Don't Get Left Out in the Cold in a Freeze-out Merger: Lessons to Learn From Hazelett Strip-Casting
Don't Get Left Out in the Cold in a Freeze-out Merger: Lessons to Learn From Hazelett Strip-Casting
This article discusses the events surrounding an attempted buyout of Hazelett Strip-Casting Corporation’s minority shareholders by way of a reverse stock split and shareholder freeze-out. The Delaware Chancery Court ruled on the fairness of the attempted buyout, both with respect to the price that was paid as well as the process that was followed.1
Founded in 1929 and located in Colchester, Vermont, Hazelett Strip-Casting Corporation (“Hazelett” or the “Company”) manufactures casting machines for the production of aluminum, zinc, lead, copper strip, and related products. Given the size and nature of the products that Hazelett produces, the Company only sells between zero and four new machines per year. Most of Hazelett’s stable and recurring revenue actually comes from servicing existing machines and selling spare parts.
Since 1956, Hazelett had been owned by two brothers, with one owning 70% of the equity and the other owning 30%. When the brother with the 30% interest passed away, he left his shares to 169 individuals. In order to avoid the inconvenience of having to run his family business with the oversight of 169 new shareholders, the controlling owner of Hazelett decided to buy out the new minority shareholders. As such, the controlling owner of Hazelett cashed out the minority shares held by the estate of his deceased brother by way of a reverse stock split.
The Buyout Offer and Reverse Stock Split
In October 2004, the controlling owner of Hazelett offered to buy out all of the minority shareholders of the Company for $1,500 per share. This price was set unilaterally, and no valuation analysis was performed. In conjunction with the buyout offer, and in order to push for a quick sale, the controlling owner communicated to all of the minority shareholders that he would always be in control of the Company, Hazelett would not pay any dividends in the foreseeable future, the Company would never be sold, and that he was not in a position to increase the offer. However, the minority shareholders and the executors of his brother’s estate were concerned that the $1,500 per share offer undervalued the Company and that they should hold out for a better offer.
Given the delays and lack of motivation to sell by the new minority shareholders, the controlling owner, with the approval of the Board of Directors, decided to enact a reverse stock split. In October 2005, the Company approved the reverse stock split, which created fractional shares among the minority shareholders, along with an amendment to Hazelett’s certificate of incorporation prohibiting fractional shares. Given that the minority shareholders’ interests were no longer allowed to remain outstanding, a valuation was performed in order to determine a buyout price.
Following the reverse stock split and proposed buyout, the minority shareholders filed a lawsuit challenging the reverse stock split as a breach of fiduciary duty and a violation of Section 155 of the Delaware General Corporation Law. Upon its review, the Delaware Chancery Court (the “Court”) determined that, “by statute, if a corporation effects a transaction that results in fractional interests and opts to compensate stockholders in lieu of issuing fractional shares, then the corporation must pay ‘in cash’ an amount equal to the ‘fair value’ of the fractional interests ‘as of the time when those entitled to receive such fractions are determined.’”
Before the Court could make a fair value determination, it first had to decide upon the appropriate standard of review. The Court ultimately ruled that, “when a controlling stockholder uses a reverse split to freeze out minority stockholders without any procedural protections, the transaction will be reviewed for entire fairness with the burden of proof on the defendant fiduciaries.” In applying this standard to the Hazelett transaction, the Court found that the 70% shareholder had complete control of the Company and the Board of Directors, which meant that he controlled the authorization of the reverse split. Neither the decision to authorize the buyout, nor the price of the buyout, included any shareholder safeguards such as a special committee of the board or a majority-of-the-minority vote. Ultimately, the Court concluded that, “there was no dealing in this case that could be called ‘fair.’”
The Valuation Standard
Once the Court determined that the process followed in the attempted buyout of Hazelett’s minority shareholders was not fair, the focus turned to the applicable valuation standard. To this end, the Court noted that, “in the one Court of Chancery ruling to address the valuation standard for a controlling stockholder freeze-out implemented through a reverse split, the Court held that the defendants had a duty ‘to pay stockholders who are cashed out the fair value of their stock as that term is defined in the appraisal cases and in the breach of fiduciary duty cases in merger transactions.’”
