March 01, 2013

The Orchard Enterprises, Inc. (“Orchard” or the “Company”) is a company that generates revenue from the retail sale (through digital stores such as Amazon and iTunes) and exploitation of its controlled, licensed music catalogue. In March 2010, Orchard’s controlling shareholder, Dimensional Associates, LLC, offered to cash out the minority shareholders at a price of $2.05 per share. As part of the contemplated transaction, Orchard hired a financial advisor to issue a fairness opinion that the offer of $2.05 was fair to the minority shareholders from a financial point of view. After performing a variety of financial analyses, the Company received a signed fairness opinion and proceeded with the transaction. On July 29, 2010, Dimensional Associates, LLC took the Company private and cashed out the minority shareholders at a price of $2.05 per share. It should be noted that a majority of the minority shareholders of Orchard voted in favor of the going private merger.

Subsequent to the deal, certain minority shareholders of Orchard filed suit, claiming that their shares were actually worth $5.42 as of the date of the transaction. By contrast, the Company claimed that the merger price was generous and that the shares were actually only worth $1.53 each. This case was taken before the Delaware Court of Chancery (the “Court”) to decide on the Fair Value of the minority shares in a statutory appraisal action that took place in 2012. Like many recent cases that have come before the Court, this case provides some important insights into the valuation process that other experts should be aware of going forward, particularly when testifying in Delaware. While the Court addressed many issues between the experts in its 55-page opinion, this article is going to focus on the two most significant valuation issues that impacted the conclusions in this case. The most hotly contested issues were the treatment of the preferred stock of Orchard and the appropriate discount rate to be used in the Discounted Cash Flow (“DCF”) analysis.

Treatment of Preferred Stock

Based on the capitalization of Orchard, the preferred stockholders, who were also the controlling common shareholders, had the right to a $25 million liquidation preference upon the occurrence of certain events (e.g., liquidation, change of control). Given that the transaction that was the subject of this proceeding was not a liquidation or change of control, the liquidation preference was not triggered by the going private transaction. However, the expert for the Company subtracted the value of the preferred stock from the total value of Orchard in order to derive the common equity value. After a review of the terms of the preferred stock, the Court disagreed with this position. The Court stated that, “For purposes of an appraisal proceeding, ‘fair value’ means ‘the value of the company to the stockholder as a going concern, rather than its value to a third party as an acquisition.’ The court should consider ‘all relevant factors known or ascertainable as of the merger date that illuminate the future prospects of the company,’ but ‘any synergies or other value expected from the merger giving rise to the appraisal proceeding itself must be disregarded’.”

Based on the facts and circumstances of the Company’s preferred stock, the Court noted that, “Unlike a situation where a preference becomes a put right by contract at a certain date, the liquidation preference here was only triggered by unpredictable events such as a third-party merger, dissolution, or liquidation. Most important, according to settled law as originally set forth by the Delaware Supreme Court in Cavalier Oil Corporation v. Harnett, the petitioners are entitled to receive their pro rata share of the value of Orchard as a going concern. This means that the value of Orchard is not determined on a liquidated basis, and the company must be valued ‘without regard to post-merger events or other possible business combinations’.” The Court concluded that because the liquidation preference was only applicable upon a sale or liquidation of the Company, it was not consistent with the going concern premise that is required in an appraisal proceeding.

The Court noted that in prior cases, where preferred stockholders had the right to put their shares back to the Company and obtain their liquidation preference, the going concern value of the company as of the date of the merger had to take into account the detriment to common equity of the non-speculative obligation of the company to pay out the liquidation preference. However, in this case, the Court stated that, “if Orchard remains a going concern, the preferred stockholders’ claim on the cash flows of the company (if paid out in the form of dividends) is solely to receive dividends on an as-converted basis. That is, in the domain of appraisal governed by the rule of Cavalier Oil, the preferred stockholders’ share of Orchard’s going concern value is equal to the preferred stock’s as-converted value, not the liquidation preference payable to it if a speculative event (such as a merger or liquidation) that Cavalier Oil categorically excludes from consideration occurs . . .
Thus, Cavalier Oil makes clear that in an appraisal action, the petitioners are entitled to their ‘proportionate interest in a going concern.’ Importantly, this means that the value of the company under appraisal is not determined on a liquidated basis, and the company must be valued ‘without regard to post-merger events or other possible business combinations’.”

Based on this ruling by the Court, it is clear that the specific terms of any preferred stock need to be analyzed carefully in a valuation given the going concern nature of a statutory appraisal action. If the preferred stock holders do not have the right to obtain their liquidation preference without the occurrence of speculative future events, it may not be appropriate to subtract the preferred liquidation amount in order to value the common equity.

