fair-value-240px-477457721Owen v. Cannon, 2015 Del. Ch. LEXIS 165 (June 17, 2015)

A joint fiduciary duty and statutory appraisal suit provided an opportunity for the Delaware Court of Chancery’s new chief, Chancellor Bouchard, to rule on the issue of tax affecting. In discussing the choices that informed his discounted cash flow analysis, the chancellor explained in detail how he used the controlling Kessler model to calculate a 22.71% hypothetical corporate tax rate.

Success and disunity. Around 2000, three partners built a successful company that provided software-related services to the then-nascent retail energy industry. The company was organized as a subchapter S corporation. Pursuant to a stockholder agreement, the plaintiff/petitioner owned a 35.20% interest and his partners, the individual defendants (one of whom was the plaintiff’s brother), owned 61.80%. Another executive, who was not a party to the litigation, owned the remaining 3%. The plaintiff served as president, and he and the two defendants were directors of the company. The plaintiff’s exact ownership interest became a point of contention later on.

The company made pro rata distributions of most but not all of its income to stockholders. The three executives received salaries that were below market rate. They also received monthly “draws,” that is, interest-free loans against their distributions, and they received distributions that covered their tax liabilities.

In the five years before the contested transaction, the company experienced consistent growth, notwithstanding competition. For example, revenue climbed from $14.9 million in 2008 to $32.2 million in 2012; during the same period, EBIT increased from $5.6 million to $17.3 million.

But by the late 2000s, an irresolvable disagreement over the direction of the company prompted the defendants to terminate the plaintiff as president and start working toward a buyout. One of the defendants took over as interim president. There was a problem, however: The ouster started to become costly for the company because, even though the plaintiff stopped working in 2009, he continued to receive his base salary, benefits, and stockholder distributions. In the five years preceding the 2013 merger, he received over $14 million in distributions, with the majority of them made after his ouster.

Valuations in contemplation of buyout. In 2012, the defendants hired a major accounting firm to assist the company in obtaining financing for the buyback of the plaintiff’s shares. The accountants prepared a series of valuations based on projections by the defendant who was serving as president and in charge of day-to-day operations of the company. In his new role in the company, the defendant president developed a solid understanding of the company’s future prospects, holding weekly and other meetings with the company’s senior management. By the middle of the year, he had heard some company employees expressing concern “about possible attrition” in their customer base and had asked the accounting firm to revise its valuation.

In the fall 2012, the firm prepared a discounted cash flow (DCF) analysis for purposes of mediation that assumed a discount rate of 15.1%, a tax rate of 40%, and a perpetuity growth rate of 2.5%; it excluded the cash on the company’s balance sheet. The firm arrived at an enterprise value of the company of approximately $118.5 million. Assuming the plaintiff owned 33.3% on a fully diluted basis, the firm valued the plaintiff’s interest at about $39.5 million on a going-concern basis, excluding his pro rata share of any cash on hand.

Further assuming a 20% discount for lack of marketability (DLOM) and a 20% discount for lack of control (DLOC), the firm found the enterprise value of the plaintiff’s interest was approximately $25.3 million, not counting his share of the company’s cash.

Around that time, the company offered to buy out the plaintiff for $18 million, based on a 2011 valuation, rather than the contemporaneous DCF-based valuation. The plaintiff rejected the offer, arguing the company was “exploding in growth.”

By December 2012, the company was aware that its largest customer would switch to one of its major competitors. There also was an increasing risk that customers, to cut costs, would do some of the work the company was doing for them in-house. Regardless, the defendant president saw the loss of the company’s big customer as a “one-time event,” rather than a “defect in the business model.” In a sales and marketing presentation at the beginning of 2013, he talked about a “[v]ery full sales pipeline” and about his expectation of a significant amount of deals to come.

2013 projections. In March 2013, the defendant president revised the annual budget to reflect the recent loss, more competition, and some other changes in the business. The company provided the updated projections to the accounting firm. When compared with the 2012 projections, the 2013 forecasts revealed an expectation of lower revenue growth and operating margin. The 2013 projections also appeared to include “normalized” salary expenses for the two defendants and the fourth shareholder.

Based on the 2013 projections, the accounting firm prepared another DCF valuation that assumed a discount rate of 16%, a tax rate of 40%, and a perpetuity growth rate of 2.5%; it excluded $13.6 million in cash on the company’s balance sheet. Under this valuation, the plaintiff’s interest in the company was $22.3 million, excluding cash. On client instructions, the accounting firm sent the 2013 projections to a bank to obtain financing for the buyout.

The company also provided the 2013 projections to the plaintiff and in a cover letter proposed to buy out his interest for $26.3 million, including $4 million for his share of cash on hand. The plaintiff declined to respond.

In early May 2013, the defendants scheduled a special board meeting to vote on a proposed merger resulting in the plaintiff’s buyout for $26.3 million. At that time, the accounting firm stated that there had been “no material changes to the business operations or forecast assumptions since completion of the analysis back in March.”

