The market events of the past two years have provoked a lot of debate and press coverage, if not a lot of definitive action, regarding legislative and regulatory changes that will impact the activities of financial sponsors and institutional investors. While adjusting to the changing legislative and regulatory landscape, deal makers and their advisors would also be well served to understand the effect of the latest judicial developments when contemplating transactions. One relatively recent legal decision that is particularly interesting from a valuation and financial opinion perspective to those in the financial sponsor and institutional investor community, and to their investment bankers and other deal advisors, comes from the In re Sunbelt Beverage Corp. Shareholder Litigation.1
The Sunbelt decision in early 2010 yielded Delaware Chancery Court commentary on both appraisal rights actions and breach of fiduciary duty issues in transactions. While it is always advisable for investment bankers and valuation professionals to be familiar with the latest academic and industry developments related to valuation techniques, Sunbelt highlights the benefit of also being intimately familiar with the latest relevant Delaware court decisions on transaction and valuation issues when preparing fairness opinions in transactions or preparing valuations in shareholder disputes.
The Sunbelt proceeding emanated from the August 22, 1997 merger of SBC Merger Corporation with and into Sunbelt Beverage Corporation (“Sunbelt”), one goal of which was the cash-out of the Plaintiff as a minority shareholder in Sunbelt. Sunbelt is a privately held Delaware corporation that is a wholesaler of wine and spirits in multiple states. Plaintiff contended that members of the Sunbelt board of directors violated their fiduciary duties in cashing her out at an unfair price ($45.83 per share), for which Plaintiff sought either rescissory relief or an award of the fair value of her shares in Sunbelt as of the merger date. At the time of the Merger, Plaintiff held 120,000 shares of Sunbelt stock, or approximately 14.9% of the company. Ultimately, although denying the request for rescissory relief, the Court ruled in favor of the Plaintiff and awarded a price of $114.04 per share (the result of an expert valuation process), plus pre- and post-judgment interest and experts fees.
There are five main areas of commentary in Sunbelt which financial sponsors and their investment banking and valuation advisors should be aware of when considering transactions that may involve a fairness opinion or when presenting valuation analysis in a shareholder dispute.
1I Process is key. While this is not a new concept, Sunbelt is yet another case that drives the issue of transaction process home as the Court noted the board of directors failed to, “use any of the procedural devices that could temper…the applications of the entire fairness standard, such as a special negotiating committee of disinterested and independent directors or a majority-of-the-minority stockholder vote provision…the process here was anything but fair…the ultimate step in the process, the Merger, included no procedural protections designed to ensure arm’s-length bargaining or to approximate a fair valuation procedure. There was no special committee, no opportunity for genuine negotiations regarding the merger consideration, and no dissemination of material information that would level the playing field and prevent Plaintiff from becoming a drastically disadvantaged minority shareholder.”
2I Fairness opinions without demonstrated due-diligence are not favorably received. Again, not a new concept, but an often ignored one. The Sunbelt board hired a valuation advisor to prepare a fairness opinion. The fairness opinion (that $45.83 was a fair price for a share of Sunbelt stock) was prepared in the span of one week, without extensive consultation with Company management, while the preparer was simultaneously working on another project which required trans-continental travel. The Court’s view was that the fairness opinion “was a mere afterthought, pure window dressing intended by defendant to justify the preordained result of a merger...In short, defendants abjured any semblance of a fair process.” Fairness opinion analyses are almost always required within an expedited time frame, at least in comparison to the timing of a typical tax or financial reporting related valuation project. However, fairness opinion providers need to balance the need for expediency with the need for diligent analysis. Even if achieving such balance requires difficult conversations with a client or their counsel regarding reasonable timing, all will be better served in the end. Strict adherence to the guidelines outlined in NASD Rule 2290 will also serve fairness opinion providers and their clients well.