Discount Rate to be Utilized in the DCF

The largest disagreement between the opposing experts in the DCF analysis related to the appropriate discount rate to be used. Each expert utilized three different methods to derive a discount rate: the capital asset pricing model (“CAPM”), the build-up model (“BUM”), and the Duff & Phelps Risk Premium Report model (another form of the traditional BUM). As will be discussed, the Court ultimately ruled that CAPM is the accepted model for valuing corporations while the BUM is purportedly not accepted by mainstream corporate finance (despite the fact that both experts employed two versions of the BUM).

CAPM vs. BUM

Before even analyzing the specific inputs and assumptions in the discount rates determined by the experts, the Court spent a significant amount of time analyzing the methods themselves, and effectively eliminating everything other than traditional CAPM. In its lengthy ruling on this topic, the Court stated the following:

“The build-up model is not, in my view, well accepted by mainstream corporate finance theory as a proper way to come up with a discount rate. Indeed, its components involve a great deal of subjectivity and expressly incorporate company specific risk as a component of the discount rate. This is at odds with the CAPM, which excludes company-specific risk from inclusion in the discount rate, on the grounds that only market risk should be taken into account because investors can diversify away company-specific risk. Relatedly, corporate finance theory suggests that concern about the achievability of the company’s business plan and thus its generation of cash flows should be taken into account by adjustments to the cash flow projections, and not by adjusting the discount rate. The build-up model, however, allows for a variety of risks to be poured into the discount rate, including so-called projection risk and other factors.

Because of these factors, this court has been at best ambivalent about indulging the use of the build-up method, and has preferred the more academically and empirically driven CAPM model when that can be applied responsibly. In contrast to the build-up model, which has not gained acceptance among distinguished academicians in the area of corporate finance, the CAPM method is generally accepted, involves less (but still more than comfortable) amounts of subjectivity, and should be used where it can be deployed responsibly. In deploying that method, this court has taken into account, as it will here, evolving views of the academy and market players regarding its appropriate application.”

Despite the Court’s claims that the BUM is not accepted by mainstream corporate finance theory, several of the very books that the Court cites as treatises in its opinion actually devote whole chapters to the BUM and its application. The most prominent sources include Ibbotson’s SBBI Valuation Yearbook and Cost of Capital: Applications and Examples, by Shannon P. Pratt and Roger J. Grabowski. Notwithstanding the Court’s decision in this case, the BUM does appear to be a widely recognized method to estimate the discount rate for a privately held company. Nonetheless, if you are testifying in the Delaware Court of Chancery, it is advisable to be aware of this claim by the Court so that you are fully prepared to defend your analysis if you consider the BUM in your DCF method.

CAPM Components

Even within CAPM, there are several areas of debate that the Court addressed, as outlined in the following paragraphs.

Equity Risk Premium

For the third time in recent years, the Court determined that when estimating the equity risk premium to include in CAPM, the supply-side equity risk premium is more appropriate than the historical equity risk premium. The Court stated that, “Golden Telecom’s default acceptance of the supply-side equity risk premium was recently embraced by this court in Gearreald v. Just Care, Inc. In that appraisal action, Vice Chancellor Parsons rejected the respondent’s use of a historical equity risk premium under Golden Telecom, finding that the expert had provided ‘no persuasive substantive financial reason as to why the application of a supply-side equity risk premium would be inappropriate.’ Like the respondent in Just Care, Orchard has not provided me with a persuasive reason to revisit the supply-side versus historical equity risk premium debate. I therefore find that the Ibbotson Yearbook’s supply-side equity risk premium of 5.2% is an appropriate metric to be applied in valuing Orchard under the CAPM.” Based on this ruling, it appears that anyone who would attempt to utilize the historical equity risk premium in Delaware had better have convincing empirical data that the supply side is unreliable, as the Court’s viewpoint on this topic appears to continue to grow stronger.

Size premium

Like the equity risk premium, the size premium to be included in CAPM has become an accepted component of a discount rate analysis. In this case, the Court stated that, “A size premium is an accepted part of CAPM because there is evidence in empirical returns that investors demand a premium for the extra risk of smaller companies.” While the existence of a size premium may have a consensus, the level of the size premium is still being contested. The appropriate size premium to utilize for small companies continues to be analyzed in Delaware, with the appropriateness of Ibbotson’s 10th decile coming under scrutiny. In this case, both experts relied upon the same size premium of 6.3% in their respective CAPM calculations of Orchard’s cost of capital, which is the size premium for the broader 10th decile published in the 2010 Ibbotson Yearbook. This analysis was well received by the Court.

