Delaware has developed a large body of case law interpreting the Delaware

Financial Valuation: Applications and Models, Third Edition By James R. Hitchner Copyright 2011 by James R. Hitchner CHAPTER 16 ADDENDUM 1 Testing for an Implied Minority Discount in Guideline Company Prices Gilbert E. Matthews, CFA and Michelle Patterson, JD, PhD Delaware has developed a large body of case law interpreting the Delaware statute s appraisal standard in dissenting shareholder cases. The appraisal statute states, [T]he Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, 1 which gave rise to the appraisal proceeding. Fair value is to be ascertained on a going-concern basis. Unfortunately, when Delaware Chancery Court appraisal decisions have applied the guideline company method, the court has often incorporated the concept that guideline company valuations should be adjusted upward to offset a presumed implied minority discount (IMD). 2 The court has accepted the assumption that the market prices of publicly traded shares represent minority interests. As Vice Chancellor Leo Strine put it: The comparable companies analysis generates an equity value that includes an inherent minority trading discount, because the method depends on comparisons to market multiples derived from trading information for minority blocks of the comparable companies. In a [Delaware] appraisal, the court must correct this minority trading discount by adding back a premium designed to offset it. 3 This addendum addresses the Delaware Court s misapplication of control premiums from a business valuation perspective. 4 It focuses on why it is inappropriate to assume that the market prices of guideline companies necessarily include an IMD. A method is proposed whereby the valuator, in any specific valuation, can ascertain whether implied minority discounts exist in the relevant guideline company prices. This article is reprinted with permission from Jim Hitchner s Financial Valuation and Litigation Expert, Issue 19, June/July 2009, pages 4 6, 2009, Valuation Products and Services, LLC. All rights reserved. 1 8 Del. Code Ann. tit. 8, 262(h). 2 The IMD is sometimes called an inherent minority discount or an implicit minority discount. 3 Agranoff v. Miller, 791 A.2d 880 (Del. Ch. 2001) at 892. 4 This issue is discussed in more detail in Gilbert E. Matthews, Misuse of Control Premiums in Delaware Appraisals, Business Valuation Review, Summer 2008. 1

2 FINANCIAL VALUATION LEGAL COMMENTATORS HAVE DISAGREED WITH THE CHANCERY COURT S POSITION Several significant law journal articles have rejected the theory that market prices always include an implied minority discount that must be added back when calculating the fair value of the shares. In 2001, Professor Richard Booth wrote, [I]t is not necessarily the case that actual market price is always less than fair market price. If it were, then there would be no such thing as a fair market price. 5 Professor William Carney also argued that market prices of most publicly traded shares do not include a significant IMD: [C]ontrol premiums only occur in transactions involving a transfer of control, where there are thought to be gains from trade.... Even if all values, both present and potential, are valued in the market price for the firm s shares, one would not expect to find a discernible control premium in a widely held firm that is well managed and appears to offer little probability of a transfer of control. Any small probability of a control transaction will already be reflected in the market price, because absent a dominant shareholder, all shareholders expect to have an equal opportunity to share in any such premium, should it appear. Absent an actual transfer of control, control premiums represent probabilities of a control transfer at a premium. Where the probability is close to zero, so is the premium. 6 In order to determine the amount of adjustment for the premium, Delaware decisions have relied on average premiums in acquisitions. Professors Lawrence Hamermesh and Michael Wachter question this approach and argue that acquisition premiums do not support the assumption that market prices necessarily include IMDs. [I]t is incorrect to make the logical jump that these premiums [paid in acquisitions] reflect some kind of IMD. The fallacy is obvious and analogous to the dogs that don t bark metaphor: there are lots of dogs, and most of the time, most dogs are not barking. Similarly, in any given year, the vast majority of companies are not involved in a change of control transaction. 7 They point out that generally accepted financial theory assumes that market prices of liquid securities in informed markets represent going concern value. They add, There is no evidence that such [market] prices systematically and continuously err on the low side, requiring upward adjustment based on an implicit minority discount. FINANCIAL WRITERS HAVE CONCLUDED THAT PRICES OF GUIDELINE COMPANIES OFTEN DO NOT INCLUDE AN IMD It is incorrect to assume that market prices of guideline companies always include an IMD. Publicly traded shares may trade higher or lower than their pro rata portion 5 Richard A. Booth, Minority Discounts and Control Premiums in Appraisal Proceedings, 57 Business Lawyer 127, p. 130. 6 William J. Carney and Mark Heimendinger, Appraising the Nonexistent: The Delaware Courts Struggle with Control Premiums, 152 U. Pa. L. Rev. 845 (2003), p. 860. 7 Lawrence A. Hamermesh and Michael L. Wachter, The Short and Puzzling Life of the Implicit Minority Discount in Delaware Appraisal Law, 156 U. Pa. L. Rev. 1 (2007), p. 33.

