In Re: Appraisal of Orchard Enterprises, Inc., C.A. No. 5713-CS (Del. Ch. July 18, 2012).
In this post-trial decision in an appraisal action arising out of a merger, the Court determined the fair value of the shares, relying on the discounted cash flow method of valuation.
The common stockholders of The Orchard Enterprises, Inc. were cashed out at a price of $2.05 per share by Orchard’s controlling stockholder. Relying on a discounted cash flow analysis (“DCF”), the petitioners claim that each common share was worth $5.42 as of the date of the merger. By contrast, the respondent company contended that the merger price was generous and that the common shares were worth only $1.53 as of the date of the merger. After trial, the Court determined that the fair value of the shares pursuant to Section 262(h) of the DGCL were worth $4.67 per share, which was supplemented with an award of interest at the statutory rate.
The Court observed that the largest disparity in the valuation approach of the experts was based on the differing treatment by the parties of a $25 million liquidation preference owed by Orchard in certain circumstances to the holders of its preferred stock. Although Orchard admits that the liquidation preference was not triggered by the merger, Orchard argued that the liquidation preference must still be deducted from the enterprise value of Orchard before calculating the value of its common stock in this statutory appraisal. The Court disagreed with that position as a matter of law and found that whether the liquidation preference would ever be triggered in the future was entirely a matter of speculation as of the date of the merger. The liquidation preference was not the subject of a put right by contract at a certain date, but rather was only triggered by unpredictable events, such as a dissolution or a liquidation.
Most importantly, the Court relied on settled Delaware law that the applicable standard entitled the petitioners to receive their pro rata share of the value of Orchard as a going concern, and not on a liquidated basis, and without regard to post-merger events. See footnotes 6 through 9 (citing Cavalier Oil Corporation v. Harnett, 564 A.2d 1137, 1144 (Del. 1989); and Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 298 (Del. 1996)).
The Court explained that the proper way to value the shares of the petitioner is to value Orchard as a going concern, and to allocate value to the preferred and common stock based on the allocation made in the Certificate of Designations. The Court added that such an approach “marries perfectly with the DCF method of valuation, which is based on the notion that a corporation’s value equals the present value of its future cash flows.”
The Court observed that the largest disagreement between the parties over aspects of the DCF value was over the discount rate to use. Each expert used three different methods to arrive at the discount rate. Two of the methods are versions of the so called “build-up” model, which is a method that is filled with subjectivity, and uses elements “not accepted by the mainstream of corporate finance scholars.” Instead, the third method each of the experts used to determine the discount rate was based on the Capital Asset Pricing Model (“CAPM”) that is the widely accepted model for valuing corporations. That is the only method that the Court used.
After applying the recognized supply-side equity risk premium, which is recognized in prior Delaware appraisal opinions, the parties and Orchard agreed that the discount rate under the CAPM method is 15.3%.
As a historical matter, prior to the merger, after a Special Committee was formed and a formal valuation was done by Fesnak and Associates, and after the Special Committee and the full board approved the merger at an annual meeting, the majority of the minority stockholders voted in favor of the merger.
Although there was some discussion about the efforts of the majority shareholder to sell the company, before it decided to buy out the minority, the Court emphasized that this was a statutory appraisal action and the focus was on the value of Orchard as a going concern, and not on the quality of the efforts to market the company. Thus, the testimony at trial focused mostly on the value of Orchard as a going concern as of the date of the merger, based on Cavalier Oil and its progeny.
Pursuant to DGCL Section 262, the Court explained the well-known standard in a statutory appraisal action which requires the Court to “determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger for consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value.”
For purposes of an appraisal proceeding, the Court explained that “fair value” means the “value of the company to the stockholder as a going concern, rather than its value to a third party as an acquisition.” Moreover, the Court considers: “All relevant factors known or ascertainable as of the merger date that illuminate the future prospects of the company, but any synergies or other value expected from the merger giving rise to the appraisal proceedings itself must be disregarded.” See footnotes 20 to 22.
Each party bears the burden to prove their respective valuations and the Court has discretion to select one of the valuation models or to create its own, but it must use its own independent judgment. See footnotes 24 and 25.
The biggest difference in the approaches of the experts was regarding how to value the preferred stock. The expert of the petitioner was from Willamette Management Associates. The company’s expert was from Fesnak and Associates, who was also the financial advisor to the Special Committee.
In rejecting the approach of the expert for the company regarding the valuation of the preferred shares, the Court described the position of the company’s expert as follows: “Ever-evolving yet constantly confused arguments . . .” The Court also described the argument in the company’s briefs regarding valuation as follows: “. . . illogical, and non-factual . . .” In rejecting the argument that was contrary to the clear terms of the Certificate of Designation that the valuation should take into consideration the future liquidation preference even if it was not triggered by the merger, the Court relied on a prior Delaware decision that rejected a similar argument. See In Re: Appraisal of Metro Media International Group, Inc., 971 A.2d 893 (Del. Ch. 2009).
The Court acknowledged that regardless of what market realities may exist, an appraisal remedy is designed to address the potential for a majority shareholder to treat the minority unfavorably. Although Delaware law gives the majority shareholders the right to a control premium, the law limits the chance of getting one by requiring minority stockholders to be treated on a pro rata basis in an appraisal proceeding. See footnote 45 (citing Cavalier Oil Corp., and noting that this approach takes into account the “risky, time-consuming and burdensome remedy that involves a stockholder tying up its investment in a legal proceeding for several years and having to bear its own costs of prosecution, without any guarantee to receive any floor percentage of the merger consideration.”)
Although the Court relied on the DCF analysis, it referred to the use of a comparable company method as “rooted in the same intuition as the DCF method.” The Court explained that comparable company method allows comparisons to similar companies and the drawing of inferences about the future expected cash flows from the expectations of the market about those comparable companies. See footnotes 54 to 57 (which include citations to two seminal works in the field by Shannon P. Pratt, including his well known reference: The Lawyer’s Business Valuation Handbook). In this case, however, because the company was in a niche market, it was difficult to find companies that actually do the same thing, thereby making the comparables approach less reliable.
The Court explained the basic premise underlying the DCF methodology and its component parts. See Slip op. at 29.
In choosing one method that is widely recognized for determining the discount rate, instead of blending several different methods, the Court reasoned as follows:
“As a law-trained judge who has to come up with a valuation, deploying the learning of the field of corporate finance, I choose to deploy one accepted method, as well as I am able, given the record before me and my own abilities.”
See Slip op. at 42.
After a thorough explanation of the reasoning that led to the conclusion of the Court in this 55-page decision, (including mathematical “equations with letters” more likely to be found in a finance textbook, and that I do not include in this overview), the Court gave the parties the opportunity to explain if any adjustments the Court made that were different than either of the expert reports, needed editing, because “the parties failed to engage on several issues” until after post-trial oral argument.
Postscript: Kevin Brady’s videocast for LexisNexis provides a short overview of the case.
Supplement: We recently posted an overview of Delaware law on fair value in appraisal cases based on DGCL Section 262, available here.