Read the following case studies and then answer the questions that follow.

DELAWARE SUPREME COURT RULES ON THE ROLE OF VALUATION METHODS IN APPRAISAL RIGHTS

Some argue that a firm's current publicly traded share price reflects all relevant information about the firm's future earnings stream and its associated risk; and, new information will cause the share price to adjust quickly. Others believe that over long time periods public markets are efficient but that at any moment in time a firm's share price can be above or below its true value. In the absence of an efficient market (i.e., one in which current share prices reflect all available information), fair value is a term that applies to a rational and unbiased estimate of the potential value of a firm's share price. Numerous methodologies exist to estimate the value of a firm, including discounted cash flow (DCF), relative valuation, recent comparable sales, and asset based valuation methods.

1 If subsequent to closing, minority shareholders dispute the accuracy of the price offered for their shares, they can exercise their appraisal rights specified in the statutes of the state in which the target is incorporated. Such rights represent the statutory option of a firms minority shareholders to have the fair market value of their stock price determined by an independent appraiser and the obligation of the acquiring firm to buy back shares at that price. While alternative valuation methods often are used to estimate the fair market value of shares in dispute, courts often are inclined to defer to the merger price or actual price paid as long as the process used to determine the price was fair. A recent court case in Delaware illustrates this point.

2 On August 1, 2017, the Delaware Supreme Court reversed the Delaware Court of Chancery's3 appraisal decision involving the acquisition of DFC Global Corp. (DFC), a publicly traded payday lending firm4 by private equity firm Lone Star. As a result, the case was returned to the Chancery court for further consideration. The Chancery court had determined that the sales process was competitive but concluded that because of the potential overhaul of pay-day industry regulations, DFC's publicly traded share price was an unreliable estimate of fair value. The Chancery court therefore decided to use a weighted average of the merger price, DCF estimates, and comparable sales analyses to determine fair value. Each of the three factors was given a onethird weight. The resulting estimate of fair value was 8.4% above the $1.3 billion merger price. The Delaware Supreme Court endorsed the merger price negotiated in the absence of duress or conflicts of interest (so-called "arms-length deals") as the most reliable indicator of fair value. The high court emphasized that the Chancery court, in determining fair value, must consider the reliability of all appropriate factors (such as the merger price and a DCF analysis) and explain factually the relative importance or weight it attributes to the methodologies employed to 1 DCF methodologies are discussed in Chapter 7 and the other valuation approaches are described in Chapter 8. 2 Most U.S. companies are incorporated in Delaware and are covered by the states corporate law. Therefore, Delaware court rulings often have national implications.

3 The Court of Chancery consists of one chancellor and four vice chancellors. The chancellor and vice chancellors are nominated by the Governor and must be confirmed by the Senate for 12-year terms. The Delaware Court of Chancery is a non-jury trial court that adjudicates a wide variety of cases involving trusts, real property, guardianships, civil rights, and commercial litigation. 4A pay-day loan is a form of short-term borrowing in which an individual borrows a small amount of money at very high interest rates. estimate fair value.5 The extent to which the Chancery court should rely on the deal price versus other valuation methodologies should depend on how competitive (unbiased) the sales process is as compared to the reliability of alternative valuation methodologies. The Supreme Court also rejected that the Chancery court's assertion that the deal price was unreliable due to regulatory uncertainty arguing that the collective wisdom of investors should have been able to incorporate this uncertainty in the share price. Since Lone Star had participated in a competitive bidding process, the high court rejected the notion that a merger price based on an "LBO model" may be inherently unreliable as it reflects the buyer's required return rather than the going concern value6 of the target firm.7 The Supreme Court's continued reliance on merger price to determine fair value in "armslengths" deals should discourage appraisal claims except in deals fraught with conflicts of interest. Furthermore, in determining fair value using the alternative valuation methods in addition to the merger price, the court must explain clearly and factually the thinking on the relative importance of each in determining fair value. While a merger price could be a flawed indicator of fair value at a moment in time, DCF valuation is only as good as the reliability of its inputs (assumptions) and the challenge of finding truly comparable companies may render this methodology undependable. In the end, valuation is both an art and a science: the art is in the subjective judgments an analyst makes in identifying and projecting key inputs and the science is the logical process followed in estimating fair value.

COURT RULES DELL UNDERPAID PUBLIC SHAREHOLDERS HIGHLIGHTING LEGAL DISTINCTION BETWEEN FAIR VALUE AND FAIR MARKET VALUE ______________________________________________________________________________

Financial theory postulates that the value of a firm is determined by discounting projected net cash flows at an appropriate discount rate. In practice, buyers and sellers estimate the value of a firm using an array of valuation methodologies discussed in Chapters 7 and 8 of this text. The actual price paid by the buyer to selling firm shareholders is determined when the parties to the negotiation reach an agreement on what is a mutually acceptable price. Assuming neither party was under duress to accept the price, the price paid by the buyer and accepted by the seller is said to represent the "fair market value" of the firm. Despite investment banking "fairness opinions," some target firm shareholders will argue the price offered for their shares is inadequate, contest it in court, and choose to have their shares valued by an independent appraiser, state statutes permitting. Historically, judges in so-called 5 The Supreme Court stipulated that the Chancery court erred when it increased the "perpetuity growth rate" from 3.1% to 4% as it presented no data to justify the increase.

