Delaware Supreme Court Affirms Appraisal Ruling Relying On DCF Analysis To Determine Fair Value
On January 22, 2021, the Delaware Supreme Court affirmed en banc the Delaware Court of Chancery’s decision appraising outsourcing and financial services company SourceHOV Holdings, Inc. based on a discounted cash flow analysis (“DCF”). SourceHOV Holdings Inc. v. Manichaean Capital LLC, No. 215, 2020 (Del. Jan. 22, 2021). Petitioners were minority stockholders who filed the appraisal action following the company’s participation in a series of transactions that resulted in a three-party business combination. In its concise order, the Delaware Supreme Court affirmed “on the basis of and for the reasons stated” by the lower court it its opinion. The Court of Chancery had explained that the circumstances surrounding the business combination that triggered the appraisal rights “disqualif[ied] market evidence as reliable inputs for a fair value analysis,” leaving the court to consider competing expert opinions on a DCF valuation. Moreover, the Court of Chancery largely adopted petitioners’ analysis, which it found more reliable than that of respondent’s expert.
Explaining its reliance on a DCF analysis instead of market evidence, the Court of Chancery highlighted that the company’s “deal process (or lack thereof) undermine[d] any reliance on deal price as an indicator of fair value.” In particular, the court noted that the company’s board did not hold a single formal board meeting to consider the transaction or solicit offers from other parties after it received the initial overture. The court also noted that the privately held company’s equity was not traded in an efficient market and, therefore, its unaffected market price could not be relied upon as an indicator of fair value.
As to the competing expert opinions, the Court of Chancery found petitioners’ expert more reliable. Preliminarily, the court explained that respondent’s overall presentation of evidence “lacked credibility.” In this regard, the court emphasized that respondent had abandoned its own expert’s conclusion and advocated for the use of a lower set of financial projections “in its zeal to reach a desired litigation outcome.” The court found that the lower set of projections—that even respondent’s own expert declined to use—were outdated and not otherwise utilized by the company. The court also noted that one of respondent’s key witnesses had not been “forthright” about a backdated valuation that respondent had allegedly obtained from its financial advisor during the course of the appraisal litigation.
More specifically regarding respondent’s expert analysis, the Court of Chancery found that respondent’s expert’s “novel approach” to calculating the company’s equity beta (a measure of systematic risk and an important input in the DCF analysis) “raised serious questions about the credibility of his entire valuation analysis.” Petitioners’ expert’s methodology—calculating beta indirectly based on publicly traded comparable companies—was generally accepted among valuation experts and supported in the academic literature. By contrast, respondent’s expert admitted that his purported calculation of beta using certain yields and interest rates on the company’s debt was not supported. The court also noted that even if respondent’s expert’s approach were to be validated, there was a “fundamental” problem with the “execution” because the expert relied on trading prices of the debt that had been erroneously reported.
Although the Court of Chancery found respondent’s calculation of a size premium (another DCF input) more accurate than the premium proposed by petitioners’ expert, the court otherwise found petitioners’ expert’s analysis both credible and reasonable. The court thus adopted the approach of petitioners’ expert “in toto” with one adjustment for the size premium. This resulted in an appraised value of $4,591 per share as compared to an implied equity value in the business combination of $4,177 per share.