The Problem With Delaware Business Valuations
A recent decision by the Delaware Court of Chancery has caused the defenders of all things corporate America wants from its courts to complain once again of unfair treatment. While their complaints are misplaced in this particular case, they do raise the question of how Delaware values business entities.
First some background is helpful. In re Appraisal of Dell, C.A. No. 9522-VCL (Del. Ch. May 31, 2016), decided that the stock of Dell was worth $17.62 per share. The critics of Dell argue that was too much, citing the court's own praise for the process used to set the merger price of $13.65 per share. They also point out the court's valuation is substantially above the Dell market price for a significant period before the merger. Thus, the critics argue that if a fair process and the market itself valued Dell at no more than $13, how could a court know better?
The Dell decision effectively answers its critics by pointing out that the process was still imperfect and that the market price, standing alone, has never been viewed as the "fair value" required by Delaware law. Moreover, if the court was even close to being right in its valuation, then the proponents of the merger got a multibillion-dollar benefit from the merger price. After all, only a very small portion of Dell stockholders involved in the Dell appraisal proceedings will receive the court's $17.62 per share value. All the other stockholders who were cashed out will get much less, leaving the buyout group as the real winners.
Putting aside the question of whether the court got it right in Dell, a more basic question is whether Delaware valuation methods are a problem generally. There is legitimate concern (acknowledged by the Court of Chancery) over a system that must deal with widely divergent views offered by the litigants over the fair value of stock in a Delaware entity. Dell itself is an example of this where the plaintiffs argued for $28.61 per share or over 200 percent of the merger price. Both sides used highly credentialed experts to testify on their valuations. But how can both experts be able to come up with such a valuation spread?
The problem has its roots in the way Delaware determines fair value. In valuing almost any other asset, the selling price of similar assets is accepted as its value. Real estate is often appraised that way, for example. In fact, there is ample precedent in Delaware that the price of stock in another comparable transaction, such as a merger or acquisition, is a good indicator of the value of the subject company. But that often is not accepted by the court.
There are several reasons why the courts have not accepted comparable transactions as indicators of value. To begin with, the Delaware appraisal statute requires that fair value not include any element of value that arises out of the merger itself. Thus, if the acquirer values the acquired company not based on how it actually operates but on how the acquirer will improve it, that extra value is not to be part of the fair value. That makes sense because the cashed-out stockholders could not have realized that extra value themselves. It is not part of what they lost.
However, the statutory limit on what may be included in fair value has caused defenders of the merger price to argue that all allegedly comparable transactions are infected by this "extra" value. The result has been that the courts are hesitant about what other companies and transactions are truly comparable to the company being valued.
That hesitancy has led to the use of discounted cash flow (DCF) analysis to value Delaware entities. But that method too has its problems. For example, its use typically results in a war of experts with a wide range of values, all claiming to use the right DCF analysis. Understanding why this occurs explains the problem a DCF analysis may present.
The simple truth is that any DCF analysis contains at least three big variables that are dependent on the subjective views of the valuators. First, the DCF analysis requires a projection of future revenues of the company to be valued. Plaintiffs claim the future is bright, but the defense argues the end is near. Since predictions of the future are inherently uncertain, the result is too often widely different claims.
The Court of Chancery knows this is a problem. To cope with it, the court often prefers management predictions prepared in the ordinary course of business. Those, at least in theory, are free of hindsight bias driven by litigation motivations. The court will also cap even management predictions by the inflation-adjusted expected growth in gross domestic product. Of course, that still involves a prediction.
The second, subjective component of a DCF analysis is the choice of the equity risk premium (ERP) to use in calculating the discount rate. That ERP can vary widely. The most recent edition of Pratt, Cost of Capital, for example, lists more than 10 sources for an ERP and notes how much they vary as well. Of course, some sources of ERP have at least precedent on their side having been used in past court valuations. However, recognized scholars argue that the Great Recession has changed ERPs and the past is no longer a sound predictor of the present. Again, subjective choices are available.
Third, whatever ERP is selected, it must be modified by the appropriate beta to take into account the subject company's risk compared to the market as a whole. While that sounds simple, one recognized source of a beta, Duff & Phelps, often has over 60 different possible betas for each industry classification. Again, picking the right beta also involves a subjective element.
All these three elements (and more) of a DCF analysis may lead to disparate valuations. The Court of Chancery always does a commendable job of sorting out the best of the abundant alternatives it faces. Nonetheless, the problem of uncertainty continues and critics point to that as evidence the process is flawed.
What then is the solution? Each case depends on its own facts. Where the court has reliable projections at least that variable of a DCF analysis should not generate concern. Practitioners and the court must contend with the subjectivity involved in selecting the ERP and the beta. In some cases, comparable transactions may offer the best method of valuation, although the degree of comparability and the nature of appropriate adjustments will still generate debate.