Discounted Cash Flow Analysis

We’ve posted before about the DFC Global decision, in which Chancellor Bouchard awarded a 7% premium over merger price, and then further increased that uplift by 9 cents in a ruling on reconsideration.  That ruling is now on appeal to the Delaware Supreme Court, and the appellant’s brief was submitted last week.

As reported in Law360, DFC Global has argued to the Supreme Court that the lower court’s decision “undermines confidence in Delaware appraisal actions.”  The Delaware Supreme Court has not heard an appraisal case since its February 2015 ruling in CKx; their ruling in this case will be closely watched.

Today Vice Chancellor Laster issued a new appraisal ruling, Merion Capital LP v Lender Processing Services, pegging the appraised fair value to the merger price.

The court found no reason to depart from merger price given the apparently reliable sale process and reliable projections.  The court performed its own DCF valuation, which came out 4% above the merger price.  Vice Chancellor Laster found that his own valuation’s proximity to merger price gave him comfort as to the reliability of merger price and thus chose not to vary from it in determining fair value.

The court rejected the respondent’s synergies argument — intended to set fair value below the merger price — for being raised too late and unsupported by any evidence.  The decision also includes a thorough and instructive survey of recent appraisal case law.

In Farmers & Merchants Bancorp, an appraisal case involving a small closely-held community bank that was sold in a stock-for-stock deal valued at $83 per share, Chancellor Bouchard disregarded merger price, as well as the “wildly divergent valuations” of both sides’ experts.  He arrived at an independent valuation of $91.90 per share based on his own discounted net income analysis (which is similar to a discounted cash flow but does not adjust net income for non-cash income and expenses and does not consider cash outflows for capital goods).

The court rejected the merger price as a reliable indicator of fair value because the merger was not the product of an auction and was not conditioned on obtaining the approval of a majority of the minority shareholders.  Rather, the sale was driven by the same family that controlled both the target and the acquiror; even though the target formed a special committee to negotiate on behalf of the minority stockholders, the court was not confident that the negotiations were truly arms-length.

Likewise, the court rejected the comparable transaction analysis that the petitioner’s expert put forth.  The petitioner’s expert calculated the median P/E ratio from the eight most comparable companies out of a pool of 160 community bank acquisitions that had taken place over the prior two years.  The court found that the eight selected banks were good comparables but rejected the analysis because the expert failed to adjust for synergies that were potentially incorporated into the merger price of those banks, despite strong evidence from several witnesses that community bank mergers typically do include synergies.  As to the respondent’s expert, the court rejected its comparable transaction multiples because the choice of selected comparables was suspect – it excluded 15 regional banks that would have raised the average P/E ratio significantly – and found that its guideline public company valuation was unreliable since most community banks were not publicly traded, and even the publicly traded shares were less liquid than non-community banks.

In light of these facts, the court gave no weight to the merger price or either expert’s analysis, relying entirely on its own discounted net income analysis, which projected a stream of income using a single year of earnings and applied a long-term growth rate, while using a discount rate calculated under CAPM.  In determining the equity risk premium, the court chose the long-term supply-side as opposed to the historical premium, citing then-Vice Chancellor Strine’s ruling in Golden Telecom that the professional and academic valuation literature favored that approach.

Finally, the court adopted the respondent expert’s 3.0% terminal growth rate over the 4.375% rate suggested by the petitioner.  Citing Owen v. Cannon, the court recognized that Delaware precedent favored a perpetuity growth rate that is a premium, such as 100 basis points, over inflation.  The court also found that the 3.0% rate was consistent with the annual growth rate projected in the target’s strategic plan, which reflected its limited growth potential in a county with a declining population and stagnant economy.  That rate likewise comported with the perpetual growth rates used to value mature companies in several recent cases.

It remains to be seen how much precedential value a decision like this will have on the public M&A that is more commonly the subject of Delaware appraisals, but once again the court has rejected merger price and undertaken a truly independent valuation.

In response to the article on appraisal arbitrage by Gaurav Jetley and Xinyu Ji of the Analysis Group, about which we’ve posted before, Villanova Law Professor Richard A. Booth now argues in  The Real Problem With Appraisal Arbitrage [via Social Science Research Network] that Jetley and Ji’s charge against the Delaware courts for overly indulging appraisal arbitrage is misdirected.  According to Professor Booth, while Jetley and Ji believe that the Delaware courts incentivize arbitrageurs by using a discount rate lower than the rate typically applied by investment bankers, Professor Booth argues that the bigger and more significant problem is that the Delaware courts additionally reduce the discount rate in the terminal period.  Nevertheless, after identifying what he believes is the Delaware courts’ truly faulty practice, Professor Booth offers up a full-throated defense of the appraisal remedy in general and arbitrage in particular.