Testing for an Implied Minority Discount in Guideline Company Prices 3 of the equity value of the entire company. There are numerous periods when shares of companies in some industries have traded at higher prices than any prospective cash acquirer would pay for the entire business. A notable example is the dot.com phenomenon in the late 1990s. Internet-related shares in the late 1990s commonly traded at prices well above financial control value. Therefore, Internet companies were seldom bought for cash but were acquired through stock-for-stock mergers with other Internet companies. In 1990, Eric Nath was the first to question whether publicly traded share prices included an implied minority discount. His position questioned the conventional wisdom and argued that market prices generally incorporate control value. His thencontroversial view was that a company s financial control, positives or negatives, was already reflected in its freely traded market prices. 8 Professor Bradford Cornell wrote in 1993: The fact that most companies do not receive takeover bids at premiums above market price indicates investors believe that the shares of those companies are not worth significantly more than market price [emphasis in original]. 9 In a 1999 article, Shannon Pratt stated, Valuation analysts who use the guideline public-company valuation method and then automatically tack on a percentage control premium... had better reconsider their methodology. 10 Mark Lee pointed out in 2001: If there is no M&A market available to sell a company at a premium to its stock market value, then there is little or no acquisition premium, much less a theoretical premium based on an average of acquisitions of dissimilar companies. 11 Pratt quoted Lee s 2001 article and added, [I]t is obvious that, given the current state of the debate, one must be extremely cautious about applying a control premium to public market values to determine a control level of value. 12 Lee further pointed out in a book chapter in 2004 that the acquisition value of a company may be equal to or below its market value. He wrote, While a company may be viewed as very attractive to a purchaser of a minority interest in the public market, the company as a whole may be perceived as too risky at its publicly traded market price. 13 In the same book, Matthews pointed out that when acquisition multiples in contemporaneous transactions are at the same level as market multiples, it makes sense for the analyst to conclude that no [IMD] is warranted. 14 Philip Clements and Philip Wisler agreed in their fairness opinion book, stating, 8 Eric Nath, Control Premiums and Minority Interest Discounts in Private Companies, Business Valuation Review, June 1990, p. 43. 9 Bradford Cornell, Corporate Valuation (McGraw-Hill, 1993), p. 243. 10 Shannon P. Pratt, Control Premiums? Maybe, Maybe Not 34% of 3rd Quarter Buyouts at Discounts, Business Valuation Update, January 1999, pp. 1 2. This article is cited in Pratt, Reilly, and Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fourth Edition (McGraw-Hill, 2000), p. 357. 11 M. Mark Lee, Control Premiums and Minority Discounts: The Need for Economic Analysis, Business Valuation Update, August 2001, p. 4. 12 Pratt, Business Valuation Discounts and Premiums, 2001, p. 40. 13 M. Mark Lee, The Discount for Lack of Control and the Ownership Control Premium, in The Handbook of Business Valuation and Intellectual Property Analysis, Robert F. Reilly and Robert P. Schweihs, eds. (McGraw-Hill, 2004), p. 37. 14 Matthews, Fairness Opinions: Common Errors and Omissions, in The Handbook of Business Valuation and Intellectual Property Analysis, p. 215.

