routinely made unless the petitioner brought the action in bad faith. The Court rejected any argument of bad faith and awarded prejudgment interest to petitioners consistent with Section 262(h), on the value of the appraised shares.
The Court ordered the parties to “cooperate to determine the amount of the interest award” based on a valuation of about $34 million.
Although the amount of interest awarded was not computed as a final, total number, it was not obvious whether the shareholders would have been better off accepting the $40 million acquisition valuation of the Company – – or if the prejudgment interest at the statutory rate of “5% over the Federal Reserve Discount Rate” would put them in a better position than if they had accepted the original merger consideration and generated a return that was less than the amount of statutorily mandated prejudgment interest.
Supplement: Professor Stephen Bainbridge, a friend of this blog and Delaware’s favorite corporate law scholar, provides an insightful analysis of this case and also cites to related Delaware court decisions and relevant scholarship on the key topic addressed in this case.
Postscript: I prepared an overview of the Delaware law of “fair value” for a presentation I gave recently, which is available here.