Some Highlights of the Article

  • Professor Booth believes that Jetley and Ji’s criticism of the Delaware courts’ use of the so-called supply-side discount rate, rather than the historical rate of return, is overblown.  He agrees that the supply-side rate can inflate a valuation, but not by as great a magnitude as Jetley and Ji seem to believe.
  • In rebutting the argument that so-called arbs “are not themselves long-term common stock investors and should not be so compensated for the time value of their money,” he observes that “they have bought the stock they hold from legacy investors and thus should be entitled to the same package of rights enjoyed by such investors.”  If arbs’ rights were to be curtailed, that would cause stockholders who choose to sell out suffering an even bigger discount, which in turn would raise the price of deals for acquirors, because target stockholders “will be less confident that they will be paid based on the agreed amount when they want to be paid.”  In this respect, arbitrage actually serves the acquirors well.
  • Professor Booth critiques the presumption of fairness that some Delaware cases have accorded to the deal price:
    • First, the deal price may often be too low, as deal price sometimes depends on the percentage of shares bought.  Thus, dissenting stockholders may well be entitled to “higher and higher prices as the public float gets smaller and smaller,” which he finds consistent with the policy objective underlying appraisal: to compensate stockholders for being forced to sell out at a time and/or price not of their own choosing.
    • Second, Professor Booth cautions against according too much weight to the premium paid over market price, as a depressed stock price will naturally warrant a higher premium; in that case the premium is simply “compensation for a discount built into the market price.”
    • Finally, it is inherent in the concept of nearly any acquisition that a buyer is only willing to pay some lesser price than full fair value, in order to extract the expected value to be gained by redeploying the target company to its highest and best use; to that extent, he suggests, “deal price should always be a bit lower than going concern value [emphasis added],” prompting stockholders to hold out.
  • Given these factors, he finds that appraisal performs the valuable function of testing deal price against investor expectation based on CAPM.  He believes that appraisal thus helps drive price toward fairness, as a robust appraisal remedy will induce bidders to pay a fair price up front.  His critique of the court’s further reduction of the discount rate in the terminal period is intended to improve the appraisal process, not undermine it; he encourages the courts to embrace his reforms rather than “hide behind the aw-shucks notion that law-trained judges are ill-suited to address” questions of valuation, finance, and investment banking.

In summary, the author concludes that appraisal arbitrage has gotten a “bad rap” and that appraisal itself works best if arbitrage is made possible; he fears that absent arbitrage, buyers may rely on the hope that potential dissenters will simply decline to exercise any appraisal rights, allowing the bidder to get away with paying a reduced price.

In a new ruling in the DFC Global appraisal case, about which we’ve posted before, Chancellor Bouchard has now reconsidered his prior award of 7% over the merger price and increased his prior award by an extra 9 cents per share, translating to an additional $12 million in value above his prior ruling.

Both sides had asked the court to reconsider different aspects of its ruling, prompting the Chancellor raise the perpetuity growth rate in his DCF model from 3.1% to 4.0%.  In reconsidering his ruling, the Chancellor held that he “failed to appreciate the extent to which DFC Global’s projected revenue and working capital need have a codependent relationship,” and that the high-level requirement for working capital necessarily corresponds to a high projected growth rate.  In so ruling, the court had to overcome its initial theory that a company’s perpetual growth rate should never exceed the risk-free rate.  The court came to realize that this proposition would be true only for companies that have reached a stable stage of development; where a company is expected to achieve fast-paced growth throughout the projection period, the court now agreed that the perpetuity growth rate should indeed be higher than the risk-free rate.

The court’s initial opinion rejected the stockholders’ use of a three-stage DCF model in favor of a two-stage model, but on reconsideration the court recognized that using the two-stage model required increasing the terminal growth rate to sufficiently take into account the company’s growth rate beyond the five-year projection period.

Finally, the court’s new ruling also unwound two adjustments to the company’s baseline projections that the court had inadvertently made in accepting the company’s DCF model wholesale.

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 applySpecifically, 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.

Vice Chancellor Glasscock issued his valuation decision this week in the BMC Software case, which we have previously blogged about concerning its threshold ruling rejecting any share-tracing requirements and thus allowing appraisal arbitrageurs to proceed with a valuation case. As we have previously reported, Merion Capital was seeking a 45% premium to the merger price, while BMC Software argued that the fair value was actually far below the merger price.

Merger Price Reflected Fair Value in This Deal

In rendering his decision, the Vice Chancellor once again looked to merger price as a measure of fair value, as he did in the Ancestry.com decision. Perhaps most interesting was his discussion of synergies toward the end of the opinion, in which he hypothesized that if Company B, holding a patent on the bow, found it advantageous to acquire Company A, a manufacturer of arrows, “synergies could result from the combination that would not have composed part of the going concern or the market value of Company A, pre-merger,” in which case Company B might value Company A more highly than the market ordinarily would. In this situation the court would be required to deduct any such synergistic value from the merger price. However, in this particular case, the acquisition was not strategic but financial, and while Respondent pointed to tax savings and other cost savings that it claims it would have realized as a private entity, the court refused to discount the merger price for any synergies.

