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Appraisal Rights Litigation Blog

Forthcoming Law Review Article Lauds Value Creation Resulting from Surge in Appraisal Activity Due to Increased Use of Arbitrage

Posted in Arbitrage, Merger vote, Record date

In a forthcoming law review article expected to be published in 2015 in the Washington University Law Review, “Appraisal Arbitrage and the Future of Public Company M&A,” Charles Korsmo (Associate Professor at Brooklyn Law School) and Minor Myers (Associate Professor at Brooklyn Law School) report their findings showing a large uptick in the number of appraisal petitions being filed, as well as a marked increase in the size of the petitioners’ holdings and an increased level of sophistication among the filers themselves. The authors observe an increased use of arbitrage by which petitioners appear to invest in the target after the M&A deal is announced (for more about arbitrage, see our prior post here). While the authors note that the defense community has decried appraisal arbitrage as an abusive exercise of appraisal rights that ought to be suppressed, the authors argue that this criticism has it precisely backward and that the “new world of appraisal” should be welcomed and encouraged, as it ultimately provides an efficient means for benefiting minority shareholders and actually reducing the cost of raising equity capital.

Among the highly telling data points that Professors Korsmo and Myers collected for their analysis, they found that the value of claims in appraisal in 2013 was nearly $1.5 billion, a tenfold increase from 2004 and nearly 1% of the equity value of all merger activity in 2013. They attribute this surge in appraisal claims to the increased use of appraisal arbitrage in a manner that is transforming what this blog has repeatedly described as an underutilized shareholder remedy into a specialized investment strategy.

 

Are There Arbitrage Opportunities With Appraisal Rights?

Posted in Arbitrage, Merger vote, Notice of Demand for Appraisal, Record date

An interesting question first addressed many years ago has just resurfaced: can a shareholder seek appraisal rights for shares it acquires after the merger is announced and even after the record date that is set for voting on whether to approve the proposed M&A transaction? Historically the Delaware court said yes, subject to certain other conditions being met, but that may not be the last word on the subject. The New York Times recently blogged about a new case currently before the Delaware courts arising from the buyout of Ancestry.com, showing that this issue is timely again.

First, some background: in 2007, the Delaware Chancery Court opened the door to arbitrage possibilities by its ruling in the appraisal rights case of Transkaryotic Therapies, Inc. In that proceeding, the court permitted a shareholder to exercise appraisal rights for shares acquired after the record date but before the merger vote, provided that the record holder had timely notified the issuer, pre-vote, of a sufficient number of “no” votes or abstentions to cover the number of newly acquired shares being put up for appraisal. The court recognized that owners of stock certificates, such as Cede & Co. — which is typically the nominal owner of shares that are on deposit with the Depository Trust Company, hold their shares in an undifferentiated manner in “fungible bulk,” and so no shareholder has ownership rights to any particular share of stock. Accordingly, there is no voting history attached to any particular share of stock or beneficial owner; all that matters is that the record holder vote no or abstain with respect to a sufficient number of shares to cover the newly acquired shares for which a petitioner wants to seek appraisal.

There are limits as to how late a stockholder may acquire shares for purposes of appraisal; naturally, shares bought after the merger vote, even if acquired before the merger consummation or closing date, won’t count toward appraisal, as they are acquired too late and without sufficient notice to the company.

To illustrate the point, let’s assume that a shareholder currently owns five shares in XYZ Company and an announcement is made on June 10 that ABC Company will be acquiring XYZ. XYZ will be conducting a shareholder meeting regarding the proposed merger on July 1, based on a record date of June 20. Now let’s assume that after the deal is announced and before the July 1 shareholder meeting, our shareholder directs Cede to provide notice to XYZ Company that she will be dissenting with respect to her five shares. Cede then follows those instructions, as well as the directions it receives from all the other beneficial owners for whom it holds shares, and Cede goes ahead and provides notice to the company for all the “no” votes that it has been directed to give. Let’s further assume the total of “no” votes is 100, and in addition to those votes, there are 50 abstentions, so the total number of shares “eligible” for an appraisal demand is 150.

If our shareholder later buys five more shares after the June 20 record date but prior to the July 1 merger vote, she can still seek appraisal for her new total of 10 shares out of the 150 eligible shares for which Cede has given notice. If, however, other dissenting beneficial owners for whom Cede also holds have tendered 145 shares for appraisal, then our shareholder can seek appraisal for only five of her shares, not for the other five in excess of the 150 total eligible shares.