With respect to the fair value in an appraisal proceeding, the Court cited from the Delaware Supreme Court that, “the basic concept of value under the appraisal statute is that the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern. By value of the stockholder’s proportionate interest in the corporate enterprise is meant the true or intrinsic value of his stock which has been taken by the merger.” As such, both sides hired business valuation experts to determine the fair value of the stock of Hazelett that was purchased from the minority shareholders.
The Valuation of Hazelett
Between the two experts in the case, there were four valuation methodologies applied, including: capitalized earnings, book value, comparable companies, and capitalized free cash flow. The Court’s comments on the experts’ analyses, as well as the appropriate valuation methods in general, provide significant insight into how the Court views valuation and the proper execution of the methodologies.
The Rejected Valuation Methods
Comparable Companies Method. The Court completely rejected the comparable companies method in its analysis. The primary reason that the Court did not give any weight to the comparable companies analysis related to its opinion that the chosen companies lacked sufficient comparability. Hazelett was a small manufacturing company that had experienced erratic earnings. The Court noted that the companies selected for comparison were, “much bigger than Hazelett Strip-Casting, have more diversified customer bases, enjoy better access to capital, and have deeper management teams.”
Further, Vice Chancellor Laster concluded that, “I lack sufficient confidence in the comparability of the selected companies to use the comparable company method, even with adjustments to reflect their differences from Hazelett Strip-Casting.” Ultimately, the Court determined that, “while appropriate adjustments can account for some differences, ‘at some point, the differences become so large that the use of the comparable company method becomes meaningless for valuation purposes.’” Based on the Court’s ruling, it is apparent that not every business valuation can credibly utilize an analysis based on comparable public companies. For some companies, there may not be any public companies that are comparable enough to make the analysis relevant.
Capitalized Free Cash Flow Method. With respect to the capitalized free cash flow method, given that the Court endeavored to go through the process of analyzing and adjusting the capitalized earnings methods prepared by both experts, Vice Chancellor Laster chose not to undertake the exercise of modifying this analysis in light of the redundant inputs. However, one item noted by the Court as a weakness of one expert’s analysis was the use of only a two-year average in estimating a normalized level of free cash flow. Given Hazelett’s operating structure and fluctuating performance over the prior years, the Court noted that this appeared to be an inappropriate assumption as it did not capture the full volatility in earnings that could be expected going forward (based on the past).
The Accepted Valuation Methods and the Court’s Adjustments
Capitalized Earnings Method. Both experts in this case prepared valuations based on the capitalized earnings method. As such, the Court relied on this as one of the primary methods to assess the value of Hazelett.2 With respect to the capitalized earnings method, the Court stated that, “the approach boasts a considerable Delaware pedigree as one of the methodologies comprising the Delaware Block Method.” Further, with respect to whether historical or projected earnings should be utilized in this type of analysis, the Court noted that, “reliable earnings projections should be used when available. ‘[It is] intrinsically more appealing to rely on the future prospects of a company, where reliable projections are available, than the historical earnings of the company because the theoretically more correct measure of the entity’s value, under an earnings valuation approach, is the present value of its future cash flows or earnings.’” However, Hazelett management did not prepare any projections that could be used in the valuations. As such, the Court determined that, “if reliable projections are not available, then the Court should look to historical earnings to provide the best available insight into the company’s future earnings potential.” Giving further insight into the Court’s thinking on this theoretical issue, Vice Chancellor Laster stated the following with respect to the Court’s view: “When using historical results to develop a projection of future performance, Delaware courts have preferred to calculate an average across a multi-year period. This practice is designed to obtain a representative projection by smoothing out variations and balancing extraordinary gains or losses. Under the Delaware Block Method, our courts adopted a five-year period as the norm. Delaware courts would use a shorter period ‘only in the most unusual situations.’ Post-Weinberger, Delaware law does not mandate a five-year earnings period, and a court may use one year of results, a two- or three-year average, a longer period, or a weighted average to determine the earnings base.”
