Court frowns on speculative adjustments

The Delaware Chancery Court recently awarded dissenting minority shareholders more than double the merger cash-out price in a fair value appraisal decision. In Re: Appraisal of Orchard Enterprises Inc. highlights the importance of using well-supported, objective inputs throughout the appraisal process.

Court sides with dissenters

Public company Orchard Enterprises, an online music provider, was unable to find a third-party buyer. So its controlling shareholder, Dimensional Associates, decided to delist it and buy out the common shareholders for $2.05 per share in 2010. Orchard sold for $1.34 per share on the NASDAQ before announcing its going-private transaction.

Dissenting shareholders asserted that the fair value of Orchard’s stock was $5.42 per share. Orchard’s expert appraised the stock at $1.53 per share. The primary reason for the discrepancy was a $25 million preferredstock liquidation preference that the respondent’s expert subtracted from the equity’s value before allocating value to the common shares.

The court decided that the liquidation preference hadn’t been triggered and, therefore, shouldn’t be subtracted, because it was speculative. The company hadn’t dissolved, sold all of its assets or been sold to an unrelated third party.

Orchard argued that potential buyers would discount their offers for the preferred stock liquidation preference. Although the respondent’s argument “may be grounded in market realities,” the court ruled that Delaware law and legal precedent require appraisers to focus on going-concern value, not speculative liquidation values.

Breaking ground on other valuation issues

The court also resolved discrepancies between the experts’ valuation appraisal methodologies. The market approach was rejected, because the comparables Orchard’s expert used were insufficiently similar to the subject company.

When quantifying the cost of equity, the court preferred the capital asset pricing model (CAPM) to the build-up method, because the latter was “larded with subjectivity.” Although the court allowed a size premium, it stated that company-specific risk factors belong in cash flow projections, not embedded in the subject company’s cost of capital. And the historic equity risk premium was rejected in favor of the supply-side equity risk premium.

Controlling shareholders ante up

The result of these findings was a fair value of $4.62 per share — more than double the original merger cashout price. The respondent learned some hard lessons: Use methodologies supported by the latest academic research, minimize the use of subjective data and avoid speculative adjustments when valuing a business. You can avoid the respondent’s mistakes by hiring an experienced valuator who knows how to achieve the proper balance between subjective judgment and objective analysis.