The Delaware Supreme Court made its ruling this week in the ISN Software appraisal case. A three-judge panel (not the full bench) affirmed the Chancery Court’s decision awarding a premium that was more than 2.5 times the merger price, as reported in Law360 [$$]. The Supreme Court affirmed without rendering its own opinion, relying instead on the trial court’s reasoning. ISN Software was a privately held software company, with the appraisal case stemming from the controlling stockholder’s cash-out of some of the minority shares.
As reported in Law360 [$$], on October 11, 2017 the Delaware Supreme Court heard argument appealing the Chancery Court’s ruling in the ISN Software appraisal case. We have previously posted on the trial court’s decision here, in which Vice Chancellor Glasscock awarded a premium to the merger price. The Supreme Court did not rule and did not indicate when it would do so. You can see the complete oral argument here (under the October 11, 2017, listing; ISN Software v. Ad-Venture Capital). Unlike the Dell and DFC Global arguments, the Supreme Court did not convene en banc – that is, with a full five-justice proceeding – and instead conducted argument by a three-justice panel, which did not include the Chief Justice.
We will continue to monitor the docket and post when the ruling is issued.
Further to our prior post about Delaware’s two new appraisal decisions, SWS Group was a small, struggling bank holding company that merged on January 1, 2015 into one of its own substantial creditors, Hilltop Holdings. Stockholders of SWS received a mix of cash and Hilltop stock worth $6.92 at closing. Vice Chancellor Glasscock rejected the sale price as an unreliable indicator of fair value and performed his own DCF analysis, setting the fair value at $6.38, a price 7.8% below the merger price.
At trial, the petitioners persuaded the court that its critiques of the sale process were valid. However, the stockholders failed to persuade the court that SWS was on the verge of a turnaround, as the court instead determined that SWS consistently underperformed management projections and, given its structural problems, a turnaround was simply unlikely.
Problems with SWS’s Projections and Performance
As was true in PetSmart, SWS had not historically performed long-term projections, but only created annual budgets that aggregated projections from individual business sectors. Those single-year projections were then extrapolated into three-year “strategic plans” that assumed the annual budgets would be met. The court found, however, that SWS never met those budgets between 2011 and 2014. Also, despite straight-line growth assumptions in the management forecasts, SWS failed to hit its targets and continued to lose money on declining revenues. The various problems facing the company led the court to embrace the respondents’ theory that SWS would continue to face an uphill climb given its relatively small size, which prevented it from scaling its substantial regulatory, technological, and back-office costs.
Hilltop’s Influence on the Sale Process Rendered Merger Price Unreliable
Even before SWS launched its sale process, Hilltop was interested in buying the company (unbeknownst to SWS). Also, since Hilltop had observer status on SWS’s board, it had unique access to SWS’s board meetings and management not available to others. The court found that Hilltop’s acquisition theses were driven by synergies, as it viewed its acquisition of SWS as resulting mainly in cost savings by reduction of overhead. A Special Committee was formed after Hilltop made its initial offer in January 2014, and the court found that even though the committee engaged legal and financial advisors, the management projections that evolved in the sale process were still overly optimistic and unrealistic about SWS’s projected growth. Only two other bidders emerged, one of which was found not to be credible and the other continued to bid through March 2014 despite apparent pressure by Hilltop to proceed with its deal. Finally, in response to Hilltop’s unilateral March 31, 2014 deadline, the board decided to accept its offer, which at that time was valued at $7.75, consisting of 75% Hilltop stock and 25% cash. As of closing on January 1, 2015, the value dropped to $6.92 per share based on a reduction in Hilltop’s own stock price.
Another factor making the deal price unreliable was that Hilltop was a creditor of SWS pursuant to a Credit Agreement. That agreement contained a covenant prohibiting SWS from undergoing a “Fundamental Change,” which was defined to include the sale of SWS. The agreement thus conferred upon Hilltop a veto right over any competing offers, which right Hilltop refused to waive during the sale process.