The Transkaryotic opinion back in 2007 was issued by the Delaware Chancery Court, and the rule in this case has not yet been affirmed or otherwise opined on by the Delaware Supreme Court; it is indeed the standing principle today but could become more controversial and may well be revisited if it reaches the Supreme Court and they see things differently. And now that Ancestry.com seems to be taking a run at challenging the Transkaryotic ruling, based in part on a change in the appraisal statute since the time that that case was decided, the Delaware courts may take up this issue again. We’ll watch this case as it proceeds and post any new developments here.

 

Chancery Court Rejects Use of Merger Price in Appraisal Action and Accepts Experts’ Direct Capitalization of Cash Flows Valuation Method; Court Also Accepts Experts’ Use of Buildup Model

Posted in Buildup Model, Direct Capitalization of Cash Flows, Discounted Cash Flow Analysis, Fair Value, Independent valuation, Merger Price, Short-Form Merger, WACC

On May 12, 2014, the Delaware Court of Chancery issued its latest appraisal opinion, Laidler v. Hesco Bastion Environmental, Inc., addressing, among other things, the limitations on the use of merger price in an appraisal proceeding.

The petition for appraisal was brought by a former employee of Hesco Bastion USA, Inc. (“Hesco”), which manufactured and sold “Concertainer units” – deployable barriers designed to protect against flooding – in the United States. On January 26, 2012, Hesco was merged into its majority shareholder, the respondent, pursuant to a short-form merger. Immediately prior to the merger, the respondent held 90% of the outstanding equity of Hesco, and the petitioner held 10%. The petitioner refused to accept the $207.50 per share cash consideration offered by the respondent, and instead exercised appraisal rights.

Vice Chancellor Glasscock concluded that the fair value of the petitioner’s shares was $364.24 per share, a 75% increase over the merger consideration. In reaching his conclusion, the Vice Chancellor rejected the respondent’s position that the Court should consider the merger price as persuasive evidence of fair value because it was the result of an arm’s-length negotiation between the controlling shareholder and an independent director. The Court found that it was not an arm’s-length transaction subject to a full market check, but rather a short-form merger consummated by a controlling shareholder who set the merger price. “Under our case law,” the Court stated, “a statutory appraisal is the sole remedy to which the Petitioner is entitled, and to defer to an interested controlling shareholder’s determination of fair value in a transaction such as this would render that remedy illusory.”

Vice Chancellor Glasscock used a direct capitalization of cash flows (“DCCF”) valuation method to determine the fair value of the petitioner’s shares. The Vice Chancellor did not perform a traditional discounted cash flow (“DCF”) analysis because Hesco had not created management projections in its ordinary course of business. The Court relied on the DCCF analysis – which was the sole method applied by the petitioner’s valuation expert and one of the methods applied by the respondent’s valuation expert – determining a normalized figure for annual cash flows in perpetuity and then dividing those cash flows by a capitalization rate. To determine the company’s normalized annual cash flows, the Court averaged the company’s cash flows from the three years preceding the merger. To determine the capitalization rate, the Court subtracted the company’s long-term growth rate (4%) from its weighted average cost of capital (“WACC”) (21.83%). This appears to be the only Delaware case in which the Court based 100% of its valuation on a DCCF analysis.

The Court’s acceptance and application of a DCCF analysis may be significant. The DCCF analysis provides the Court with a methodology for valuing a company where there are no reliable management projections from which to craft a DCF analysis, and where the company is not sufficiently comparable to other companies for the Court to conduct a comparable companies or precedent transactions analysis. Rather than using the merger price as evidence of going concern value, the Court capitalized historical normalized cash flows in perpetuity to independently value the company as a going concern.

The Court’s acceptance of the buildup model to calculate the company’s WACC is also notable. What is the buildup model? The buildup model is similar to the Capital Asset Pricing Model (“CAPM”), except that it adjusts for industry risk by adding an industry-specific equity risk premium rather than using a beta, and also adds a company-specific equity risk premium. In In re Orchard Enterprises, Inc., (Del. Ch. July 18, 2012), then-Chancellor Strine was highly critical of the buildup model, finding that it was not “well accepted by mainstream corporate finance theory” because “its components involve a great deal of subjectivity.” Nevertheless, both parties’ experts used the buildup model in Laidler. The opinion in Laidler, therefore, should not be read as a signal that the Court of Chancery has abandoned the CAPM in favor of the buildup model.