This had the effect of significantly increasing the value of DFC shares. Small changes in this growth rate can result in sizeable changes in DCF valuation estimates. 6 Going concern value is the value of the firm as a continuing entity as opposed to the value of the business if liquidated and its assets sold separately. 7 In an LBO Model, the rate of return required by equity investors would normally be above the return generated in calculating the going concern or standalone value because of the high degree of leverage and associated risk. "appraisal rights" hearings have relied on experts whose opinions rely on conventional valuation methodologies. In recent years, judges frustrated by the often contradictory opinions expressed by experts have deferred to the merger price or actual price paid for target firm shares as long as the process used to determine the price was deemed fair. As such "fair market value" and "fair value" are the same, under these circumstances.8 The concept of "fair value" is applied when no active market exists for a business, accurate cash flow projections are problematic, or it is not possible to identify the value of similar firms. "Fair value" differs from "fair market value," which is the cash or cash-equivalent price that a willing buyer and a willing seller would accept for a business. "Fair value" is, by necessity, more subjective because it represents the dollar value of a business based on an independent appraisal of the net asset value (assets less liabilities) of a firm.

What follows is a discussion of a court ruling in which a judge concluded that the actual price paid (or "fair market value") selling shareholders for their shares did not represent "fair value." The judge determined what was fair (rather than the market) despite finding nothing unfair with the process employed by the parties to the negotiation. Was this an example of judicial overreach (i.e., a judge in effect changing the statute rather than simply applying existing law to the facts of the case) or an illustration of protecting shareholder rights? As you will see, the answer is not straight forward. Vice Chancellor Travis Laster of the Delaware Court of Chancery exercised his legal right to determine what is fair on June 16, 2016 in ruling that public shareholders were undercompensated for their shares in the 2013 $24.9 billion management buyout of Dell Corporation. The judge ruled that the price paid to such shareholders was undervalued by 22% and should have been $17.62 per share, even though he found no wrongdoing with the process Dell management and Silver Lake Partners employed in buying out public shareholders. With interest, investors who sought appraisal will collect about $20.84 per share. While finding the process fair, Vice Chancellor Laster viewed it as incomplete as he argued that the Dell board of directors did not pay sufficient attention to all bidders (both private equity and strategic buyers).

The judge also argued that the purchase price was based on a leveraged buyout model valuation which he argued was not an actual market determined price. In an LBO model valuation,9 a buyer's offer is based on its desired return which is often higher than what a strategic buyer would require due to the amount of financial leverage involved in financing the LBO. The judge claimed that the purchase price in the Dell deal reflected only what a private equity firm would pay and not a true market price. The latter he reasoned would be higher because strategic buyers often pay higher prices than private equity firms because they can exploit synergy opportunities. Concluding the buyout price was not reflective of "fair value," the judge used the DCF analyses provided by the experts to compute a "fair value" of $17.65 for each share held by Dell's public investors. 8 See the case study at the beginning of this chapter for a more detailed discussion of this point. 9 A leveraged buyout (LBO) valuation model analyzes the contribution of alternative sources of funds to the determination of financial returns to equity investors (i.e., so-called financial buyers). The use of large amounts of debt to finance the acquisition of a target firm improves significantly the return to equity investors, although excessive amounts of debt add to the risk of the deal. The judge's conclusion ignored the absence of strategic bidders showing an interest in buying Dell. Thus, the auction process included only private equity firms.

The deal was widely contested in public by the likes of such activist investors as Carl Icahn who argued relentlessly that the price offered by Michael Dell and Silver Lake Partners undervalued the stock held by public shareholders. If the judge's conclusion was correct, Dell's public shareholders acting rationally should have chosen to vote against the deal, as they did have access to Icahn's arguments. Instead, they voted for the transaction in large numbers. While the ruling applied to 5.5 million Dell shares (out of the more than 40 million purchased by Dell) costing the firm an additional $36 million, the potential impact could have been much greater. A number of shareholders including T. Rowe Price were excluded from the appraisal case because they had voted for the deal. To qualify for having shares appraised in most states, a shareholder must have voted against a deal. Consequently, had other shareholders been included as plaintiffs, the ruling could have cost Dell hundreds of millions of dollars. Will the ruling accelerate the trend toward "appraisal arbitrage" in which hedge funds buy a firm's shares after takeover announcements intent upon suing the bidder claiming the price was too low? The number of appraisal rights petitions has indeed increased from a trickle of cases in early 2000s to over 20 a year in recent years, or close to one-quarter of all transactions where appraisal rights were available to target firm shareholders.10 Also, will deals be more difficult to negotiate because of the additional uncertainty posed by the potential adverse impact from appraisal arbitrage? Critics of the Delaware Court of Chancery's decision expressed concern over the broad implications for the future of corporate takeovers, arguing that the judge's ruling exceeded a reasonable interpretation of the law. Critics also argued that seller shareholders could be hurt in the future because fewer private equity firms might participate in auctions for fear the price agreed to by the buyer and seller can be increased postmerger by hedge funds encouraged to profit from activist judges presiding over appraisal rights hearings. The decision means that companies, critics contend, do not simply have a fiduciary duty to find a buyer willing to pay the highest price, but that a judge may ultimately deem what the price should be.

Discussion Questions

1. Whats the appropriate way to determine a takeover price? (Consider the application of conventional valuation methodology, the negotiating process in which the parties involved are not subject to duress, and an impartial arbiter's (i.e., a judge) determination)

2. Do you believe this court ruling is appropriate considering the facts of the case? Explain your answer.

3. Should a freely negotiated purchase price always be used as the appropriate valuation of a target firm's shares assuming the process was fair? Explain your answer.

4. How does this case illustrate the shortcomings of discounted cash flow (and other methodologies) in valuing a business?