The court further noted that receiving fair value is not necessarily the same as going concern value, and that any tax or other take-private savings may not be subject to exclusion from the awarded price as synergistic, but those savings could indeed be excludable from the going-concern value. The evidence in this case did not demonstrate any specific dollar-per-share value attributable to such savings, so the court refused to so discount the merger price. In a footnote, Vice Chancellor Glasscock said that the requirement to reduce from fair value any “non-speculative increases in value requiring a change in corporate form” was an “artifact of the policy decision to engraft ‘going concern’ valuation onto the explicit language of the appraisal statute itself,” citing Union Illinois.

The court also rejected Respondent’s request to deduct synergies based on take-private cost savings because they required a 23% internal rate of return in their business model to justify the acquisition, which raised the question of “whether the synergies present in a going-private sale represent a true premium to the alternatives of selling to a public company or remaining independent.” Thus, it was unclear whether any alleged going-private savings outweighed the buyer’s rate of return that was required “to justify the leverage presumably used to generate those savings.”

The Court’s DCF Exceeded Merger Price

The parties relied exclusively on their own DCF models, finding a comparable companies or precedent transactions analysis unreliable. Likewise, the court did its own DCF analysis and came up with a $48 per share price, exceeding the $46.25 merger price that it ultimately found to be fair value. The Vice Chancellor said that he was reluctant to use his own valuation and instead deferred to merger price, given the optimism inherent in the management projections; the raging debate within the academic community over the proper equity-risk premium to apply (thus undermining the reliability of his discount rate); and the difficulties in predicting the accurate terminal growth rate, which could be anywhere in between the floor of inflation and GDP (here, the court had picked the midpoint of those two measures in setting its own terminal rate). In this respect, the court’s DCF valuation, which exceeded merger price, was different from that in Ancestry.com, where the court’s own DCF came up just short of the merger price.

Sale Process

In examining the merger process itself, the court found the process to be robust insofar as there were two auctions conducted for several months each, and there were a total of five financial sponsors and eight strategic entities considering the acquisition. There was a go-shop clause, as a result of which the company contacted sixteen bidders — seven financial and nine strategic — which resulted in no alternative offers. And finally, in an arguable blurring of the line between fiduciary duty actions and appraisal rights (a subject on which we’ve posted several times before), the court explicitly looked to the settlement of the class action fiduciary duty litigation as an indication that the process was found to be free of any irregularities or fiduciary duty violations. In particular, the court found significant that the company’s activist investor, Elliot Associates, who had pressured the company to sell, was also forced to conclude that the auction itself was “a fair process.”

Other DCF Valuation Metrics

As to some of the basic valuation metrics (which were used to calculate the court’s own DCF that it ultimately refused to utilize in favor of the merger price):

  • The court adopted a supply-side equity risk premium, finding that it had already been done in Golden Telecom and Orchard Enterprises and is thus indicative of the “Court’s practice of the recent past.” The court found a preference for using forward-looking data as opposed to the historical or the supply-side approach, notwithstanding the continuing debate within academe concerning the more reliable method.
  • The court reaffirmed that inflation is generally the floor for a terminal value, and here, since there was no evidence to suggest that the growth rate should be limited to inflation, the court ultimately chose a growth rate at the midpoint of inflation and GDP, which was 3.25%.
  • The court found it appropriate to include a reasonable offset for the tax associated with repatriating offshore cash, rejecting Petitioner’s argument that the company’s plan to keep that money offshore indefinitely should translate to no offset at all. We have seen this same point argued (and now pending before the court) in the Dell appraisal case as well.
  • As is true of many tech companies, BMC had a sizable stock-based compensation (SBC) policy, which the court found was required to be accounted for, and further found reasonable to treat as an expense, particularly because this practice was expected to continue into the future. The court thus agreed with Respondent’s expert, who treated SBC as a cash expense, as opposed to Petitioner’s expert, who didn’t account for future SBC at all.

While the court seemed to take a jab at Petitioner for being “arbitrageurs who bought, not into an ongoing concern, but instead into this lawsuit,” nothing in this opinion referred back to or otherwise altered its prior ruling allowing appraisal arbitrage to proceed unfettered by a constraint such as the share-tracing requirement that BMC had asked the court to impose.

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.