 

Newly Appointed Delaware Chancellor, With Extensive Background in Shareholder Litigation, Brought At Least One Appraisal Rights Petition While in Private Practice

Posted in Fair Value, Informed consent to merger price

Last month the Delaware governor appointed attorney Andre Bouchard to take the helm of Delaware’s Chancery Court, where he will assume the Chancellor’s position vacated by Chancellor Strine’s elevation to the Delaware Supreme Court. The seventy-eight reported decisions that bear Mr. Bouchard’s name don’t tell the full story of the cases he has handled during his career in private practice, but we do know this much: he has brought at least one appraisal rights petition, in the case of Nagy v. Bistricer, 770 A.2d 43 (Del. Ch. 2000), and his law firm handled several other appraisal rights cases as well, typically as respondents, including as counsel for the respondent company in the well-known line of cases involving Cede & Co. v. Technicolor, Inc.

In Nagy, Mr. Bouchard represented Ernest Nagy, the sole minority stockholder of Riblet Products Corp., a closely held manufacturer of power cords and wires. Riblet was acquired by Coleman Cable Acquisition, Inc. in what then-Vice Chancellor Strine described as “an extremely unusual merger agreement”; the two individuals who were the controlling stockholders and directors of Riblet were also the controlling stockholders and directors of Coleman. Nagy, 770 A.2d at 46. In addition, the disclosures provided to Nagy in connection with his decision whether to seek appraisal or accept the merger consideration contained no information about why or how the two controlling stockholders and directors of the target had approved the merger agreement; no information regarding their interest in the acquirer; and no financial information about the target or the acquirer. Id. Moreover, Nagy was forced to decide whether to exercise appraisal rights even before he knew for certain what the final merger consideration would be.

Based on these unusual facts, the court rejected the company’s argument that appraisal was Nagy’s exclusive remedy, and found, among other things, that Nagy was permitted to pursue his unfair dealing and appraisal claims in a combined civil action; that the controlling shareholders of Riblet breached their fiduciary duties by failing even to attempt to provide Nagy with adequate disclosures that would allow him to make an informed decision as to whether to elect appraisal or accept the merger consideration; and that they breached their fiduciary duties by inequitably coercing Nagy into a forced appraisal.

Of course, the cases Mr. Bouchard handled as an advocate say nothing about how he will view appraisal rights cases once he becomes Chancellor. Indeed, the underlying conduct in Nagy was found to be so egregious that the court actually awarded Nagy attorneys’ fees under the “bad faith” exception to the American rule — by which both parties usually pay their own fees in a lawsuit, win or lose, as opposed to the English rule requiring the loser to pay — for being forced to respond to the defendants’ frivolous arguments made in support of their motion to dismiss and in opposition to Nagy’s motion for summary judgment.

Bouchard’s appointment has been well received among the bar. As reported in Law360 at the time of his initial appointment, Bouchard is expected to be a “more even-keeled judge” than former Chancellor Strine, who was one of the most outspoken Chancellors ever to serve in the Chancery Court. Bouchard has been described by other lawyers as an “outstanding individual” who is not a “flamethrower,” and who was favorably characterized as not necessarily becoming another Chancellor Chandler or a Chancellor Strine, but who will simply be himself, providing a “huge benefit” to the Chancery Court.

 

Valuation Basics: Calculating the Equity Size Premium

Posted in Discounted Cash Flow Analysis, Fair Value, Size Premium, Valuation Expert, WACC

In a prior post, we explained how the Capital Asset Pricing Model (“CAPM”) has become one of the frequently employed methods used by the Delaware Court of Chancery to calculate the cost of equity for the discount rate in a DCF analysis. In this post, we focus on one specific component of the CAPM: the equity size premium.

The equity size premium is a number added to the risk-free rate and the equity risk premium (modified by beta) to reflect additional returns on small companies. The argument is that investors may demand a higher rate of return on small companies than they do for large companies because of the increased risk associated with small company investments. The size premium supposedly quantifies the increased risk.

One method the courts have used to determine the size premium is to refer to the Ibbotson SBBI Valuation Yearbook. The Ibbotson tables, published by Morningstar, contain historical capital markets data that include, among other things, total returns and index values for stocks dating back to 1926. Morningstar recently discontinued the Ibbotson SBBI Valuation Yearbook, which means a court seeking to apply a small-size premium will have to look to other valuation materials for mergers occurring after 2013.

