October 2013

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.

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.