The Delaware Chancery Court’s recent opinion in Owen v. Cannon has garnered little notice or press coverage, but deserves attention not only because the hybrid fiduciary duty-appraisal decision is Chancellor Bouchard’s first foray into the appraisal space, but because it reinforces some basic appraisal tenets and yet also bucks what some have called a recent trend of merger price rulings.
The transaction arose from the interactions of the company’s three main principals: Nate Owen, the founder and president of the firm at the center of the lawsuit, Energy Services Group; his brother Bryn, who worked at ESG directly under Nate; and Lynn Cannon, who put up the capital for the Company. Bryn and Cannon eventually forced Nate out of his job as president (with Cannon being his replacement), and cashed out in a short-form merger Nate’s significant minority stake in ESG for just under $20/share. After applying a discounted cash flow analysis, and no other valuation methods, Chancellor Bouchard awarded Nate approximately $42 million for his 1.32 million shares of ESG, or just under $32/share. The Chancellor’s $12/share premium is a departure from a recent slate of appraisal actions, including Ramtron and Ancestry.com, in which the Court of Chancery has rejected income- or market-based valuation methodologies while looking simply to the merger price as fair value.
In his lengthy opinion, Chancellor Bouchard reaffirms a number of bedrock principles of the appraisal analysis:
- The primacy of the DCF. According to Chancellor Bouchard, the discounted cash flow valuation methodology is the preferred manner in which to determine fair value because “it is the [valuation] approach that merits the greatest confidence within the financial community.” Chancellor Bouchard’s view on the use of transaction price as proof of fair value was not tested in Owen, as both valuation experts in the case used a DCF exclusively and the Chancellor thus had no occasion to opine on the merits of merger price or any other metric to determine fair value.
- Reliable management projections can be dispositive. Of course, a DCF is only as good as its inputs. Much of the Chancellor’s exhaustive 80-page opinion was dedicated to whether or not he could rely on management projections created by Cannon in 2013 in connection with Nate’s buy-out. Chancellor Bouchard determined that he could, in large part because Cannon created the projections when he was already trying to force Nate out of the company (meaning that the projections already had conservative assumptions baked in), and ESG submitted the projections to Citizens Bank to obtain a $25 million revolver (meaning that it would be a federal crime if the projections were false). In contrast, the Chancellor applied well-settled Delaware law in rejecting defendants’ expert’s post hoc, litigation-driven projections in their entirety.
- Tax treatment can mean real money. ESG was a subchapter S corporation, meaning that (unlike in a subchapter C corporation) ESG’s income was only taxed once, at the stockholder’s income rate. Because Delaware law requires a shareholder in an appraisal to be paid “for that which has been taken from him,” and a “critical component” of what was taken from Nate was the “tax advantage” of owning shares in a subchapter S corporation, Chancellor Bouchard adopted Nate’s argument that the Court’s DCF should be tax affected to take into account ESG’s subchapter S status. Under the hypothetical posed by the Chancellor in Owen, S Corp tax treatment means a nearly $14 boon to an investor for every $100 of income.
- Absent identifiable risk of insolvency, inflation is the floor for a terminal growth rate, with a premium to inflation being appropriate for profitable companies. The DCF’s terminal growth rate — which is intended to capture a firm’s future growth rate while still recognizing that firms cannot over time grow materially in excess of the economy’s real growth — is a critical DCF input. (We described one way to calculate terminal growth here, in an earlier post in our “Valuation Basics Series”). Applying Delaware precedent, Chancellor Bouchard determined that it was appropriate to set the terminal growth rate at 3%, a “modest” 100 basis points premium over the Fed’s projected 2% inflation rate. According to the Chancellor (quoting a 2010 Delaware Supreme Court decision), “the rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.” Chancellor Bouchard, however, rejected Nate’s suggested 5% terminal growth rate (above nominal GDP growth) as too high for ESG, a company facing increasing competitive pressures whose years of rapid growth may have been behind it.
The Chancellor also found breaches of fiduciary duties, generally agreeing that, by Nate’s description, the merger was conducted in a “boom, done, Blitzkrieg style,” with Nate having been given notice (by sheriff’s service) on Friday, May 3, 2013 of a Monday, May 6, 2013 special meeting of shareholders to vote on the merger. This was especially egregious as ESG had never before held a formal board meeting until Cannon and Bryn orchestrated two such last-minute meetings, the first one being to terminate Nate’s employment with ESG (which meeting Nate found out about while tending to a health issue for his wife). The May 6 meeting was conducted despite Nate’s request for an adjournment, and the meeting was overseen by an armed guard who stood “at the door with a gun at his hip.” Nevertheless, the damages award for the fiduciary duty claims equaled those decided by Chancellor Bouchard’s appraisal ruling.