The Delaware Court of Chancery has used market capitalization as the benchmark for selecting a size premium. Thus, the court multiplies the amount of outstanding stock by the market price on the day prior to the merger and determines which Ibbotson decile the company falls under. The court then applies the appropriate size premium from the applicable Ibbotson table. The court may accept adjustments to the Ibbotson size premium if there is evidence of individual characteristics that distinguish the subject company from other companies within the same market capitalization decile.

Some valuation experts in appraisal cases have argued that the problem with this market capitalization approach is that it creates circularity based on the market price of the stock. The Delaware courts have acknowledged that the market price of a stock is not determinative of value in an appraisal proceeding because, among other things, the market price reflects a minority discount. The appraisal statute requires that the company be valued as a going concern, exclusive of any trading discounts. Moreover, the market price of a stock is an unreliable indicator of value when the market is inefficient (which is often the case for small companies) or when other factors affect market price. By relying on the market price to determine the size premium for the discount rate, these experts contend, the court is effectively incorporating that minority discount and inefficient market price into its valuation analysis in contravention of Section 262’s mandate that the company be valued as a going concern. An alternative approach to determine the company’s size for the purpose of ascertaining the small-size premium is to conduct an independent valuation of the company using a non-DCF method, such as a valuation based on comparable companies or precedent transactions. This alternative approach avoids the pitfalls of relying on an inefficient and discounted market price in calculating the company’s discount rate.

Chancellor Strine’s Elevation To Chief Justice of Delaware’s Supreme Court Will Benefit The Appraisal Process

Posted in Fair Value, Independent valuation, No Proof of Wrongdoing Needed

Among the thirty-five appraisal rights opinions written by Chancellor Strine over the past decade are some of the most cited and comprehensive treatments of the appraisal rights remedy to date. On January 29, 2014, the Delaware General Assembly unanimously confirmed Chancellor Strine’s appointment to the Delaware Supreme Court, where he will also become the court’s next chief justice, further underscoring the already significant deference his decisions have come to receive.

Among the several themes within Chancellor Strine’s vast appraisal rights jurisprudence, two are particularly striking: (i) Chancellor Strine repeatedly took the time to clarify the important but often overlooked distinction between fiduciary duty claims alleging director misconduct, as opposed to appraisal rights actions, which do not involve any accusation of wrongdoing. In addition, (ii) Strine repeatedly emphasized that the courts were required by law to reach “independent” determinations of a stock’s fair going concern value.

This past year, in In re MFW Shareholders Litigation, 67 A.3d 496 (Del Ch. 2013), Chancellor Strine once again spelled out the fundamental difference between (a) fiduciary duty claims brought by shareholders criticizing the board’s conduct in respect of the process or the price of an M&A transaction, on the one hand, and (b) appraisal rights cases involving a purely financial valuation, which does not raise any question of director misconduct. The appraisal rights proceeding requires the court to determine solely the appropriate valuation of the company as a going concern, which value the shareholder believes was not accurately reflected by the acquirer’s purchase price.

Indeed, eight years ago in Delaware Open MRI Radiology Associates v. Kessler, 898 A.2d 290 (Del. Ch. 2006), then-Vice Chancellor Strine provided a more detailed description of the court’s task in deciding an appraisal rights case, with particular emphasis on the fact that the court was duty-bound to make an independent determination of value, a consistent theme in his rulings:

My task in addressing the appraisal aspect of the case is easy enough to state, if more difficult in practice to accomplish with any genuine sense of reliability. Put simply, I must determine the fair value of [the company’s] shares on the merger date and award the [shareholder] a per-share amount consistent with their pro rata share of that value, supplemented by a fair rate of interest, regardless of whether that amount is greater or less than the merger price. Fair value is, by now, a jurisprudential concept that draws more from judicial writings than from the appraisal statute itself. In simple terms, to reach a fair value award, I must determine [the company’s] value as a going concern on the merger date and award the [shareholder] the percentage of that value that tracks its […] pro rata interest in [the company] on that date. In valuing [the company], I may consider all relevant, non-speculative factors bearing on its value as of the merger date. That includes the input provided to me by the contending parties’ experts. But I cannot shirk my duty to arrive at my own independent determination of value, regardless of whether the competing experts have provided widely divergent estimates of value, while supposedly using the same well-established principles of corporate finance. Such a judicial exercise, particularly insofar as it requires the valuation of a small, private company whose shares do not trade in a liquid and deep securities market, using a record shaped by adversaries whose objectives have little to do with reaching a reliable valuation, has at best the virtues of a good-faith attempt at estimation. That is what I endeavor here [emphasis added].