When the plaintiff asked to push the meeting back one day to give him time to review the relevant documents, the defendants refused. At the meeting, the two defendants approved the merger and transferred their stock to an acquisition company in exchange for acquisition corporation stock. Shortly afterwards, they filed a certificate of merger. According to the plaintiff, the merger was “boom, done, Blitzkrieg style.”

The plaintiff subsequently filed a complaint with the Delaware Court of Chancery, alleging the individual defendants and acquisition corporation had breached their fiduciary duty and asking the court for a fair value determination of his shares under Delaware’s appraisal statute, Section 262.

‘Delta’ between valuation. For purposes of the statutory appraisal claim, both sides presented expert testimony. Both experts, and the court, relied on a DCF analysis to value the plaintiff’s interest. But, instead of adopting either expert’s analysis completely, the court performed its own valuation. It noted that disagreements over several key components created a “delta” between the experts’ final values.

The plaintiff’s expert based her valuation on the 2013 projections. Because she thought it appropriate to tax affect the company’s tax rate to reflect the company’s S corp status, she used a tax rate of 21.5%. Her weighted average cost of capital (WACC) was 13.28%, but the plaintiff subsequently accepted the opposing expert’s rate of 14.13%. The plaintiff’s expert assumed a terminal growth rate of 5.0%. She said she based her calculation on an ownership interest of 33.3% and acknowledged that the plaintiff’s share of $17.4 million cash on hand might require adjustment for tax liabilities. She determined that the plaintiff’s stock in the company was worth $51.7 million. After a post-trial adjustment of the plaintiff’s percentage ownership and changes to the cash on hand figure, the plaintiff claimed his interest was worth $52.65 million.

In contrast, the company’s expert rejected the 2013 projections but instead created a 10-year set based on per-unit calculations of revenues and costs. This meant that his projections for the five years covered in the 2013 projections were significantly lower. He also argued it was inappropriate to tax affect the company’s earnings and used a 44.8% tax rate. At the same time, he proposed that the court use a 31.4% tax rate should it approve of tax affecting. The expert’s WACC was 14.3%, and he calculated a 3% terminal growth rate. He concluded that, at the time of the transaction, the company was worth $65 million. Considering an ownership interest of 33.08%, the plaintiff’s fair value of his stock was worth about $21.5 million.

Most of the value gap could be ascribed to the differing cash flow projections and the disagreements over tax affecting, the court said.

Litigation-driven projections. The plaintiff argued that, at the time of the transaction, the 2013 projections reflected management’s best estimate of the company’s future. They were based on assumptions the defendant president had made and revised as he was preparing to cash out the plaintiff.

In an about-face, the company cited a number of reasons why its own 2013 projections were inappropriate for a DCF valuation. It said they “were not the product of a robust process that included a broad management team, were not developed within [the company’s] ordinary course of business, did not involve a thorough review of [the company’s] or industry drivers, and were accepted by Defendants in the hope that a high merger price would avoid litigation.” Accordingly, the company militated in favor of basing a DCF analysis on its expert’s post-transaction 10-year projections.

The court found the company’s arguments unconvincing. As a general rule, it explained, Delaware courts place great weight on contemporaneous management projections because “management ordinarily has the best first-hand knowledge of a company’s operations” as well as “the strongest incentives to predict the company’s financial future accurately and reliably.” Here, the court said, the defendant president had undertaken a “deliberate, iterative process over a period of three years to create, update and revise multi-year projections.” The process culminated in the 2013 projections, which the accounting firm prepared at his direction and in consultation with him. The record showed that the growth assumptions underlying the projections came from the company, not the accounting firm. Also, even though the defendant president may have been the only one creating the projections, he did so based on steady exchanges of information with the company’s management. In testimony, he admitted that he was “very familiar” with the company’s business lines and that its revenues ‘have generally been predictive.” The defendant president was well informed about the company and “brought this knowledge to bear on the 2013 Projections,” the court said.

The court pointed out that there was evidence that he worked with the accounting firm to make significant downward revisions to his earlier projections at a time when he knew he wanted to force the plaintiff out of the company—if necessary based on a valuation using the 2013 projections. The revisions led to material decreases in the company’s future performance, which were justifiable given the loss of a major customer and other pressures, the court noted. When the plaintiff failed to respond to the buyout offer based on these projections, the merger went through at essentially the same price. According to the court, the motive for the buyout was to “stop the hemorrhage,” that is, paying millions of dollars in distribution to the plaintiff who had not worked for the company for years. The defendant president admitted as much at trial, the court said.

Also, the company authorized the accounting firm to submit the projections to a bank for purposes of obtaining a $25 million credit card facility that would finance the buyout. Considering it is a federal felony “to knowingly” obtain funds from a financial institution based on fraud or misrepresentation, the Chancery typically accords “great weight” to projections given to a financing source, said the court.

