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.

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.

In a prior post we mentioned the three basic components of a discounted cash flow (“DCF”) valuation analysis — cash flow projections, a discount rate, and a terminal value — and explained how to calculate one of those components, the discount rate. In this post, we tackle another component, the terminal value.

In a typical DCF analysis, the appraiser will discount to present value the cash flows that the company projects it will receive over a discrete period. Because most companies’ financial projections forecast only a few years into the future, usually five years at most, an appraiser must add a “terminal value” to the projected cash flows in order to value all of the company’s future income beyond the initial near-term projections.

One common method applied by the courts in calculating that terminal value is the Gordon Growth Model. The first step of the Gordon Growth Model is to determine the company’s expected income for the year immediately following the initial discrete projection period. A “perpetuity growth rate” is applied to that projection income to estimate the company’s long-term growth. The perpetuity growth rate is determined based on a number of considerations, such as the company’s historical and expected future performance, the rate of inflation, and other factors. That amount is then capitalized using a capitalization rate that is equal to the discount rate minus the perpetuity growth rate. Thus, if Company A has a cost of capital of 10%, is expected to make $10,000,000 in normalized economic income in the year following its discrete projection period and is expected to grow past the discrete projection period at a rate of 5%, its terminal value would be $210,000,000, calculated as follows:

$10,000,000 * (1 + 0.05) =      $210,000,000

0.10 – 0.05

Because the terminal value is calculated as of the end of the discrete projection period, it must be further discounted to present value as of the valuation date.

A common misconception when calculating terminal value is that by applying a “perpetuity growth rate,” the court is assuming that a company will grow into perpetuity. As a practical matter, the perpetuity growth rate merely forecasts the company’s long-term growth, not its literal perpetual growth. When discounted to present value, most of a company’s terminal value is typically realized within the first ten to twenty years following the end of the discrete projection period.