To further underscore the distinction between an appraisal rights case and a fiduciary duty claim challenging the board’s conduct, Strine further clarified in Kessler as follows: “[u]nlike a statutory appraisal action, the success of an equitable action premised on the assertion that a conflicted merger is unfair ultimately turns on whether the court concludes that the conflicted fiduciaries breached their duties.” In an appraisal action, in contrast, there is no comparable question before the court of whether director misconduct was to blame for a low buyout price; the court simply undertakes a valuation analysis.

In MFW, while addressing the various remedies available to minority shareholders in a fiduciary duty action who claim to have suffered harm as the result of a coercive tender offer, Strine once again underscores the fact that even if those shareholders were to fail to meet their burdens of proof in that action, their litigation rights are not extinguished, because they may also exercise appraisal rights as long as they voted no to the merger. And he further emphasized the effectiveness of the appraisal rights remedy: “[a]lthough appraisal is not a cost-free remedy, institutional ownership concentration has made it an increasingly effective one, and there are obvious examples of where it has been used effectively.” For those “obvious examples” he cites Golden Telecom, Inc. v. Global GT LP, 11 A.3d 214 (Del. 2010) (affirming appraisal remedy award of $125.49 per share, as opposed to merger consideration of $105 per share); Montgomery Cellular Hldg. Co. v. Dobler, 880 A.2d 206 (Del. 2005) (affirming appraisal remedy award of $19,621.74 per share for stockholders in short-form merger, as opposed to $8,102.23 per share in merger consideration); and M.G. Bancorporation, Inc. v. Le Beau, 737 A.2d 513 (Del. 1999) (affirming appraisal remedy award of $85 per share for dissenting minority stockholders in short-form merger, as opposed to merger consideration of $41 per share).

Building on Strine’s long-standing recognition that courts must make independent determinations of value, in the Golden Telecom case, the Delaware Supreme Court affirmed then-Vice Chancellor Strine and rejected the company’s challenge to his appraisal decision, in which Strine had refused to defer to the merger price as a measure of fair value. As the Supreme Court held, the appraisal statute “unambiguously calls upon the Court of Chancery to perform an independent valuation of ‘fair value’ at the time of a transaction. . . . Requiring the Court of Chancery to deter — conclusively or presumptively — to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent.”

Likewise, in In re Orchard Enters., Inc. (Del. Ch. July 18, 2012), Chancellor Strine explained that appraisal actions are unique in that both parties bear the burden of proving their respective valuations by a preponderance of the evidence. But consistent with his prior cautions, he found that the court has discretion to select one of the parties’ valuation models or create its own, but in all events, “the court may not adopt an ‘either-or’ approach to valuation and must use its own independent judgment to determine the fair value of the shares.”

With his promotion to Chief Justice, these important themes in Strine’s body of case law will likely take on greater significance.

***

Note: This Blog has previously addressed several of the decisions discussed in this post, including Golden Telecom (August 7, 2013, post); MRI Radiology Assocs. v. Kessler (October 16, 2013, post); and Orchard Enterprises (September 13, 2013, and August 7, 2013, posts).

Trading Price Is Not Indicative of The Fair Value of Stock Subject to Appraisal

Posted in Fair Value, Independent valuation, Stock Market Price

As one Delaware judge put it long ago, the Delaware courts conducting an appraisal proceeding have long ago “rejected placing absolute confidence in the market price for a share of stock.” Kleinwort Benson Ltd. v. Silgan Corp., No. 11107, 1995 Del. Ch. LEXIS 75 (Del. Ch. June 15, 1995) (Chandler, V.C.). For one thing, a publicly traded stock price is solely a measure of the value of a minority position and market price therefore reflects only the value of a single share. Delaware courts thus adjust the market value to compensate for that so-called inherent minority discount.

Furthermore, even if a court wanted to look at a company’s most recent stock price preceding the merger date as a factor in determining enterprise value, that price may already be impacted by short-term news and noise. Indeed, short-term economic and political realities — such as short-term unemployment rates, lending rates and monetary policy — may have an outsized impact on the stock market while having no necessary correlation to the underlying fundamentals of a company or its industry. That markets overreact is implied in the so-called “bounce back” period used to calculate damages under the Private Securities Litigation Reform Act, which determines damages by using the mean trading price during the 90-day period following the dissemination of corrective information rather than the trading price on just the first day.

