Valuation Issues in Dissenting Shareholder Cases McGladrey LLP. All Rights Reserved McGladrey LLP. All Rights Reserved.

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1 Valuation Issues in Dissenting Shareholder Cases May 13, McGladrey LLP. All Rights Reserved.

2 Our presenters today John Stevenson Director, McGladrey LLP Minneapolis, MN Chad Dolly Manager, McGladrey LLP Minneapolis, MN

3 Agenda Introduction Fair Value Standards Valuation Methodologies in M&A Context Selected Court Cases Summary Q&A 2

4 Introduction Typical Shareholder Disputes Dissenting shareholder appraisal rights Shareholder oppression Buy/sell agreement 3

5 Dissenting shareholder v. Minority oppression cases Dissenting Shareholder Cases Relates to appraisal rights provided to minority shareholders, which allow them to dissent from corporate actions Occurs in the context of a merger, sale of assets or stock exchange transaction, which may be detrimental to a minority shareholder Minority Oppression Cases Found in corporate dissolution statues Allows minority shareholders who have been oppressed in relation to a corporate action or at the hands of a majority shareholder to file suit for judicial dissolution of a corporation 4

6 Standards of value Fair market value the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. [Treasury Reg (b); Revenue Ruling 59-60, C.B. 237] Fair value - statutory the value of the shares immediately before the effectuation of the corporate action to which the shareholder objects, excluding any appreciation or depreciation in anticipation of the corporation action unless exclusion would be inequitable. [Revised Model Business Corporation Act,1984] Fair value - financial reporting the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction ti between market participants i t at the measurement date. [ASC 820] Investment value the value to a particular investor based on individual investment requirements and expectations ti [International ti Glossary of Business Valuation Terms, 2001] 5

7 Fair value standard Fair Value - statutory Standard of value used for dissenting shareholder cases and minority oppression cases Defined by statute t t or state t case law Several definitions exist: - Revised Model Business Corporation Act (1984 and 1999) - American Law Institute Definition - Some states have developed their own definitions of fair value 6

8 Fair value standard Revised Model Business Corporation Act 3 rd Edition (1984) The value of the shares immediately before the effectuation of the corporate action to which the shareholder objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable. Key points Provides guidelines, but is not specific on how fair value should be determined Valuation must exclude effects of the action in a dispute unless exclusion would be unfair No instructions as to what valuation method should be used No definition of inequitable 7

9 Fair value standard Revised Model Business Corporation Act was revised in 1999 as follows: The value of the corporation s shares immediately before the effectuation of the corporate action to which h the shareholder h objects using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal, and without discounting for lack of marketability or minority status except, if appropriate, for amendments to the certificate t of incorporation pursuant to section 13.02(a)(5) Key points Mirrors the American Law Institute definition: - Customary and current valuation techniques - Rejection of the use of marketability and minority discounts Majority of states still use the pre-1999 RMBCA (or a variation thereof) to define fair value 8

10 Fair value standard American Law Institute definition The value of the eligible holder s proportionate interest in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability. Fair value should be determined using the customary valuation concepts and techniques generally employed in the relevant securities and financial i markets for similar businesses in the context of the transaction giving rise to the appraisal. Key points Use customary valuation techniques Without a discount for marketability or minority status Used by six states including Colorado, Minnesota, New Jersey, Arizona, Connecticut, and Utah 9

11 Valuation methodologies in M&A context Income Approach - Discounted cash flow analysis Market Approach - Comparable public company method - Merger and acquisition transaction method Cost Approach - Net asset value method 10

12 Income approach Discounted Cash Flow method Discounted Cash Flow method Requires long-term financial projections Requires support for revenue growth and margin assumptions Free cash flow is the preferred economic measure - Amount of cash generated after providing for the investment needed to support projected operations Working capital, capital expenditures and cash acquisitions Weighted Average Cost of Capital (the discount rate) - Cost of equity - Cost of debt - Capital structure weightings Target/industry capital structure Actual capital structure 11

