July 14, 2017 | Valuations
In re ISN Software Corp. Appraisal Litig., 2016 Del. Ch. LEXIS 125 (Aug. 11, 2016)
A recent request for statutory appraisal prompted a familiar lament from the Delaware Court of Chancery about the questionable reliability of expert valuations. Three experts presented value conclusions that were eons apart. The court declined to adopt any one opinion in its entirety and instead performed its own discounted cash flow analysis.
The focal point was a privately held company that provided a subscription-based online contractor database, assisting users with record keeping and compliance. It operated around the world and had experienced substantial growth in the period leading up to the transaction. In January 2013, it merged with its wholly owned subsidiary. The controlling shareholder offered certain minority shareholders $38,317 per share in cash. Other minority shares remained unchanged and outstanding.
The two petitioners were minority shareholders that petitioned the Chancery for appraisal under 8 Del. C. § 262. For trial, all parties offered expert testimony on the fair value of the shares. The experts used a variety of valuation methods and weighted them “as they saw fit.”
The court described the gap in the resulting valuations as “alarmingly” wide. The fair value of one petitioner expert was eight times that implied by the DCF the company’s expert provided, the Chancery emphasized.
The court rejected all valuation methods but the DCF. It found the guideline public companies analysis, which all experts used to some extent, inappropriate because the subject had no “direct” public competitors. It also found there was no reason in this case to perform a direct capitalization of cash flow analysis, as the company’s expert had done.
And it disapproved of the company expert’s analysis of two precedent transactions, remarking that these transactions lacked certain hallmarks of an arm’s-length deal, such as multiple buyers and reliance on complete and accurate financial information. They also included “complex and incompatible forms of consideration,” the court said.
The surest way to arrive at fair value in this case was the DCF method, the court decided. Although complex, the DCF “relies on a simple and powerful concept,” the court explained. Because in this case management did not regularly create long-term projections, the experts had to forecast cash flow based on assumptions as to growth and efficiency. In doing so, the court noted, the experts were able to look to the company’s subscription-based business model, customer retention, and the inelastic demand for the company’s product.
All experts agreed the company was growing, but they disagreed over the remaining length of the growth stage. The court decided five years was the most reliable “projection period.” Forecasts beyond this time frame “owe more to hope than reason,” the court said.
The court hinted at disagreements among the experts on many other assumptions and inputs. It decided to build its DCF analysis on the analysis the company expert’s had done but making a series of consequential adjustments. For example, the court rejected the expert’s working capital adjustment but decided to include separate adjustments for the change in deferred revenue and an expected tax refund. It added the balance of a “Buyout and Litigation Reserve” account to the sum of the discounted cash flows. It used a 2.46% size premium and used the capital asset pricing model (CAPM) to arrive at a 10.46% cost of equity.
The court’s DCF analysis resulted in a fair value of $98,783 per share.