In an appraisal proceeding under Section 262 of the Delaware General Corporation Law, the Delaware Court of Chancery determines the "fair value" of a company's "shares exclusive of any element arising from the accomplishment or expectation of the merger." In determining fair value of a company's shares, the court values the company as a "going concern" based on the "operative reality" existing as of the date of the merger. The court has "significant discretion to use the valuation methods it deems appropriate, including the parties' proposed valuation frameworks, or one of the court's own making." Both the petitioner and the respondent share the burden of proof in an appraisal proceeding to establish fair value of a company's shares by a preponderance of the evidence.
In its recent appraisal decision, In re ISN Software Appraisal Litigation, C.A. No. 8388-VCG (Del. Ch. Aug. 11) (Glasscock, V.C.), the Court of Chancery held that the most reliable method to value a company, whose stock was not traded publicly, lacked historical sales of its stock that were reliable indicators of fair value, and for which no comparable company evaluations existed, was the discounted cash flow (DCF) method. Relying exclusively on the DCF method, and faced with widely divergent expert valuations, the court started its valuation analysis using the DCF framework of ISN Software Corp.'s expert because his valuation used the standard five-year cash flow projection period, which the court had found appropriate. After making adjustments for inputs where the parties diverged, the court subsequently concluded that $98,783 per share, which far exceeded the merger consideration of $38,317 per share, was the fair value of ISN Software as of the date of the merger.
ISN Software Corp. is a privately held Delaware corporation formed in 2000. The company provides an online database that enables subscribers to meet internal and governmental record keeping and compliance requirements. Subscriptions to the database by contractors seeking work or businesses seeking to hire contractors, primarily in the oil and gas industry, comprise the majority of the company's revenues. In the years preceding the merger, the company experienced substantial growth, serving industries in more than 70 countries.
In January 2013, ISN Software Corp. merged with its wholly owned subsidiary, with ISN Software Corp. continuing as the surviving corporation. The company did not engage a financial adviser for the merger, nor did it obtain a fairness opinion. Instead, to determine the merger consideration of $38,317 per share, the company's controlling stockholder used a valuation created by a third party in 2011, which the controller apparently adjusted based on his expectations for the company. Neither petitioner, nor respondent, relied upon the controller's valuation in the appraisal proceeding.
Court of Chancery Relies Exclusively on DCF Method
To determine the fair value of ISN Software's shares, the parties' experts relied on various valuation methods, which they weighted to reach valuations with a very large gap, ranging from $29,360 per share to $230,000 per share. Despite the experts using various valuation methods, the court relied exclusively on the DCF method. The court first found that the "guideline public companies" method was a less reliable method of valuation because the company did not have any public competitors and its industry utilized various divergent software platforms. Since the company had not reached a steady state and other feasible valuation methods existed, the court also found that the "direct capitalization of cash flow" method was a less reliable method of valuation. Lastly, the court found that two past sales of the company's stock were an unreliable indicator of fair value. The court explained that the company was privately held with illiquid stock that does not trade regularly, the two past sales of stock were not shopped or priced using complete and accurate information, and the consideration of options and land received in the two past stock sales were difficult to value.
Turning to its DCF valuation, the court explained that the DCF method estimates fair value by discounting a company's future cash-flow projections to the present value, concluding with a terminal value that represents a company's remaining cash flows in perpetuity. Accuracy of the DCF method depends on the accuracy of the future cash-flow projections and the length of the period used to project the future cash flows. In selecting the standard five-year projection period, the court balanced ISN Software's current stage within its lifecycle, the length of time that the company would remain in that stage, and the reliability of the cash-flow projections. The parties' experts determined future cash-flow projections using various assumptions for the company's growth and efficiency, which the court found "inherently less reliable than using long-term management projections" that were not available for the company. The court noted, however, that the company's subscription-based revenue model, its ability to retain customers, and consistent demand for its online-database product bolstered the reliability of the experts' cash-flow projections.
Based on its selection of the standard five-year projection period for its DCF valuation, the court based its analysis on the DCF framework of ISN Software's expert, who also used a five-year projection period. The court then made adjustments to his DCF valuation for certain inputs, including removal of a cash-flow adjustment for incremental working capital because the company historically operated with a negative working capital balance, using a 2.46 percent size premium based on Ibbotson's eighth decile to calculate its cost of equity at 10.46 percent, which was based solely on the capital asset pricing model and equal to its weighted average cost of capital since the company did not have long-term debt on the date of the merger. After making adjustments for inputs, the court concluded that $98,783 per share was the fair value of ISN Software as of the date of the merger.
ISN Software provides helpful guidance in a statutory appraisal proceeding to financial experts valuing a private company. In determining the "fair value" of a company, whose stock is not traded publicly and for which no comparable company evaluations exist, the Court of Chancery is likely to rely exclusively on the widely used DCF method of valuation. While very common in appraisal proceedings for petitioner's expert to reach a DCF value twice that of the value reached by respondent's expert, the court is more likely to rely upon the DCF valuation of the expert, who is measured, balanced, and realistic in his or her assessment of "fair value" of the company's shares.