13 Income approach Discounted Cash Flow method Terminal value - Value of the firm at the end of the forecast period Comprises ~40-60% of total value for mature firms Will be over 70% of total value for high growth firms Methodologies - Perpetual Growth Model Normalize free cash flow for the final forecast year Assumes a constant growth rate of free cash flow in perpetuity p - Exit Multiple Approach Comparable M&A transactions and publicly traded companies - M&A multiples often have embedded synergies - Public company multiples generally believed to have an implied minority discount 12

14 Market approaches Comparable Public Company method Comparable Public Company method The comparable public company method is based on valuing a company relative to the value of similar firms that trade in the public markets Comparability criteria: Similar products/ services, markets and customers Size of revenue and asset base Profit margins, earnings variability and growth outlook Financial leverage and capital requirements Qualitative factors (e.g. management strength and intellectual property) Generally results in an indication of value on a minority level of value with marketability 13

15 Market Approaches M&A Transaction method Merger and Acquisition Transaction method Same selection criteria as with the comparable public company method except it is based on sale/merger transactions of both public and private companies Generates a control level of value and normally includes payment for expected synergy benefits Transactions are often dated Private company financial data and transaction information is usually not obtainable or incomplete Generates a control, marketable level of value 14

16 Valuation approach Cost method Cost method Primarily used for investment and real estate holding companies or for asset intensive businesses with losses or low profitability Adjusts all individual assets and liabilities to market value Applies if liquidation is a consideration Not appropriate for a going concern 15

17 Levels of value Strategic Value Special Buyer Synergies Controlling Interest Value Control Premium Financial Buyer Minority Interest Discount Marketable, Minority Interest Value (publicly (Publicly traded stock price) Discount for Lack of Marketability Non-Marketable, Minority Interest Value 16

18 Delaware court Delaware Court of Chancery - The majority of U.S. companies are incorporated in Delaware, thus Delaware law plays a central role in adjudicating valuation disputes. - Decisions are closely followed by the legal and valuation community. - There has been a significant increase is appraisal litigation over the last few years. 17

19 Selected court cases Sunbelt Beverage Corporation (Delaware Chancery 2010) Background of Case - Privately held wholesale distributor of wine and spirits - Merinoff family owned 85% while remaining 15% was owned by Janet Goldring - Board approves freeze out merger to cash out Goldring at formula price of $45.83 per share supported by fairness opinion - Goldring brought suit arguing that buyout price based on the formula was unfair 18

20 Selected court cases Sunbelt Beverage Corporation (Delaware Chancery 2010) Valuation Issues - Relevance of formula based approach Cash out price determined by formula set in a 1994 Shareholders Agreement - Contemporaneous fairness opinion Validity and timing of fairness opinion questioned - Applicability of comparable transaction approach Debate on whether the transactions used were truly comparable Selection of median multiple - Size Premium and Company Specific Risk Premium Support for selection of size and company specific risk premium 19

21 Selected court cases Sunbelt Beverage Corporation (Delaware Chancery 2010) Court Ruling - Chancellor ruled that cash-out price based on formula set forth in 1994 Shareholders Agreement was not relevant to the fair value at time of merger - Court found fairness opinion which had been prepared at time of merger was highly suspect - Court rejected use of comparable transaction method due to lack of support for comparability to subject company - Selection of median multiple from comparable transaction method was not appropriate - Court rejected use of company specific risk premium since it believed risks were industry risks and not company specific 20

22 Selected court cases Golden Telecom, Inc. v. Global GT LP (Delaware Supreme 2010) Background of Case - Golden Telecom merged into Lillian Acquisition, Inc. after a tender offer in February All tendering Golden shareholders received $105 per share - Minority shareholder objected and received an appraisal of $ per share from Delaware Chancery Court - Principal matter was whether the merger price itself was proof of fair value Golden Telecom argued that fair value could be determined based on merger price - Both sides hired an independent appraiser to perform a valuation 21

