When is the sale price not equal to fair value?
Originally published by the ABA Section of Litigation, Expert Witnesses, Winter 2017, Vol. 12, Issue 2, February 21, 2017 ©2017 by the American Bar Association
After a corporate merger or acquisition, a dissenting shareholder may petition for the judicial appraisal of his or her shares. The shareholder is entitled to a recovery (sometimes with interest, depending on the jurisdiction) if the appraisal shows that the transaction did not provide fair value for the shares. All 50 states and the District of Columbia have some form of appraisal rights statute, with over half adopting provisions from the ABA's Revised Model Business Corporation Act. Delaware—where most companies are incorporated—has well-developed law in this area. And a number of recent Delaware decisions have addressed the relevance of the transaction price and importance of expert analysis in appraisal rights litigation, for example: Merion Capital L.P. v. Lender Processing Servs., Inc., 2016 WL 7324170 (Del. Ch. Dec. 16, 2016); Dunmire v. Farmers & Merchs. Bancorp of W. Pa., Inc., 2016 WL 6651411 (Del. Ch. Nov. 10, 2016); In re Appraisal of DFC Glob. Corp., 2016 WL 3753123 (Del. Ch. July 8, 2016); In re Appraisal of Dell Inc., 2016 WL 3186538 (Del. Ch. May 31, 2016); Merion Capital LP v. BMC Software, Inc., 2015 WL 6164771 (Del. Ch. Oct. 21, 2015).
Transaction price is relevant but not determinative
In BMC Software, a consortium of private equity firms purchased BMC for $46.25 per share. Dissenting shareholders sought an appraisal. The Delaware Chancery Court held that the fair value of the shares was the same as the sale price. Although the court arrived at a slightly higher value based on discounted cash flow (DCF)—between the competing experts' DCF numbers—it deferred to the sale price because of uncertainties in the calculation inputs and the robustness of the sale process. The record demonstrated a "robust, arm's-length sales process" with "multiple potential buyers" and the "pursu[it] [of] all indications of interest to a reasonable conclusion."
Likewise, in Lender Processing, the Delaware Chancery Court held that the fair value of the shares purchased by a competitor equaled the sale price. It found that the strength of the sale process (including multiple strategic buyers with equal access to confidential information) combined with the closeness of its own DCF value—different than the experts' but within 3 percent of the sale price—justified "100% weight to the transaction price."
At the opposite end, the Delaware Chancery Court in Dunmire gave no weight to the $83 per share price in a stock-for-stock merger. That price was not the product of a robust sale: There were no third-party bidders, insiders stood on both sides of the deal, and price was dependent on a set amount of return. Nor did the court give weight to either side's comparable transactions valuation because of material defects in the expert analysis. Instead, the court used a variant of a DCF model with a mix of each side's various inputs and determined fair value at $91.90 share.
Even with an orderly sale process, the Delaware Chancery Court in Dell disregarded the sale price in a leveraged management buyout. It concluded that the leveraged-buyout pricing model used in the sale process underpriced the company, Dell's stock price was out of synch with its operative reality due to the market's short-term focus, and a lack of meaningful early bidding undermined the original and final sale prices. In short, "pricing anomalies and disincentives to bid existed to create the possibility that the sale process permitted an undervaluation." So the court determined its own fair value using a DCF model and a combination of the experts' inputs. It arrived at a value exceeding the sale price by 28 percent.
In between these results, the Delaware Chancery Court in DFC Global gave partial credit to the sale price of $9.50 per share in a private equity buyout. Notwithstanding what appeared to be a strong sale process, the court found that the process deserved only one-third credit because the purchaser may have had better inside information and pegged its price to a guaranteed rate of return. The company's comparable company valuation deserved another one-third credit, and a hybrid of both side's DCF valuations deserved the final one-third credit. In the end, the court determined fair value at $10.21 per share.
Elements of a robust sale process
These cases once again demonstrate that transaction price is a relevant valuation factor in appraisal rights litigation, but they highlight how price may be disregarded in whole or in part depending on the robustness of the sale process, as well as the credibility of expert valuation evidence. Key elements of a robust sale include the following:
- The number and heterogeneity of early bidders (BMC, Lender Processing)
- Equal access to confidential information (DFC Global, Lender Processing)
- The existence of conflicts of interest or insider influence (Dunmire)
- Whether the transaction is a leveraged buyout (Dell)
- The size and complexity of the company (Dell, Lender Processing)
The defending company bears the burden to show "the outcome of the sale process offers the most reliable evidence of the Company's value as a going concern" (Dell, 2016 WL 3186538, at *44). If it does, "a reviewing court should give substantial evidentiary weight to the merger price as an indicator of fair value" (Highfields Capital, Inc. v. AXA Fin., Inc., 939 A.2d 34, 42 (Del. Ch. 2007) ).
Regardless of the credit given to transaction price, expert analysis is central to the fair value question. It may be the sole component in which transaction price is disregarded, a partial component in which transaction price is given only some credit, or simply a confirmatory check in which transaction price is given all the credit.
Valuation methods and contested inputs
In Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983),the Delaware Supreme Court abandoned the "Delaware Block" method as the exclusive means of establishing fair value. That method took the weighted averages of various elements of value such as assets and earnings, assigned them weights and added the results to derive a per share value. Instead, the court held that "a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court." Since Weinberger, Delaware courts have used one or more of the DCF and comparable/guideline publicly traded company or transaction methods to determine fair value, depending on the valuation evidence presented.
Under the DCF method, which has come to be most prevalent, a firm's enterprise value is calculated as equal to the expected future unlevered free cash flows, projected over a period of time, and then discounted to present value using a risk-adjusted discount rate. Enterprise value can be thought of as the sum of the value of a firm's monetary, tangible and intangible assets, and interest-bearing debt, less the value of excess cash.
Under the comparable/guideline publicly traded company or transaction method, a firm's value is calculated based on the prices of comparable companies or transactions. The selection of companies or transactions under this method requires that the microeconomic and investment characteristics underlying the comparable companies or transactions are sufficiently similar to those of the subject company or transaction. Factors used to make this assessment include size in terms of sales, profits, assets, and market capitalization; and operating efficiencies and financial risk measured using financial ratios, geographic areas of operation, and similarity of business lines.
Given the adversarial nature of appraisal, it is common for valuation experts to disagree as to the appropriateness of different valuation methods and their corresponding inputs. For instance, one expert may eschew a DCF method in favor of a comparable-based method because of unreliable cash flow projections. Another expert may employ a DCF method because DCF "merits the greatest confidence within the financial community." See Lender Processing, 2016 WL 7324170, at *27. That same expert may also be unable to find companies or transactions to use in a comparable-based method. More often, experts tend to agree with the valuation method but disagree on the inputs: the companies or transactions selected for the comparable-based method or the numerous inputs into the DCF method such as cash flow projection and period, perpetual growth rate (e.g., inflation, gross domestic product), discount rate (particularly Equity Risk Premium and beta), non-cash adjustments (e.g., stock-based compensation), and tax effects.
Appraisal rights litigation is alive and well. A number of recent Delaware decisions painstakingly analyze both the fact and expert evidence to determine the fair value of a company. As seen, transaction price can be an important factor in the court's analysis depending on the robustness of the transaction process and how counsel presented that at trial. But even so, transaction price is not conclusive evidence of fair value viewed on a stand-alone basis or the equivalent of fair market value (i.e., the price at which shares trade in an efficient and liquid market). Experts can bridge the gap by interpreting the transaction price in the context of other valuation evidence as part of a thorough, independent analysis.