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Update: Business Valuations Under Delaware Law

January 1, 0001

 

A recent Delaware Chancery Court decision, In re Sunbelt Beverage Corp. Shareholder Litigation,[1] provides additional analytic guidance to investment bankers and other valuation professionals involved in rendering fairness opinions and other financial advice. The decision combined an "entire fairness" review of a related-party going-private transaction with the corresponding appraisal rights action. Two aspects of the decision address issues for which the outcome was predicted in "Delaware Law, Financial Theory and Investment Banking Valuation Practice," a previously published article by Scott Widen of our New York office.[2]

As stated in the article, "a technique deemed to be unreasonable in an appraisal context... is unlikely to be deemed reasonable in a breach of fiduciary duty case involving the entire fairness test."[3] Some Wall Street lawyers have dismissed such a connection between the ideas of "fair price" in the fairness opinion context and "fair value" under appraisal procedures. In Re Sunbelt Beverage should force a change in such thinking.

In addition, the article cautioned against the use of a company specific risk premium, absent special circumstances. This view has also been confirmed by In re Sunbelt Beverage, especially in light of the rejection of the expert views of Robert Reilly, the co-author of one of the most widely cited treatises on business valuations,[4] as to the use of a company specific risk premium.

This decision underscores the need to pay close attention to Delaware Chancery Court jurisprudence as well as industry valuation techniques when preparing fairness opinions.

Set forth below are the highlights from the decision by Chancellor Chandler.

  • "Fair price" in a fairness opinion context is closely related to "fair value" under Delaware appraisal statutes.[5]

    Bankers and lawyers must acknowledge Delaware decisions regarding proper valuation methodologies in the appraisal context, for fear of otherwise doing a disservice to their clients and others who may act on their advice.

  • Hurriedly prepared fairness opinions are of little use.

    The court noted that the investment bank's analysis in connection with delivering a fairness opinion for the going-private transaction was prepared in one week, during which the lead banker was simultaneously working on, and travelling for, another project. The court essentially ignored the opinion and the underlying analysis.

  • Comparable Companies/Transaction selections are subject to scrutiny under an "entire fairness" review.

    The court ignored a comparable transactions analysis because of, among other things, differences between the "comparables" and the subject company relating to:

    – size;

    – geography; and

    – product lines.

  • Use of Median Multiples.

    The court expressed a belief in the limited efficacy of a median multiple approach in addressing precedent transaction differences (regardless of the underlying metric). Using a median multiple to establish a valuation range is not necessarily legitimate for addressing comparables that are known to be not truly comparable.[6]

  • Small-Firm Risk Premium.

    The Delaware court once again upheld the use of a small-firm risk premium in calculating a weighted average cost of capital (WACC). More importantly, it provided guidance on the selection of the appropriate size premium in the case of a private company. The court refused to use a comparable transactions analysis to estimate the equity value for determining a size premium. Instead, the court split the difference between the applicable size premiums for Ibbotson's ninth and tenth deciles. This is the approach the court interpreted Ibbotson to take in selecting premiums for companies within or between the ninth and tenth deciles. It is unclear whether the court would have used the comparable transactions analysis to estimate the equity value for determination of the size premium if the court had otherwise relied in part on the transactions analysis.

  • Company-Specific Risk Premium.

    The Delaware court once again struck down the use of a company-specific risk premium in calculating a WACC. The court noted that the use of such a premium is not per se invalid under Delaware law, although the proponent of such use bears the burden of convincing the court of its appropriateness. In particular, the court was not impressed by the arguments that such a premium is proper because of:

    – optimistic management forecasts;

    – at-will termination of supplier agreements (common to the industry); and

    – specific competition.


This decision highlights certain differences between the analyses of Delaware courts, which apply current financial theory (as interpreted by the courts), and the valuation practices of many Wall Street and other valuation professionals. Business valuations subject to review by the Delaware courts, or other jurisdictions that follow the Delaware courts, cannot be properly conducted by simply consulting someone with an MBA or a finance textbook. Proper analysis requires a combination of current financial theory and an understanding of Delaware's interpretation of such theory.

If you would like to discuss this case in particular or Delaware law regarding valuation methodologies more generally, please contact the author.




[1] 2010 Del. Ch. LEXIS 1 (Del. Ch., January 5, 2010).

[2] R. Scott Widen, "Delaware Law, Financial Theory and Investment Banking Valuation Practice," NYU Journal of Law & Business, Vol. 4, Spring 2008.

[3] Id at Note 1.

[4] Shannon P. Pratt, Robert F. Reilly & Robert P. Schweihs, "Valuing a Business" (4th ed 2005).

[5] The court stated that "[t]he element of fair price relates closely to the determination of fair value under the Delaware appraisal statute," and that "[t]he fairness of the [m]erger price is an analytical question common to both the entire fairness and appraisal claims. For the purposes of fair value, I will address the claims as one..."

[6] The court stated that such approach is best "when it smoothes out unknown or immeasurable sources of differences and error in an analysis." It cannot be used as the "sole justification for a failure to account for known and measurable variations or errors in an already small sample size."