But even beyond these considerations, the Delaware courts have identified as recently as last week another factor making a public stock price far less reliable in the valuation exercise; namely, the downward pressure a stock price will experience over time as a result of a prolonged sale process. Where a company is on the sales block for an extended time, even the mean stock price measured over a prolonged period of time will not provide the court with sufficient insight into the company’s long-term growth potential to provide a basis for the valuation exercise to be built upon. Thus, evidence that the “stock price may have undervalued the company due to the company’s inability to make acquisitions while it was up for sale” led one court to recently reject the stock’s trading price as an indicator of fair value. Huff Fund Investment Partnership d/b/a Musashi II Ltd. v. CKx, Inc., Case No. 6844-VCG (Nov. 1, 2013).

A stockholder pursuing appraisal rights is entitled to the present value of the long-term going concern value of her stock, often with the expectation that holding onto that stock over the long term is likely to realize more value than what can be achieved in a near-term sale in the existing economic environment. Courts are therefore careful to rise above immediate or even long-term market conditions and are predisposed to give little weight to the stock trading price as a proxy for whatever longer-term value that stock might represent. This is especially so where there is no reliable evidence that the stock trades in an efficient market that would permit a court to even consider whether the stock price is reflective of fair value. Moreover, in any event, Delaware law requires courts to undertake an independent evaluation of the stock’s fair value at the time of a transaction, and courts therefore cannot place too much weight on trading price as a substitute for engaging in their own independent analysis of fair value.

Do Investors Need To Worry About “Synergies” in Appraisal Proceedings?

Posted in Fair Value, Merger Price, Operative Reality, Synergies, Valuation Expert

The purchaser of a company through merger often argues in a subsequent appraisal action that the price paid was too high and that the dissenting shareholder should be paid a lower amount. Tactically, it is important for the purchaser to impress the dissenting shareholder with down-side risk in pursuing the appraisal. The resulting inference of such a position is that the acquirer must have “overpaid” for the asset. To justify such a position, the acquirer may argue that his purchase price included a payment for so-called “synergies” that must be excluded from the going-concern value of the company. However, true “synergies” should be rarely acknowledged and quantified in appraisal proceedings.

The plain language of the appraisal statute sets the stage for the “synergies” argument because it 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.” 8 Del. C.§ 262(h). What exactly does this mean, however? Consider the following hypothetical: Suppose a Company owns vast proven oil reserves, but lacks the capital necessary to drill wells and exploit the oil fields. If the Company markets itself, all potential bidders will bid for the property based upon their expected returns after making the capital investments necessary to exploit the oil reserves. Are these capital investments “synergies” because they constitute value that will be achieved only “through accomplishment of the merger? The answer should be “no.” If the Company sold the oil fields it would obtain offers that reflect the market value of the assets to purchasers who would use them. Shareholders who own the Company should share in the value of those reserves. On the other hand, what if the acquirer is willing to pay more for the Company because it is vertically integrating in an industry and will be able to extract greater value from the assets than would otherwise be possible? In that case, there is no reason to believe that the “synergy” created should be considered part of the going concern value on the date of the merger.

Although the above examples illustrate the complexity of the problem, many appraisal cases involve business opportunities that could have been pursued by the Company but had not yet reached fruition at the time of the merger. To deal with these situations, the Delaware courts have developed the concepts of “undue speculation” and “operative reality”. According to the Delaware Supreme Court in Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del 1983), the intent of the statute is to exclude only “speculative elements of value that may arise from the ‘accomplishment or expectation’ of the merger.” It is a “very narrow exception to the valuation process designed to eliminate use of pro forma data and projections of a speculative nature relating to completion of a merger.” In contrast, the “operative reality” of a company includes all “future prospects” that are ‘known or knowable” at the time of the merger –whether or not they have been achieved. MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290, 315 (Del. Ch. 2006). The value of such “future prospects” rightly belong to the dissenting shareholder who would have presumably shared in their exploitation and realization had he been allowed to continue as a long-term owner in the concern.