4 FINANCIAL VALUATION The control value of a company may not differ greatly [from] and may even be below its publicly traded minority share value. 15 Although Chris Mercer had disagreed with Nath in the early 1990s, he later came to agree with him. Mercer s 2004 book, The Integrated Theory of Business Valuation, 16 included a modified levels-of-value diagram that showed Marketable Minority Value overlapping Financial Control Value, 17 illustrating his view that the difference between financial control value and marketable minority value could be zero. He commented that unless there are cash flow driven differences between the enterprise s financial control value and its marketable minority value, there will be no (or very little) minority interest discount. 18 Over the past 20 years, Nath, Lee, and Matthews have often criticized the use of average acquisition premiums as a fairness standard. 19 Average acquisition premiums paid for shares of publicly traded companies are statistically biased because they include only companies that were attractive to acquirers and do not include unattractive or overpriced companies. Therefore, average control premium comparisons are often a misleading measure in valuations. As Pratt observed in 2001: Out of the tens of thousands of public companies only a small percentage actually are acquired each year. In recent years, the companies purchased have been best of breed, making them a very unique subset of the market. Statistically, it is unlikely that this small, select group is universally representative of the market as a whole. 20 HOW TO TEST FOR IMD AND, IF APPROPRIATE, QUANTIFY IT An implied minority discount is fact-specific in each valuation, and it cannot be determined by using a generic rule of thumb. 21 The default assumption ought to be that no IMD should be applied unless there is specific data that indicates otherwise. The fact that some companies have been acquired at a premium over market price does not 15 Philip J. Clements and Philip W. Wisler, The Standard & Poor s Guide to Fairness Opinions (McGraw-Hill, 2005), p. 94. 16 Z. Christopher Mercer, The Integrated Theory of Business Valuation (Peabody, 2004). This book and its next edition (Mercer and Travis W. Harms, Business Valuation: An Integrated Theory, Second Edition [Wiley, 2007]) innovatively show the interrelation among various approaches to valuation, discounts, and premiums. 17 Ibid., p. 110. 18 Ibid., p. 108. 19 See, for example, Nath, pp. 41 43; Matthews and Lee, Fairness Opinions & Common Stock Valuations, in The Library of Investment Banking, Vol. IV, R. Kuhn, ed. (Dow Jones Irwin, 1990), p. 407; Lee and Matthews, Fairness Opinions, in The Handbook of Advanced Business Valuation, Reilly and Schweihs, eds. (McGraw-Hill, 2000), p. 327; Lee, Control Premiums and Minority Discounts: The Need for Economic Analysis, Business Valuation Update, August 2001, pp. 2 4; Lee, The Discount for Lack of Control and the Ownership Control Premium, p. 43; Matthews, Fairness Opinions: Common Errors and Omissions, pp. 214 216. 20 Pratt, Business Valuation Discounts and Premiums, 2001, p. 60. 21 The U.S. Tax Court now requires case-specific analyses and rejects generic discounts for lack of marketability. See Mandelbaum v. Commissioner, TCM 1995-255 (1995); Pratt, Valuing a Business, Fifth Edition (McGraw-Hill, 2008), p. 449; Michael A. Paschall, The 35% Standard Marketability Discount: R.I.P, CCH Business Valuation Alert, Feb. 2005, p. 3.

Testing for an Implied Minority Discount in Guideline Company Prices 5 demonstrate that all guideline company prices include IMD. The key factor to be considered is the relation between market multiples and transaction multiples. Although average acquisition premiums are a poor standard, there is meaningful data to be found in guideline acquisitions the multiples paid in those guideline acquisitions. When there is an absence of recent guideline acquisitions, that absence in itself is evidence that market prices of the guideline companies are not at levels that are attractive to acquirers. In that situation, no IMDs would be applicable to that guideline company valuation. In the situation where guideline acquisition data is available, the multiples should be compared to multiples of the guideline companies. If the guideline acquisition multiples (appropriately adjusted to eliminate synergies and market timing) exceed multiples of guideline companies, that fact indicates that the application of an IMD should be considered, and the difference in multiples provides a basis for its quantification. As part of the process, the valuator should consider what adjustment should be made to multiples of guideline transactions to eliminate any synergistic benefits excludable in a Delaware appraisal (or in other jurisdictions with appraisal standards similar to Delaware s). Additionally, adjustments may be required for transactions that were priced at earlier dates under different market conditions, especially for valuations in today s depressed market. CONCLUSION It is clear that leading legal and valuation commentators have concluded that there is no basis for assuming that market prices of all publicly traded shares include an implicit minority discount. The default assumption should be that publicly traded shares sell at a company s going-concern value. The valuator must determine in any given situation whether the guideline companies should be adjusted for IMDs. If an analyst concludes in a given situation that an IMD is appropriate, its magnitude should be based on a comparison between market multiples and appropriately adjusted acquisition multiples. APPENDIX Delaware Cases in which an adjustment was made for IMD: Hodas v. Spectrum Technology, Inc., 1992 Del. Ch. LEXIS 252 (Dec. 7, 1992). Kleinwort Benson Ltd. v. Silgan Corp., 1995 Del. Ch. LEXIS 75 (June 15, 1995). Borruso v. Communications Telesystems Int l, 753 A.2d 451 (Del. Ch. 1999). Bomarko, Inc. v. Int l Telecharge, Inc., 794 A.2d 11615 (Del. Ch. 1999); affd. Int l Telecharge, Inc. v. Bomarko, 766 A.2d 437 (Del. 2000). Agranoff v. Miller, 791 A.2d 880 (Del. Ch. 2001). Doft & Co., Inc. v. Travelocity.com, Inc., 2004 Del. Ch. LEXIS 75 (May 21, 2004). Lane v. Cancer Treatment Centers of America, Inc., 2004 Del. Ch. LEXIS 108 (July 30, 2004).

6 FINANCIAL VALUATION Prescott Group Small Cap, L.P. v. Coleman Co., 2004 Del. Ch. LEXIS 131 (Sept. 8, 2004). Dobler v. Montgomery Cellular Holding Co., 2004 Del. Ch. LEXIS 139 (Oct. 4, 2004); aff d in part, rev d in part on other grounds, Montgomery Cellular Holding Co. v. Dobler, 880 A.2d 206 (Del. 2005). Andaloro v. PFPC Worldwide, Inc., 2005 Del. Ch. LEXIS 125 (Aug. 19, 2005).