Valuation Model & DCF Inputs
The court undertook its own DCF analysis, on which it relied exclusively. The court refused to put any weight on petitioners’ comparable companies analysis, finding that the comp set diverged too much from SWS in terms of size, business lines, and performance to be meaningful. The court held that SWS’s unique structure, size, and business model – particularly its composition of a broker-dealer business alongside its banking line – rendered the stockholders’ selected peers not truly comparable.
In performing its DCF valuation, the court used the existing three-year projection period in the management projections, rejecting the stockholders’ argument that SWS had not yet reached a “steady state” and that an additional two years was needed to normalize SWS’s financial performance. The court found that SWS’s declining revenues in the period leading up to the merger deprived it of any basis to assume (unprecedented) straight-line growth beyond the existing three-year projection period. In addition, the court found that the exercise of warrants three months prior to the merger pursuant to the Credit Agreement, which resulted in a change to SWS’s capital structure by cancelling debt in exchange for new shares, was part of SWS’s “operative reality” for purposes of the fair-value determination. This ruling differed from other cases, such as BMC Software and Gearreald, where changes to the company’s balance sheet resulting from actions by the company solely in expectation of the merger – like the company paying off its debt – was not considered to be within the company’s operative reality.
As to the other DCF inputs, the court adopted the respondents’ perpetuity growth rate of 3.35%, which was the midpoint between the long-term inflation rate of 2.3%, and the long-term economic growth rate of 4.4%. In selecting the appropriate equity risk premium, the court observed that whether to use supply-side or historical ERP should be determined on a case-by-case basis. Nevertheless, it found supply-side ERP appropriate as the “default” method in recent Delaware chancery cases, unless a party provided a compelling reason to use historical ERP. With regard to beta, the court found fault with both side’s approach. The respondents’ expert looked at two years of SWS weekly stock returns, which measurement period included a “merger froth” and too much volatility to be reliable. The petitioners’ expert, in contrast, surveyed multiple betas and used a blended median; even though the court found that this approach relied on comparable companies that were not truly comparable, it nevertheless adopted this beta – despite its apparent drawbacks – as the one more closely in line with the record evidence. Finally, to determine size premium, the court took the midpoint of both side’s decile (which was 3.46%), finding that using market capitalization is generally appropriate for public companies (the respondents’ approach), and yet SWS’s capital structure, including its substantial in-the-money warrants and the outsized influence of its major creditor, made it more like a private company and not susceptible to a market cap approach (the petitioners’ argument).
In reaching its final determination of $6.38, the court said that a sub-merger price award was not surprising here given the synergistic nature of the transaction. Also, given the award of statutory interest, which runs from the January 1, 2015 consummation date, it appears that the petitioners will ultimately recover more than the merger price after all.
Delaware Chancery has again awarded appraisal petitioners a significant bump above the merger price. In the ISN Software Corp. Appraisal Litigation, Vice Chancellor Glasscock was facing widely divergent valuation from the opposing experts, and relied exclusively on a discounted cash flow analysis as the most reliable indicator of fair value. The court’s per-share valuation award was more than 2.5 times the merger price.
ISN involved the valuation of a privately held software company founded in 2000 and specializing in assisting companies (largely in the oil and gas industry) to meet their governmental record keeping and compliance requirements. In the years leading up to the merger — which was completed on January 9, 2013, with the approval of ISN’s founder and majority shareholder — the company had experienced consistent and substantial growth. In setting the merger price, however, ISN did not engage a financial advisor or obtain a fairness opinion; rather, the company used a 2011 third-party valuation that ISN’s founder apparently adjusted based on his personal views of the company’s future prospects.
Particularly striking in this case was the sheer magnitude of the difference between the dissenters’ and ISN’s valuations, each of which was based largely on a DCF analysis with some weight given to other methodologies such as guideline public companies, comparable transactions, and direct capitalization of cash flow. The court found those other methodologies unreliable here. The petitioners’ valuation at $820 million was over eight times that of ISN’s valuation of $106 million (which was below the merger price’s implicit valuation of $137 million). The Court expressed some of the same skepticism that Delaware chancellors have historically shared regarding the reliability of competing experts in an adversarial litigation environment: “an optimist (a.k.a. someone other than a judge presiding in appraisal trials) might assume that experts hired to examine the same company, analyzing the same set of financial data, would reach similar results of present value based on discounted cash flow. . . . In a competition of experts to see which can generate the greatest judicial skepticism regarding valuation, however, this case, so far, takes the prize: one of the Petitioners’ experts opines that fair value is greater than eight times that implied by the DCF provided by the Respondent’s expert. Given such a divergence, the best scenario is that one expert, at the least, is wildly mistaken.”
