Direct Capitalization of Cash Flows

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.

We have previously posted on the Chancery decision here, and have posted on the Supreme Court oral argument here.

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.

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 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.