Delaware’s latest appraisal decision in LongPath Capital v. Ramtron International Corp. adopted the merger price as its appraisal valuation, but stands apart from the other recent appraisal decisions that likewise fell back on transaction consideration. Here, the court’s lengthy opinion repeatedly lamented the lack of any remotely reliable means of valuation other than the merger price, and the court was careful to satisfy itself that the sales process leading up to the deal was “proper,” “thorough” and “effective,” though these terms remain without precise definition. Ramtron ostensibly joins Chancery’s recent decisions — including Ancestry.com and AutoInfo — in adopting the negotiated deal price as conclusive proof of value. But unlike those two cases, the court in Ramtron found that fair value ($3.07/share) was actually below the deal price ($3.10/share) when accounting for synergies between Ramtron, the semiconductor manufacturer being acquired, and Cypress Semiconductor, the hostile acquirer.

Part of the unique nature of this action was that in a deal valued at $110 million, the merger price represented a 71% premium to the pre-deal stock price. Moreover, the petitioner, who acquired its shares after the merger announcement (more about the arbitrage play later), bought only a small stake worth about $1.5 million. But the bulk of the court’s analysis focused on whether or not the management projections presented in the petitioner’s DCF analysis were reliable, as Delaware courts apply the commonsense rule that a DCF predicated on suspect projections is worthless in an appraisal. The petitioner’s projections were fatally flawed in many respects, though three of the nine flaws identified by the court stand out the most. First, the projections were prepared by new management, using a new methodology (the product-by-product buildup method) and covering a longer time period than earlier forecasts. Furthermore, the projections had not been prepared in the ordinary course of business. Second, Ramtron distorted its revenue figures by engaging in so-called channel stuffing, the practice of pushing excess inventory into distribution channels so that more revenue can be recognized sooner (indeed, the court repeatedly cited an e-mail in which a salesman said that the company will “for sure stuff channel”). Third, Ramtron management provided alternative projections to Ramtron’s bank, which they described as “more accurate” than those cited by the petitioner. Given these deficiencies, the court had no trouble casting aside management’s pre-merger projections and the petitioner’s DCF which relied on them.

Indeed, the court took both experts to task for what appeared to be litigation-driven valuations. The court criticized the respondent’s “eyebrow-raising DCF” which, notwithstanding its reliance on projections that the expert presumed were overly optimistic, somehow still returned a “fair” value two cents below the merger price.

In any event, the court also had little trouble rejecting the petitioner’s suggested “comparable transactions” methodology, a market-based analysis which ascertains going-concern value by identifying precedent transactions involving similar companies and deriving metrics from those deals (and which we will be examining in greater detail in our next “Valuation Basics” post). The petitioner’s expert was hamstrung by a lack of deals involving companies similar to Ramtron, and could only point to two, which were themselves drastically different from each other and which resulted in disparate multiples. Given this “dearth of data points,” the court found that it could not give any weight to a precedent transactions approach. The court was also influenced by the fact that the petitioner’s expert himself only attributed 20% of his valuation to the comparable transactions analysis.

That left merger price, which the court acknowledged “does not necessarily represent the fair value of a company” as that term is used in Delaware law. To demonstrate this truism, the court cited to the short-form merger, in which the controlling stockholder sets the merger price unilaterally, forcing minority stockholders out and leaving them to choose between taking the deal and exercising appraisal rights. According to the court, pegging fair value to the merger price in such a circumstance would render the appraisal remedy a nullity for the minority stockholder — all roads lead to a merger price that has not been independently vetted. In a situation like Ramtron, however, where the company was actively shopped for months and the acquirer raised its bid multiple times, merger price could be deferred to as conclusive (and critically, independent) proof of fair value.

The court was not troubled by the fact that Cypress’s acquisition process was initiated by a hostile offer, or the fact that no other company made a bid for Ramtron. According to Vice Chancellor Parsons, there was no evidence that the hostile offer prevented other companies from bidding on Ramtron — there were six signed NDAs in total — and impediments to a higher bid for Ramtron were a result of the company’s operative reality, not any purported shortcomings in the deal process itself. Having found a fair merger process, the court concluded that the merger price was the best, if not the only, evidence of fair value. Simply put, “if Ramtron could have commanded a higher value, it would have.” Indeed, the court expressed its skepticism over the petitioner’s expert’s valuation of $4.96, as compared to its unaffected stock price of $1.81, suggesting that “the market left an amount on the table exceeding Ramtron’s unaffected market capitalization.” The court could not accept that such a significant market failure occurred here.

Coming back to the arbitrage issue, the Vice Chancellor makes a point of noting that LongPath only began acquiring Ramtron shares a month after the merger was announced. We’ve discussed the practice of appraisal arbitrage extensively, noting the arguments for (here) and against (here). The Court of Chancery has been reluctant to limit the practice thus far (here), and Vice Chancellor Parsons continues that pattern here, consistent with the Corporation Counsel of the Delaware Bar’s own refusal to recommend to the legislature that it limit or eliminate the arbitrage practice altogether, as we’ve previously posted here and here.