The court performed its own independent DCF analysis using the ISN expert’s DCF model as a baseline with various adjustments. One difficulty in doing the DCF valuation was that the company did not regularly create long-term financial projections, requiring the experts to project future cash flows using various assumptions regarding growth and efficiency. Even though the court found that approach “inherently less reliable than using long-term management projections,” it found the expert projections reliable given ISN’s subscription-based business model, customer retention, and the inelastic demand for its product. Finding that “projections out more than a few years owe more to hope than reason,” the court found a standard five-year projection period appropriate.
The court awarded statutory interest and rejected ISN’s argument that “good cause” existed to deny at least one of the petitioners any interest. Finally, even though the court set forth in detail all the various adjustments it made to the ISN expert’s DCF model, he invited the parties to revisit the math, as “relying on the mathematical skill of this superannuated history major—even as assisted by an able judicial clerk—would be hubristic.”
On July 8, the Delaware Court of Chancery issued its opinion in In re Appraisal of DFC Global Corp. A financial buyer, Lone Star Fund VIII, acquired DFC Corporation in June 2014 for $9.50 per share in an all-cash deal. Using a combination of a discounted cash flow analysis, comparable companies analysis, and the merger price, Chancellor Bouchard determined the fair value of DFC as a stand-alone entity at the time of closing to be $10.21 per share, or 7% above deal price, before adding statutory interest.
While observing “merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value,” the Court also cautioned that merger price “is reliable only when the market conditions leading to the transaction are conducive to achieving a fair price.” Concluding that deference to merger price would be improper, the Court highlighted that “[t]he transaction here was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty” arising from possible regulatory changes affecting payday lenders, such as DFC, in the countries in which they operate. These potential regulatory changes could have had the negative effect of rendering DFC’s business not viable or the positive effect of reducing DFC’s competition in certain markets. As a result of this uncertainty, DFC repeatedly lowered guidance throughout the sales process and potential bidders were deterred. Indeed, Lone Star itself cited the uncertainty surrounding DFC as a reason it perceived value in acquiring the DFC. Because of these regulatory uncertainties and their impact on management’s forecasts, the Court gave equal weight to its DCF analysis, the comparable companies analysis, and the merger price.
The Court’s opinion is also notable for its extensive discussion of the relevant beta to apply. Specifically, the Court declined to rely upon Barra beta, a proprietary model designed to measure a firm’s sensitivity to changes in the industry or the market. While not rejecting the use of Barra beta wholesale, the Court reiterated that in order to rely upon it, the expert applying the model must be able to re-create its findings and explain its predictive effectiveness, something DFC’s expert was found unable to do. The Court also reiterated its preference for a beta that applies a measurement period of five years rather than two years unless “a fundamental change in business operations occurs.”
Finally, the Court rejected Petitioners’ expert’s use of a 3-stage DCF model. As the Court recognized, “that the growth rate drops off somewhat sharply from the projection period to the terminal period is not ideal but not necessarily problematic.” The Court was particularly reluctant to perform a 3-stage DCF that extrapolated from forecasts it found to be flawed given the regulatory uncertainty. Accordingly, the Court performed a 2-stage DCF, the analysis of which is regularly cited in Owen v. Cannon, a case on which we’ve blogged on previously.
Ultimately, dissenters are receiving $10.21 per share, along with interest accruing from the June 13, 2014, closing at the statutory rate of 5% over the Federal Reserve discount rate, compounded quarterly. A back-of-the-envelope calculation suggests that, as of this posting, the appraisal award thus rises to approximately $11.50 total, or approximately 21% over the merger price, once interest is factored in.
