Appraisal Week Continues: Using Comparable Companies and Comparable Transactions Valuations

Is it the mean or the median?

I’m teaching appraisal in Mergers & Acquisitions this week. Today, we’re turning to valuation in appraisal. And, in preparing for class, I learned something interesting yesterday. (Well, interesting if you’re a corporate law geek like me.)

Mergers and sales of all or substantially all corporate assets can be likened to a form of private eminent domain. If the requisite statutory number of shares approves the transaction, dissenting shareholders have no statutory basis for preventing the merger. Granted, some of the minority shareholders may believe that the merger that is being forced upon them is unfair. They may want to retain their investment in the target or they may believe that the price is unfair.

Corporate statutes give hold-out shareholders no remedy where they simply want to keep their target shares—the statutes permit majority shareholders to effect a freeze-out merger to eliminate the minority. All the statute gives disgruntled shareholders is a right to complain about the fairness of the price being paid for their shares; namely, the appraisal remedy.

All appraisal statutes authorize appraisal rights in statutory mergers of close corporations. Beyond that, however, it is impossible to generalize. Whether appraisal rights are available for any other type of transaction depends on which state’s law governs. In many states, appraisal is available in connection with a wide range of fundamental transactions, including mergers, sales of all or substantially all corporate assets, and even certain amendments to the articles of incorporation. For example, Model Business Corporation Act § 13.02(a)(4) provides appraisal rights in connection with article amendments effecting a reverse stock split.

In contrast, under DGCL § 262(b), Delaware law provides appraisal rights “for the shares of any class or series of stock of a constituent corporation” only in connection with statutory mergers.¹

Photo by Sasun Bughdaryan on Unsplash

To exercise their appraisal rights, dissenters must give the company written notice prior to the merger vote, not vote in favor of the merger, and then file an appraisal claim in the Delaware Chancery Court. Thet court will then determine the fair value of the shares.

The statute provides no specific guidance regarding statistical methodologies, instead leaving the issue to judicial discretion.

At one time, Delaware courts—like those of many other states even today—used a valuation method known as the Delaware block method. It determined the company’s value using three measurements: book value, capitalized earnings, and market value. It then took a weighted average of the three to produce a final number. Relatively simple but laughingly inexact.

In Weinberger v. UOP, Inc.,² the Delaware Supreme Court officially abandoned the block method. (The method’s retention of the Delaware name thus is a misnomer.) The court acknowledged that the block method makes little sense from a finance theory perspective. The court therefore set out to up-date Delaware law. Curiously, it did so by seemingly throwing open the courthouse door to virtually anything short of the valuation equivalent of junk science: “We believe that a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court. . . .”³

In the years following Weinberger, the Delaware Chancery Court came to rely mainly on the discounted cash flow (DCF) valuation method. As Chancellor William Allen observed, the Court’s members came to believe that: “In many situations, the discounted cash flow technique is in theory the single best technique to estimate the value of an economic asset.”⁴

Gradually, however, the Delaware Chancery Court has departed from exclusively focusing on DCF analysis. As one Chancellor explained, where “a discounted cash flow analysis reveals a valuation similar to a comparable companies or comparable transactions analysis, I have more confidence that both analyses are accurately valuing a company.”⁵

The comparable companies approach asks what stock price (or earnings multiple) is commanded by similar publicly traded companies. The comparable transactions approach looks at prices recently paid in acquisitions of similar companies. The Delaware Supreme Court has endorsed the use of both.⁶

In a comparable companies analysis, the appraiser begins by select a set of peer firms comparable to the firm to be value. The appraiser then picks several activity measures to use as metrics, such as sales, operating income, or EBITDA. The appraiser then calculates the value of each comparable company as a multiple of the chosen activity measure, chooses a representative value or range, and applies the resulting multiple to the same activity measure at the target company.

In a comparable transaction valuation, the appraiser begins by selecting recent acquisitions of comparable companies using such criteria as growth prospects, investment strategy, leverage, and corporate structure. The appraisal then proceeds as in the comparable company analysis, except that the transaction price is used as the enterprise value instead of current market value.

As I thought about those methods preparing for class, I wondered whether the Delaware courts have given any guidance as to whether one uses the mean value of the comparable set’s metrics or the median value. It turns out, they have.