The post-merger 10-year projections the company’s expert prepared were not management’s best estimate of future performance at the time of the merger, the court concluded. They were created in the context of litigation and were too pessimistic, projecting noticeably lower revenue in a line of business that between 2009 and 2012 had grown from $12.34 million to $18.76 million. In contrast, the expert projected that going forward revenue would drop to $12.74 million in 2020 and slowly increase to $13.67 million in 2023. All told, the court said, there was no sound reason to replace the 2013 projections with the post hoc forecasts.

Tax-affecting dispute. What corporate tax rate to apply in calculating the company’s projected cash flows was another point of contention between the experts. The plaintiff’s expert argued a valuation of the plaintiff’s interest had to capture the denial—due to the merger—of the future benefits of the company’s S corp status.

The court agreed with this proposition. “A critical component of what was ‘taken’ … in the Merger was the tax advantage of being a stockholder in a Subchaper S corporation,” it said. Accordingly, adequate compensation for the plaintiff’s loss required tax affecting the company’s earnings as part of a DCF valuation.

In terms of how much of the earnings should be subject to tax affecting, the court rejected the company expert’s contention that the plaintiff should only receive the value of being an S corp stockholder for the actual distributed earnings (76.7%), not for earnings the company retained and reinvested in the company (23.3%). It stated that “the operative metric under the Kessler-based valuation method is not the actual distribution made by a Subchapter S corporation, but the amount of funds that are available for distribution to stockholders.” To conclude otherwise would deprive the petitioner of “his proportionate interest” in the company as a “going concern,” the court said.

As for reinvesting in the business, the court pointed out that historically the company had not actually reinvested significant amounts of its undistributed earnings. Instead, it had kept the earnings as cash on its balance sheet. Nor was there any evidence that it intended to reinvest its cash as of the merger. Nor did it need to reinvest earnings to grow. Both experts, the court said, testified that the relevant projections included all of the capital expenditures necessary to enable the company to generate the projected future cash flows.

Using the Kessler model, the court determined the hypothetical corporate tax rate was 22.71%, assuming zero entity-level tax and a 47.25% rate applicable to the plaintiff’s distribution from corporate earnings. The latter is the result of 35.5% actual federal income tax, 3.8% net income investment tax, and 7.95% state tax.

Additional disputed inputs. The experts also differed on what an appropriate terminal growth rate should be for the company. The plaintiff’s expert calculated a 5% rate, which, she explained, represented a 0.5% premium to the midpoint of three estimates of nominal U.S. GDP growth prepared in March 2013, the month of the merger, for 2017 and beyond. The company’s expert computed a 3% rate, which represented a 1% premium to the Federal Reserve’s projection of inflation as of the merger.

Two principles should guide the calculation of the terminal growth rate, the court said at the beginning of its analysis. First, the rate “should not be greater than the nominal growth rate for the United States economy” because, if it were, the company’s cash flow at some point would surpass the gross national product. Consequently, the 5% rate was too high for the subject company, which had developed into a company confronting increasing competition and flatter growth. Second, the rate of inflation represented a floor for calculating a terminal growth rate in circumstances where a company recorded solid profits and there was no noticeable risk of insolvency. This was the case here, the court said, adopting the 3% rate the company’s expert proposed.

Moreover, the parties argued over the amount due to the plaintiff as a result of the company’s $17.4 million “excess” cash at the time of the merger. They agreed that it was appropriate to deduct $2.3 million for certain tax liabilities. However, the company’s expert proposed deducting an additional $916,000 as working capital, which represented 3% of the company’s 2012 revenue. He called it an “extremely conservative estimate” and said not having cash on hand was not “a prudent thing to do.” The plaintiff’s expert said the company did not need extra working capital since it generated millions of dollars in capital every month.

The court agreed with the company’s expert. Moreover, for its DCF analysis, the court decided to deduct an additional $1.2 million from the “excess” cash to account for outstanding liabilities related to the company’s nonpayment of Texas use and sales tax.

Determining that the plaintiff had a 33.85% ownership in the company, the court valued his shares at $42.16 million.

Fiduciary duty claim. Lastly, the court found the merger was self-interested and unfair to the plaintiff. The defendants breached their fiduciary duty when they approved it. They timed the merger to exploit the loss of a major customer, which translated into a downward revision of the 2012 projections to the 2013 projections. The latter became the foundation for the company’s $22.3 million valuation.

Also, in terms of process, the court noted that it was “inequitable” to reject the plaintiff’s reasonable request to postpone the merger-related board meeting by a day. Moreover, under the court’s DCF-based fair value determination, the price the defendants offered to the plaintiff was not within a range of fair value.

In conclusion, the court found that damages in this instance represented the fair value of the plaintiff’s shares, that is, $42.16 million.