Fair value is defined in Delaware Code Annotated Section 262(h) as (with parenthetical numbers and emphasis added):
After the court determines the stockholders entitled to an appraisal, the appraisal proceeding shall be conducted (1) in accordance with the rules of the Court of Chancery, including any rules specifically governing appraisal proceedings the Court shall determine the fair value of the shares (2) exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value. (3) In determining fair value, the Court shall take into account all relevant factors…
All Relevant Factors
This statute states that the Delaware Court of Chancery will determine fair value according to its own rules for so doing. So it is good to understand “the rules” (1).
Fair value will be determined without consideration of any benefit or detriment that might arise from a contemplated transaction (that gives rise to statutory dissent rights) (2).
And we know that the Court of Chancery will take “all relevant factors” into account (3). All relevant factors covers a lot of ground, both related to valuation and to other factors that might be relevant for a court.
In Wisniewski v. Walsh, a recent New Jersey Appellate decision, we learned that the bad behavior of a selling shareholder could be one of the “relevant factors” in a New Jersey fair value determination. The range of potential “relevant factors” is quite wide.
In Delaware, a term has developed in the statutory fair value case law that helps to interpret what fair value might mean. That term is “a proportionate interest in a going concern.” While this term originated in Delaware, it has come to pervade cases in many jurisdictions. So we ask an important question.
What is a Proportionate Interest in a Going Concern?
In Tri-Continental vs. Battye (1950 Del. LEXIS 2), we read:
The basic concept of value under the appraisal statute is that the stockholder (1) is entitled to be paid for that which has been taken from him, viz., (2) his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant (3) the true or intrinsic value of his stock which has been taken by the merger. In determining what figure represents this true or intrinsic value, (4) the appraiser and the courts must take into consideration all factors and elements which reasonably might enter into the fixing of the value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other factor which were known or which could be ascertained as of the date of merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholders’ interest, but must be considered by the agency fixing the value. (emphasis and parenthetical numbers added)
We can break this down somewhat. Begin by noticing that this guidance introduces new terms like “true or intrinsic value.” The cited case was written some 65 years ago, but the concepts of “proportionate interest in a going concern” and “true or intrinsic value” have been cited in many, more recent cases. We now look at the components of this guidance:
- The shareholder is entitled to be compensated for that which was taken from him. It may seem obvious, but in a statutory fair value matter, a dissenting shareholder is to be paid for what was forcibly (in a legal sense) taken from him.
- What was taken from him was his proportionate interest in a going concern. So if the going concern was worth $50 million and the shareholder owned 10% of it, the shareholder is entitled to a fair value of $5 million (10% x $50 million). That part is simply math. But we have to figure out what is meant by “proportionate interest in a going concern.”
- What was taken is the true or intrinsic value of the stock taken by the merger. These words are difficult for appraisers to address. What is “true value.” I’m certainly not sure. What is “intrinsic value.” Intrinsic value in valuation terms is defined in the ASA Business Valuation Standards as: “The value that an investor considers, on the basis of a valuation or available facts, the “true” or “real” value that will become the market value when other investors reach the same conclusion.” What is “true” or “real” value? What is meant by the value “that will become the market value when other investors reach the same conclusion? That sounds like a concept of “investment value,” which is defined in the same standards as: “The value to a particular investor based on individual investment requirements and expectations.” Investment value is value to a given investor based on his or her view of the economics of a particular business asset. This is sometimes calculable, but it is not a concept of market value. If the current market price of a stock is $40 per share, and I believe that in the near future, based on what I know, the shares will be worth $50 per share, then what is the value to me under this guidance? It is murky at best.
- The appraiser will take all reasonable and relevant factors that go into determining value. These factors are precursors of Revenue Ruling 59-60 and its famous list of factors. The Tri-Continental factors include market value, asset value, dividends, earnings prospects and the nature of the business. They also include any other relevant information that was known or reasonably discernable at the valuation date which might give insight into the future prospects of the merged corporation. This guidance is a bit confusing in light of the statute above which precludes any benefit or detriment from the merger. Nevertheless, the guidance calls for looking at the outlook for and the prospects of the business under consideration.