A widely followed corner of the blog is our “Valuation Basics” series, where in earlier posts we have described many of the components of the discounted cash flow analysis, the income-based valuation methodology preferred by Delaware’s Court of Chancery. (See here, here, and here). Earlier this month we examined a market-based valuation approach — the comparable companies analysis — that derives the subject company’s value based on the share price of analogous publicly traded companies. Working knowledge of these and other valuation methodologies is essential for both appraisal professionals and professional investors, since as the Court of Chancery recently described in Merlin Partners LP v. AutoInfo, Inc., enterprise value can and will be determined in an appraisal proceeding a variety of ways, “depending on the case.” Readers of our “Valuation Basics” series should check back in for the next post in that series, which will examine another market-based approach to valuation, the precedent transactions analysis.
Our “Valuation Basics” series has focused on the various components of a discounted cash flow analysis under the income approach, which seeks to value a company based on the present value of its projected cash flows. This post and those to follow in this series will now move away from the income approach and instead examine two “market” approaches: (1) the comparable companies method; and (2) the precedent transactions method. Under these approaches, we look at how the market values similar companies in order to determine the value of the subject company.
The purpose of a comparable companies analysis is to derive a value for the subject company based on the stock price of similar publicly traded companies. Accordingly, the first order of business is to select publicly traded companies that are “comparable” to the subject company. No two companies are truly identical, so an appraiser must use her judgment to select companies that have sufficiently similar characteristics to the subject company from which meaningful valuation data can be extracted. The more similar the selected companies are to the subject company, the more weight the court is likely to place on a comparable companies valuation.
After selecting the applicable comparable companies, valuation multiples are derived for each of the comparable companies by dividing their respective enterprise values (“EV”) by appropriate financial metrics, such as revenue or EBITDA. The comparable companies’ stock price on the valuation date is used to calculate their enterprise value. So, for example, assume that Comparable Company A has a stock price on the valuation date that yields an enterprise value of $2 billion. Assume further that Comparable Company A has reported revenue for the last twelve months (“LTM”) of $500 million. Comparable Company A’s LTM EV/revenue multiple would be 4.0.
Next, the valuation multiples of the comparable companies should be adjusted to account for differences between the comparable companies and the subject company. For example, if the comparable companies have a large amount of outstanding debt but the subject company is debt free, the valuation expert might adjust the valuation multiples to account for the subject company’s more attractive balance sheet. In our example, if the median LTM EV/revenue multiple of Comparable Companies A, B, C, and D is 3.8, the appraiser might select an LTM EV/revenue multiple of 4.0 to apply to the subject company if there are factors warranting an upward adjustment based on the subject company’s superior performance.
Once the appraiser has determined the correct valuation multiples, those multiples can be applied to the relevant financial metrics of the subject company to calculate the market value of invested capital of the subject company. Using our example above, if the subject company had reported revenue of $750 million for the previous year, its market value of invested capital based on the LTM EV/revenue multiple of 4.0 would be $3 billion. To derive the equity value of the subject company, the subject company’s interest-bearing debt should be subtracted.
Appraisal experts typically adjust a comparable companies valuation to account for the inherent minority trading discount reflected in the valuation multiples. The stock price that is used to derive a comparable company’s enterprise value is based on transactions involving non-controlling ownership interests traded on the stock market. Accordingly, the Delaware Court of Chancery has allowed appraisers to correct for this lack-of-control discount by adding a premium to the equity value derived from a comparable companies analysis. While there is no set premium, the Delaware Court of Chancery has accepted as appropriate a premium of 30%.
In recent years, the Delaware Court of Chancery has become more exacting in its acceptance of comparable companies valuations in appraisal cases. In cases where the court has rejected a comparable companies valuation proffered by a party’s expert, the court has often expressed its concern with the numerous subjective judgment calls made by the valuation expert in arriving at his comparable companies valuation. Why did the expert choose some companies as comps but not others? Why did the expert use certain multiples and not others? Why did the expert adjust the selected multiple upward or downward rather than simply apply the mean or median multiple? To address these concerns, valuation experts in appraisal cases should carefully describe in their expert reports not only the subjective judgment calls they made in conducting their comparable companies analysis, but also their principled basis for doing so.
In our next post in the Valuation Basics series, we will explain how the comparable transactions analysis differs from the comparable companies approach.