23 Selected court cases Golden Telecom, Inc. v. Global GT LP (Delaware Supreme 2010) Valuation Issues - Does the merger price serve as a proxy for fair value? - Use of historical average versus supply-side Equity Risk Premium Golden expert used SBBI long-term historical average Minority shareholder expert used SBBI supply side ERP - Historical versus forward looking Beta Golden expert used Bloomberg five-year weekly historical Minority shareholder expert used the Barra forward-looking beta - Terminal Growth Rate Golden expert used lower terminal growth rate based on inflation in Russia Minority shareholder expert used a higher terminal growth rate based on the midpoint between forecasted Russian GDP growth rate and the forecasted Russian inflation rate 22

24 Selected court cases Golden Telecom, Inc. v. Global GT LP (Delaware Supreme 2010) Court Ruling - Rejected merger price as fair value since all relevant factors must be considered in determining fair value - Court concluded that use of the lower supply side equity risk premium better supported the current view of the valuation community - Court developed a blended beta based two-thirds on Bloomberg data and one-third on industry beta - Court favored use of higher terminal growth rate. 23

25 Selected court cases Berger v. Pubco Corporation, et al. (Delaware Chancery 2010) Background of Case - Pubco Corporation completed a short-form merger Minority shareholders received $20 per share - Minority shareholder, Barbara Berger, objected and filed a class action lawsuit and sought appraisal - Chancellor Chandler of the Delaware Court ruled fair value at $38 per share - Each of the valuation professionals used only the Discounted Cash Flow method and the book value method 24

26 Selected court cases Berger v. Pubco Corporation, et al. (Delaware Chancery 2010) Valuation Issues - Control Premium Two parties disagreed on appropriateness of adding control premium to the value of Pubco s shares derived from the discounted future benefits method - Capital Gains Tax Treatment Pubco owned a portfolio of securities which had appreciated Pubco s valuation professional reflected the expected capital gains tax that would be realized if Pubco s portfolio of securities were sold at current market prices by reducing the per share price by $

27 Selected court cases Berger v. Pubco Corporation, et al. (Delaware Chancery 2010) Court Ruling - Control Premium Should only be applied under certain circumstances using the guideline public company method - Capital Gains Tax Treatment Court rejected taking a haircut to the per share value to reflect the expected capital gains tax A dissenter should receive a proportionate share of fair value in the going concern and not the share of liquidation value 26

28 Selected court cases Answers Corporation Shareholders Litigation (Delaware Chancery 2011) Background of Case - Board of Directors concluded a sale of the company would be in the best interest of the shareholders - Shareholders moved for an injunction of sale, arguing the sale was a result of an unfair sales price and process - An offer price of $10.50 per share was received - Board of Directors hired a financial advisor who prepared a fairness opinion and concluded $10.50 per share was fair - Plaintiffs argued that Board relied on a flawed fairness opinion in assessing the transaction No DCF analysis performed Use of guideline public companies that are not comparable to Answers No add back for excess cash 27

29 Selected court cases Answers Corporation Shareholders Litigation (Delaware Chancery 2011) Valuation Issues - Discounted Cash Flow method Is the DCF method appropriate when company management is not able to prepare a long term forecast due to unique characteristics of the business? - Guideline Public Company method Is it appropriate to use the Guideline Public Company method when pure comparable companies are not available? - Excess cash Add back the excess cash as of date of transaction 28

30 Selected court cases Answers Corporation Shareholders Litigation (Delaware Chancery 2011) Court Ruling - Court ruled that it was acceptable for financial advisor not to perform a DCF valuation since Answers management did not prepare a long-term forecasts DCF is not an absolute necessity - Court recognized that no other company was truly comparable to Answers and stated that the financial advisor recognized this weakness and attempted to make reasonable adjustments for it Use of only the most comparable companies to Answers - Add back of excess cash Unique financial structure Financial advisor correctly included cash in reaching the value conclusion 29