In light of these principles, so-called “synergies” should be a narrow, rarely invoked exclusion to going concern value. When the acquirer is an insider or an investment professional, one should be very suspicious about alleged claims of synergies that are only first identified post-closing to downgrade the valuation analysis. Most claims of synergy will likely be nothing more than the financial exploitation of known or knowable prospects — like the oil fields in the example above. In the case of strategic buyers — who are either vertically or horizontally related to the Company — claims of synergy may be real. However, many analysts and lawyers believe that in order for synergy claims to be credible in an appraisal proceeding, they must be opportunities that the Company could never have identified or implemented on its own and should be quantified and disclosed to shareholders before they vote on the merger.

Valuation Basics: Calculating Terminal Value Using the Gordon Growth Model

Posted in Discounted Cash Flow Analysis, Fair Value, Terminal Value, Valuation Expert

In a prior post we mentioned the three basic components of a discounted cash flow (“DCF”) valuation analysis — cash flow projections, a discount rate, and a terminal value — and explained how to calculate one of those components, the discount rate. In this post, we tackle another component, the terminal value.

In a typical DCF analysis, the appraiser will discount to present value the cash flows that the company projects it will receive over a discrete period. Because most companies’ financial projections forecast only a few years into the future, usually five years at most, an appraiser must add a “terminal value” to the projected cash flows in order to value all of the company’s future income beyond the initial near-term projections.

One common method applied by the courts in calculating that terminal value is the Gordon Growth Model. The first step of the Gordon Growth Model is to determine the company’s expected income for the year immediately following the initial discrete projection period. A “perpetuity growth rate” is applied to that projection income to estimate the company’s long-term growth. The perpetuity growth rate is determined based on a number of considerations, such as the company’s historical and expected future performance, the rate of inflation, and other factors. That amount is then capitalized using a capitalization rate that is equal to the discount rate minus the perpetuity growth rate. Thus, if Company A has a cost of capital of 10%, is expected to make $10,000,000 in normalized economic income in the year following its discrete projection period and is expected to grow past the discrete projection period at a rate of 5%, its terminal value would be $210,000,000, calculated as follows:

 

$10,000,000 * (1 + 0.05)

 

=      $210,000,000

0.10 – 0.05

Because the terminal value is calculated as of the end of the discrete projection period, it must be further discounted to present value as of the valuation date.

A common misconception when calculating terminal value is that by applying a “perpetuity growth rate,” the court is assuming that a company will grow into perpetuity. As a practical matter, the perpetuity growth rate merely forecasts the company’s long-term growth, not its literal perpetual growth. When discounted to present value, most of a company’s terminal value is typically realized within the first ten to twenty years following the end of the discrete projection period.

Icahn’s Plan to Exercise Appraisal Rights Still Intact Even After He Abandoned Launching A Competing Offer For Dell

Posted in Fair Value, Merger Price, No Proof of Wrongdoing Needed

As discussed in our very first post, back in July of this year Carl Icahn famously encouraged his fellow shareholders in Dell Inc. to exercise their appraisal rights rather than cash out and accept the offer on the table from Michael Dell in his bid to take his namesake company private. This week, on September 9, 2013, Mr. Icahn sent another letter to Dell stockholders, announcing his decision not to defeat Mr. Dell’s take-private proposal after acknowledging that too many obstacles to his counter-proposal stood in his path.

Importantly, however, despite Icahn’s throwing in the towel on any competing proposal to Michael Dell’s, he repeated his opposition to that offer and trumpeted once again his intention to seek appraisal rights for his shares in the company. This is especially significant because Icahn had brought a lawsuit in Delaware Chancery Court claiming that the Dell directors breached their fiduciary duties in renegotiating the buyout deal with Michael Dell and undertaking other actions such as adjusting the record date for determining which shareholders were eligible to vote. In rejecting Icahn’s initial challenges, the Delaware Chancellor validated the board’s procedures and indicated skepticism over any breach of fiduciary duty claims. And yet Icahn — quite correctly — still remains undaunted in pursing his appraisal rights, knowing full well that the apparent lack of a breach of fiduciary duty in no way suggests that the merger price is inherently fair. After all, fiduciary duty and appraisal rights are two totally different animals.

In short, the issue at stake in an appraisal proceeding is not whether the board acted improperly but whether the merger consideration short-changes shareholders by giving them less than the fair value of their shares. Icahn clearly continues to believe that the company is worth more than the deal price suggests, and the Delaware Court’s statements to date about the deal process says nothing about the shares’ true value.