3I Comparable company transaction selection – be prepared for scrutiny. While Delaware courts have certainly recognized the use of the comparable transactions approach when determining the fair value of companies, they have also stated that “the burden of proof on the question whether the comparables are truly comparable lies with the party making that assertion.”2 Highlighting the need for sufficient due diligence in comparable transaction selection and analysis in Sunbelt the Court was, “hesitant to examine what apparently are personality-driven transactions in a private market and to use the terms of those transactions to project what the value of another transaction should be. When faced with these concerns, it is important to be particularly diligent about selecting companies and transactions that are as comparable as possible to the company in question. Ultimately, I am skeptical that Defendant’s valuation expert’s analysis achieved sufficient comparability, which alone is a basis for me to reject it as a reliable indicator of fair value.” While the selection and interpretation of truly appropriate comparable transactions can be challenging in any situation, the Sunbelt decision makes it particularly clear that it is not sufficient to simply apply the
median implied multiple from a set of transactions involving companies in the same general industry. A comparable transaction analysis is much more likely to be a meaningful indicator of value, and to therefore withstand serious scrutiny, if the unique attributes of each transaction are fully understood
and accounted for in applying the data to the subject company.
4I Small firm risk premia selection in WACC calculations requires thoughtful support. While the Court in Sunbelt upheld the use of a small firm risk premium in the calculation of the weighted average cost of capital (“WACC”) for the discounted cash flow analyses of both Defendant’s and Plaintiff’s valuation experts, it also challenged the method of selecting the appropriate small-firm risk premium. While both experts made use of the widely utilized Ibbotson Associates size based risk premium data, the court had issue with the selection of the appropriate premium, stating,
“a discounted cash flow analysis both values the size of a company (and thus points to the appropriate Ibbotson premium to use) and relies on the appropriate Ibbotson premium to determine the value of the company. This process is circular; which should come first, the valuation of the company or the selection of the Ibbotson risk premium?...when the very issue in dispute is the value of the company itself and when a discounted cash flow analysis is a proposed means for resolving the dispute, the appropriate risk premium cannot be taken as exogenous. There must be some independent basis or value used for determining the propriety of applying a risk premium from the Ibbotson table.”
While a properly vetted comparable transaction analysis may have been useful in alleviating the Court’s concern in this instance, the point is clear that the Delaware court is looking for independent support for selection of the appropriate small firm risk premium when using the Ibbotson data as a source.
5I Company specific risk premia in WACC calculations – are they supportable? The Court began its discussion of this issue in Sunbelt by reciting prior case law that “the proponent of a company specific premium bears the burden of convincing the Court of the premium’s appropriateness.”3 After referring to other Delaware case law that deemed a company specific risk premium to be appropriate,4 Defendant’s valuation expert offered three primary points in support of the inclusion of a company specific risk premium in the valuation of Sunbelt: (1) the at-will termination of supplier agreements that prevailed throughout the wholesale alcohol distribution industry; (2) the competition Sunbelt faced from specific players; and (3) the level of optimism contained in Sunbelt’s management projections. The court concluded “that none of these justifications merits inclusion of a company specific risk premium for Sunbelt. The first and second justifications clearly relate to the industry as a whole, rather than specifically to Sunbelt…I see no evidence, persuasive or otherwise, that at the time they were developed management projections were excessively or generously optimistic…Furthermore...I am skeptical that a company specific risk premium is an appropriate response to optimistic management projections…It is important for any proposed company specific risk premium to be based on specific financial analysis, so that the Court can verify both the propriety of including the risk premium and the appropriate level of the premium. Defendants have failed to meet their burden to demonstrate why Sunbelt faces company specific risks rather than risks faced by all companies in its industry and thus why valuations of the company merit inclusion of a company specific risk premium.” Clearly the Court is expecting a rigorous explanation for inclusion of any company specific risk premium in a WACC calculation.
The Sunbelt case is another interesting example of the differences between the typical academic or investment banking application of corporate finance theory and the interpretation of some of the same issues by the Delaware courts. While they may or may not agree with the court interpretations, investment banking and valuation professionals will surely want to understand the Delaware court interpretations of current financial theory before undertaking a fairness opinion or shareholder dispute related valuation assignment involving a Delaware corporation.