As noted above, other courts have picked up on the concept of the proportionate interest in a going concern. In the New York statutory fair value case, Beway (Matter of Friedman [Beway Realty Corp]. 87 NY2d 161), we find the term used as follows:
Thus, we apply to stock fair value determinations under section 623 the principle we enunciated for such determinations under section 1118 that, in fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, “‘what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business’” (Matter of Pace Photographers [Rosen], 71 NY2d at 748, supra, quoting Matter of Blake v Blake Agency, 107 AD2d at 146, supra [emphasis supplied]).
New York is not Delaware, but in Beway, we get some elaboration on the concept of a proportionate interest in a going concern. The New York decision interprets what that means by saying it is what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business. That is helpful guidance, because it clarifies that the valuation concept is what can be called an enterprise, as opposed to a shareholder, type of value.
By enterprise here, I mean the value of the equity of the corporation as a whole. So the shareholder gets his or her proportionate share of the value of the corporation as a whole. The New York court in Beway clarifies this by saying it is the kind of value that would be derived from a transaction with a “willing purchaser” capable of acquiring the corporation in its entirety. This is a control level of value concept.
Recall the traditional levels of value chart.
A great deal of confusion has arisen in statutory fair value matters because the valuation concepts and evidence provided in the precedent cases in many jurisdictions relates to the traditional levels of value chart.
For example, in New York, under Beway, a minority interest discount is forbidden. In the chart above, if no minority interest discount is taken, then the value is that of control. But as we learned in an earlier post, the evidence giving rise to this upper level of value relates primarily to strategic or synergistic acquisitions.
It is difficult to avoid confusion in a fair value determination if the appraisers and the courts are using the terminology in the 3-level, levels of value chart above. On the one hand, fair value sounds like a control concept, but if no minority interest discount is allowed, then the only control concept is the top level in the chart above, which is really a strategic control concept.
But courts in various jurisdictions may not like the concept of strategic control for fair value. In a recent New York statutory fair value decision involving AriZona (Iced Tea) Beverage Company, the court found specifically that “going concern” value was to be determined at the financial control level of value.
[Counsel for Ferolito, the selling shareholder in AriZona, argued that strategic control was appropriate because there were a number of strategic buyers who had already expressed interest in AriZona. Since these were the most likely buyers, they argued, potential synergies should be considered in the determination of fair value.]
Note that there is no such level on the chart above. The financial control level of value is found on the updated, 4-level chart we discussed in an earlier post in this series and shown again below:
In the updated chart just above at the top, we see that strategic, or synergistic, control is separated from the financial control level by a strategic control premium. The chart is annotated to say that the inverse of the strategic control premium is not a minority interest discount. So if we determine value at the financial control level, which is coincident with the marketable minority level, there is little or no minority interest discount separating these two concepts.
Justice Driscoll in the AriZona matter did not allow consideration of the cash flow elements giving rise to a strategic (or synergistic) control premium, and therefore did not allow consideration of the strategic control level of value. Justice Driscoll wrote:
The Court will thus not assume a valuation that relies on hypothetical so-called synergies, as these would be too speculative to quantify with any certainty. Instead, the Court will value AriZona using the “financial control” measurement, that is, “the value of a company exposed to a representative group of buyers who are not expecting synergies, who are looking at the value of the business on a standalone basis, who may not be able ro run the company [a little differently but not –] a little better but not differently like the synergies.” Trial Tr. at p. 2429, lines 19-24.
Justice Driscoll quoted the trial testimony of an expert to find that the going concern value he sought was not strategic control but was financial control. At that point there was no thought of applying a separate and forbidden minority interest discount. The quoted testimony was mine and it related to the 4-level chart above.
If fair value in a jurisdiction is the proportionate interest in a going concern, it could either be at the strategic control level or the financial control level. However, because of the prohibition of the use of minority interest discounts, appraisers and courts need to develop a common vocabulary that will enable both to develop realistic indications of statutory fair value.
In the meantime, be well!