31 Selected court cases Cox Enterprises, Inc. v. News Journal Corp. (U.S. Court of Appeals, 11 th Circuit, December 21, 2007) Background of Case - News Journal Corporation was a privately held Florida company which publishes a daily newspaper - Cox Enterprises is a diversified media company which owns 47.5% of News Journal - Cox learned of a contribution totaling $13 million for naming rights on a performing arts center and sued for fraud, waste, and mismanagement - News Journal elected to purchase Cox s interest at fair value pursuant to Florida statue - Parties disputed the amount and sought judicial appraisal of shares 30

32 Selected court cases Cox Enterprises, Inc. v. News Journal Corp. (U.S. Court of Appeals, 11 th Circuit, December 21, 2007) At trial, Cox s expert determined fair value of the interest to be $145 million while News Journal determined the value at only $29 million Valuation Issues - Fair Value Versus Fair Market Value Cox s expert used the comparable M&A transaction method which implied fair market value District court ruled that FMV could be used to calculate fair value, but News Journal challenged this issue - Going Concern Definition Both experts valued News Journal as a going concern but Cox s expert normalized operating margins whereas News Journal s expert assumed the company would operate in the future exactly as it had in the past 31

33 Selected court cases Cox Enterprises, Inc. v. News Journal Corp. (U.S. Court of Appeals, 11 th Circuit, December 21, 2007) Court Ruling - Fair value and fair market value Not synonymous, y but terms aren t mutually exclusive Can be appropriate for a court to use fair market value to estimate fair value as long as certain conditions are met District court and Eleventh Circuit concurred with Cox s expert s use of comparable M&A transactions to determine fair market value 32

34 Selected court cases Cox Enterprises, Inc. v. News Journal Corp. (U.S. Court of Appeals, 11 th Circuit, December 21, 2007) - Going Concern Valuation District court agreed with Cox s expert s use of normalization adjustments since News Journal would be managed in a reasonable prudent manner going forward, even though it hadn t been in the past Eleventh circuit ruled that fair value should consider the impact of waste resulting mismanagement and thus operating margin normalization adjustments performed by Cox s expert were appropriate 33

35 Summary of Delaware valuation cases Increased scrutiny as to the comparability of guideline public companies Preference for the discounted cash flow method Preference for projections made by management in the ordinary course of business Preference for Perpetuity Growth Model over the Exit Multiple Approach in deriving the terminal value Improvements in cash flow obtainable by current management/control shareholder and not deemed too speculative are included in the valuation Fair value normally disregards d a third-party t sale price as it includes synergies dependent on the transaction/plans by the acquirer Exclusion of capital gains tax attributable to speculative future sales of assets is acceptable 34

36 Conclusion Fair value is generally considered to be similar to fair market value without the application of shareholder level discounts Do not use only one valuation method if others are suitable Do not apply a control premium to the value from the Discounted Cash Flow method unless there are extenuating circumstances Must have in-depth support for the application of a company specific risk premium Must support the selection of valuation multiples with detailed financial analysis and consideration of qualitative factors The valuation professional must work closely with legal counsel to understand the facts and circumstances including the statutory context and case law implications for the case at hand. 35

37 Addressing your questions John Stevenson Director, McGladrey LLP Minneapolis, MN Chad Dolly Manager, McGladrey LLP Minneapolis, MN Please type questions in the Q&A dialogue box and click Ask 36

38 Thank you for attending! Reminder to obtain CLE credit Attend the webcast for a minimum of 50 or 60 minutes to receive credit depending on your state requirement Answer all the poll questions Complete post-event evaluation 1.0 CLE credit hours will be issued to eligible participants within 60 days via Follow-up materials The presentation slides and a link to the call recording will be sent to all participants within a few days of the webinar 37