In the Orchard opinion, the Court stated that, “The parties agree that Orchard technically falls into sub decile 10z… The Ibbotson Yearbook size premium for sub decile 10z is 12.06%, which is nearly twice the size premium chosen by the parties’ experts. But, a rote application of the 12.06% premium to Orchard is improper because the 10z sub decile includes troubled companies to which Orchard, which is debt free, is not truly comparable. The Ibbotson Yearbook does not exclude speculative or distressed companies whose market capitalization is small because they are speculative or distressed. Before one uses the size premium data for 10z, one needs to determine if the mix of companies that comprise that sub decile are in fact comparable to the subject company… [One of the experts] explained at trial that he was cautious to use the 10z sub decile because doing so would ‘run the risk of including companies in there that may be going through financial distress or other situations that may, in fact, skew [the] size premium numbers’.” Based on this ruling, any use of the Ibbotson 10z sub decile (even if the company being valued technically falls into that category) should be utilized with great caution given the attributes of the companies included in that classification.

Company-Specific Risk Premium

The Court once again showed great skepticism toward any inclusion of company-specific risk in the discount rate. The Court went so far as to say that, “I do not believe that a companyspecific risk premium should be used in a CAPM calculation of a discount rate, especially in a case like this.” To read into this, the Court is stating not that this company does not warrant a company-specific risk premium, but that no company does. This implies that any expert testifying in Delaware should think twice (or maybe three times) about including this component in a CAPM analysis. While, once again, well-respected valuation treatises (e.g., Cost of Capital: Applications and Examples) include a discussion on the implementation of a company-specific risk premium, the Court has shown a strong propensity to eliminate this component of the CAPM consistently. As such, it would likely be wise to incorporate this admittedly subjective assumption into your DCF analysis in another way. In fact, the Court addressed another method of adjusting a DCF analysis for company-specific risks when it stated the following:

“For a corporation that operates primarily in the United States and where there are sound projections, the calculation of a CAPM discount rate should not include company-specific risk for the obvious reason that it is inconsistent with the very theory on which the model is based. If there are concerns about projection risk because the projections were generated by an inexperienced management team, the company’s track record is such that estimating future performance is difficult even for an experienced management team, or projections seems to be infected with a bias, it would be better for the expert to directly express his skepticism by adjusting the available projections directly in some way, to make plain his reasoning. Admittedly, this would involve as much subjectivity as heaping on to the discount rate, but it would also force more rigor and clarity about the expert’s concern …

In terms of projection risk, I suppose I can see the rough utility of ‘stress testing’ projections when they are from an unreliable source. No doubt private equity and venture capital firms use hurdle rates to see how far off the projections of unproven managers can be for an investment to still make sense. Having no way to directly adjust the cash flows in the manner that some standard valuation treatises suggest is proper (but do not explain how to do), some market participants no doubt use the discount rate as a crude way of applying a doubt factor to the projections. In this way, they are ‘discounting’, but not coming up with a discount rate in a way consistent with CAPM. Rather, they are conflating what is being discounted with the discount rate.”

Based on this analysis, it appears that the Court would prefer to see an expert who has doubts about projected cash flows either: 1) adjust the projected cash flows; or 2) utilize multiple scenarios for projected cash flows and then apply appropriate weightings.

In this case, the expert who was applying the company-specific risk premium was involved with management in creating the projections. As such, the Court did not find his testimony on company-specific risk related to optimistic projections to be credible. Further, according to the Court, all of the items that he used to support his company-specific risk premium were known to management at the time the projections were prepared, and were therefore inherent in the various projections. Because the expert already weighted the different projection scenarios based on his own opinion, the Court determined that he had already dealt with the projection risk. An expert must be careful not to double count risk by probability weighting the cash flows and also applying a company-specific risk premium.

Conclusion

The Delaware Court of Chancery continues to be the leading business court in the country, so valuation experts would be well advised to consider the rulings that emerge in future valuation projects. However, some of the rulings from the Court may be influenced by a lack of convincing evidence and empirical research, such that certain precedents could be overturned with the proper support. As such, as the valuation industry continues to research important components of our work such as CAPM, BUM, equity risk premium, and size premium, it is critical for experts to stay on the cutting edge in order to ensure the most current research and practices are presented to the judges who are ruling on these cases and helping to develop the business valuation profession.