It is important to note that the level of earnings utilized in the capitalized earnings method is not simply the reported earnings from the company’s financial statements. An expert should first adjust a company’s actual earnings to remove the impact of unusual or nonrecurring items to better represent future expectations. However, it should also be recognized that in a shareholder dispute, it is typically not appropriate to make controlling or synergistic adjustments to earnings consistent with what an outside buyer would pay for the business.
In this case, one of the experts made an adjustment to the research and development costs for Hazelett because he deemed that it was too high and that a rational buyer would invest less in research and development. However, this breaks the rule of valuing the business “as a going concern based on the operative reality.” As the Court stated, “the R&D adjustment that [the expert] advocates ‘normally would be made only in the case of a controlling interest valuation, unless there was reason to believe that the changes were imminent and probable.’ It represents a change in business operations that a minority stockholder has no power to make. ‘[F]air value’ should be determined on the basis of future free cash flows associated with the going concern, including the agency costs inherent in the enterprise prior to the merger. This view comports with the well established principle of Delaware law that minority shareholders have no legal right to demand that the controlling shareholder achieve – and that they be paid – the value that might be obtained in a hypothetical third-party sale. Because a reduction in R&D expense only could be made by a new controller of Hazelett, adjustments to reflect those changes would generate a third-party sale value, not going concern value.”
Based on the Court’s ruling, it appears that valuations for shareholder disputes in Delaware should utilize a normalized level of earnings (which could include adjustments for excessive compensation or above-market related-party transactions), but should not consider changes to the operating structure of the company that minority shareholders cannot make. Further, whenever possible, valuation experts should utilize forward-looking earnings to appropriately capture the value of the business. If projections are not available, a normalized level of earnings should be utilized, considering the variations in the company’s business over time.
Book Value Method. While the book value method can be a reasonable method for valuing an operating company under certain circumstances, it typically sets the floor value for a profitable business. In its analysis, the Court noted some of the important attributes of the book value method, including that, “book value can be an appropriate valuation method for a business that derives significant value from its physical assets. Book value tends to undervalue a business as a going concern because it does not fully account for intangible value attributable to the operations.” Based thereon, if a valuation analysis utilizing one of the going concern valuation methods concludes on a value below the company’s book value, it is important to consider whether or not the value of the company’s assets (less the corresponding liabilities) would be higher on a liquidation basis. In this case, the expert for the defendants did not even consider the fact that the Company’s book value was more than four times higher than his concluded value of equity based on the capitalized earnings method.
It should be noted that there are times when the book value of a company could be higher than a reasonable conclusion of value given certain accounting treatments or market value conditions, but it is important to consider the impact an asset-based valuation method would have on a final conclusion of value. In this case, the expert for the defendants did not even consider these implications, and the Court was critical of this oversight.
In the Court’s decision on this case, Vice Chancellor Laster made it clear that when a controlling owner intends to force a buyout of minority shareholders by way of a reverse stock split, that controlling owner has a fiduciary duty to look out for the best interest of the minority shareholders. In addition, implementing safeguards such as an independent special committee or a vote of the minority shareholders may be a prudent course of action. Further, once the buyout has been approved, the valuation of the minority interests needs to employ accepted methodologies and practices, including utilizing projections or normalized historical earnings. Experts should likely not: 1) consider adjustments that could only be made by a third-party purchaser to change the operations of the company; 2) utilize a valuation based on public companies that are not sufficiently comparable; or 3) ignore the value of a company’s underlying assets. As stated in this decision, in a reverse stock split and freeze-out, the minority “stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern.”
1 Reis v. Hazelett Strip-Casting Corporation, Case No. 3552-VCL, January 21, 2011.
2 It should be noted that the capitalized earnings method utilized and referenced by the Court was simply average adjusted net income divided by a capitalization rate. The Court stated that the capitalization rate in this method is typically obtained by using the inverse of a price-to-earnings ratio for comparable public companies. In this case, given that no comparable public companies were found, a build-up method was utilized to estimate the capitalization rate.