The Problem With Delaware Business Valuations
Edward M. McNally,
Delaware Business Court Insider
June 29, 2016
Edward M. McNally.
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.
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?
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
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
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.
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.
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.
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
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.
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.
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.
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
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.
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.
there are too few similar transactions to refer to, even a truly
comparable transaction may not be enough to inspire confidence that
its values should be used. The bottom line is that at least in
management buy-out transactions, the court may have a degree of
skepticism even of a well-run process as the best indicator of fair
value and will be left to use more conventional analyses to determine
is a partner at Morris James in Wilmington and a member of its
corporate and fiduciary litigation group. He practices primarily in
the Delaware Superior Court and Court of Chancery, handling disputes
involving contracts, business torts, and managers and stakeholders of
Delaware business organizations.
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