We posted last month about the Delaware Chancery Court’s ruling in Ancestry.com, in which it upheld the growing practice of appraisal arbitrage. The Chancery Court has now rendered its valuation decision in that case, finding the merger price itself to be the most fair measure of stockholder value on a going concern basis. As Reuters has reported, the court also declined to find fair value below the deal price. To the extent that the court relied on merger price for its valuation, it is reminiscent of the same judge’s decision in the CKx case, which is currently scheduled for en banc review next week in the Delaware Supreme Court (as we have previously posted). But unlike the court’s approach in CKx, in Ancestry.com the court undertook a DCF analysis based on the parties’ competing valuations. The court’s own DCF analysis yielded a value 21 cents short of the $32 merger price, but given its uncertainty over the projections, the court said it was uncomfortable insisting that a buyer who actually put its own money at risk nevertheless overpaid. The court refused to second-guess the market price, especially given what it found to be a robust sales process.
The court expressed skepticism over the reliability of any after-the-fact valuation analyses, suggesting that valuation experts are more in the business of reverse engineering to arrive at their pre-selected values than in presenting the court with truly objective values. To underscore the point, the court cited one side’s expert who saw it as his job to “torture the numbers until they confess[ed].” The other side’s expert likewise suggested that if he had reached a valuation that widely departed from the merger price, he would have had to find a way to reconcile those numbers, or, as the court put it, he would have “tailored his analysis to fit the merger price.” One option the court did not address is having the court itself engage a non-party independent valuation expert to report its own analysis directly to the court, which the Chancery Court has done in the past.
With respect to the particular DCF issues the court addressed, the court focused on certain components in the calculation of terminal value that have not traditionally been addressed in court opinions, including how to determine the “plowback” ratio — the percentage of future profits that the company would have to “plowback” into capital expenditures to remain competitive over the long term — and whether to “normalize” EBIT margin. Both of these adjustments can temper the valuation-enhancing effect of a high terminal growth rate. Another interesting issue raised by this case is whether and, how to account for stock-based compensation (SBC) in a DCF, which is especially significant for Internet-based companies in particular, as they tend to have large SBC components to their employee compensation programs. Here, the court concluded that SBC had to be taken into account, and it did so in a way that reduced its valuation.
Finally, the court lamented that appraisal actions are unique in that each party bears the burden of proof, such that if neither party meets its burden, the burden instead falls on the court. But this observation effectively repeats the long-standing principle that courts in appraisal cases are required to perform an independent analysis. In that regard, it will be interesting to see how the Supreme Court reacts next week to this judge’s prior opinion in CKx and whether the court sufficiently discharged its duty to perform an independent valuation when it deferred to the merger price as the only reliable indicator of value after having rejected the valuation methods proposed by the parties, unlike its approach in Ancestry.com.