Chancery Rejects Merger Price as Indicator of Fair Value in Appraisal Based on Flaws in Sales Process
Appraisal is a limited statutory remedy that provides a Delaware general corporation’s stockholders, who dissent to the sufficiency of the merger price, with the right to have the Delaware Court of Chancery determine the “fair value” of their shares, 8 Del. C. Section 262. In determining fair value, the court must consider all relevant factors. While a single or multiple factors may be considered in the valuation, the court’s determination of the relevant factors must be grounded in the evidentiary record and “accepted financial principles.”
In Dell and DFC, the Delaware Supreme Court declined to adopt a presumption that the merger price was reflective of fair value, but emphasized that the merger price was often a “strong indicator” of fair value, at least where the company is publicly traded and sold after a robust sales process, including a meaningful market check, unhampered by significant deal protection measures. Dell also counseled that the unaffected trading price produced by an efficient public market is often a more reliable indicator of fair value than a party’s valuation experts, who invariably tailor their valuation to client objectives in the appraisal. But if the sales process in a merger is flawed and the efficient capital markets hypothesis does not yield an unaffected trading price that is a reliable indicator of fair value, the Court of Chancery will turn to traditional valuation methodology, such as discounted cash flow, comparable companies, and comparable precedent transaction analyses, as the most reliable means to determine fair value.
In its recent decision, Blueblade Capital Opportunities v. Norcraft Companies, C.A. No. 11184-VCS (Del. Ch. July 27, 2018) (Slights, V.C.), the Court of Chancery held that there were significant flaws in the sales process leading to the merger that precluded reliance on the merger price as a reliable indicator of fair value and that the efficient markets hypothesis also did not yield an unaffected trading price reflective of fair value. In its analysis of the sales process, the court found that there was no pre-signing market check, the company was solely focused on one buyer and never expanded its market check to other potential buyers. Moreover, the company’s lead negotiator was conflicted, negotiating his future employment with the buyer and his own tax benefits in the merger while he simultaneously purported to seek the best merger price for the company and its stockholders. While the merger agreement contained a 35-day post-signing go-shop period, certain deal protection measures, such as the limited time period to value the company and make a topping bid, and unlimited buyer matching rights, rendered the sales process ineffective as a price discovery tool. Thus, the court accorded no weight to the merger price in its determination of fair value. Turning to the efficient markets hypothesis, the court noted that the company had recently completed an IPO and its stock was thinly traded because of the company’s niche market, and analyst coverage of the company’s stock was also limited. Thus, the court found that the efficient capital markets hypothesis did not yield an unaffected trading price that was a reliable indicator of fair value.
Having concluded that the sales process in the merger was flawed, rendering the merger price unreliable, and that the efficient capital markets hypothesis was also not a reliable indicator of fair value, and finding no sufficiently comparable companies or precedent transactions, the court determined that the DCF valuation method was the most reliable means to determine fair value. In performing its DCF valuation, the court borrowed the most credible components of the competing experts’ analyses to conduct its own DCF analysis in compliance with the appraisal statute’s mandate for the court to conduct an independent assessment of fair value. The court first noted the basic components of a DCF valuation: estimate of projected future cash flows for a discrete period; estimate of the terminal value at the end of the discrete period using a perpetual growth model; and the value of the cash flows for the discrete period and the terminal value must be discounted using the asset pricing model or CAPM. In its DCF valuation, the court relied upon management’s base case cash flow projections over a five-year period. In determining the weighted average cost of capital (debt and equity) or WACC, to discount the projected cash flows and terminal value to present value, the court noted that the competing experts used the same risk-free rate of return, equity risk premium, and size premium for the company’s cost of equity. The experts differed, however, on the beta coefficient, which measures the relative change in the trading price of the stock over a discrete period of time, and modifies the equity risk premium component of the cost of equity. Due to the company’s limited trading history, the court did not rely on the company’s own beta coefficient, but instead relied upon a proxy beta derived from beta coefficients of comparable Guideline Public Companies. For the cost of debt, the court used the average of the experts’ estimates of the company’s pre-tax cost of debt. The court’s DCF calculation resulted in a fair value determination of $26.16 per share. Finally, as a reality check, the court considered the $25.50 merger price, and concluded that the $0.66 difference between its higher DCF valuation and the merger price was attributable to the infirmities in the sales process.
Blueblade Capital Opportunities teaches that the merger price is often a “strong indicator” of fair value, where the company is publicly traded and sold after a meaningful market check. If the sales process leading to a merger is flawed, however, and the efficient capital markets hypothesis does not yield an unaffected trading price that is a reliable indicator of fair value, the Court of Chancery will turn to traditional valuation methodology, such as the discounted cash flow analysis, as the most reliable means to determine fair value of a dissenting stockholder’s shares.Share