In re Appraisal of The Orchard Enterprises, Inc., C.A. No. 5713-CS (Del. Ch. July 18, 2012) (Strine, C.)
In this post-trial Memorandum Opinion, Chancellor Strine addresses the treatment of a preferred stock liquidation preference and revisits fundamental valuation principles applied in statutory appraisal proceedings on his way to finding a fair value of $4.67 per share of respondent The Orchard Enterprises, Inc. (“Orchard” or the “Company”) common stock. The fair value assigned by the Court represents a 127% increase to the $2.05 per share merger consideration paid by Orchard’s controlling stockholder Dimensional Associates, LLC (“Dimensional”) to the minority stockholders in the underlying cash out transaction.
The parties’ principal dispute over Orchard’s value stemmed from their differing treatment of a $25 million liquidation preference owed by Orchard in certain circumstances to its preferred stockholders – which consisted primarily of Dimensional. The $25 million liquidation preference was payable to Dimensional in three circumstances: a dissolution of the Company, a sale of all or substantially all of the Company’s assets leading to a liquidation of the Company, or a sale of control of the Company to an unrelated third party. The parties agreed that the underlying going private transaction did not fall into one of the three categories and therefore did not trigger the $25 million liquidation preference. Nevertheless, Orchard argued that the liquidation preference was a “near certainty” on the merger date and therefore reflected the value of the preferred stock. Based on that argument, Orchard’s expert deducted the liquidation preference from the Company’s going concern value prior to pro-rating the going concern value among the common stockholders for purposes of determining the per share fair value of Orchard’s common stock. Petitioners posited that the triggering of the liquidation preference was speculative and that the preferred stock should therefore be valued on an as-converted to common stock basis.
The Court agreed with Petitioners and found that the liquidation preference had not been triggered as of the merger date and that the possibility of any of the triggering events occurring at all “was entirely a matter of speculation.” Relying on settled precedent in the statutory appraisal context, the Court found that the speculation about a potential post-merger event required by Orchard’s position was improper. The Court also found that the speculative post-merger event – a potential third-party merger or liquidation – that would trigger the liquidation preference was not the type of event that is supposed to be the basis for an appraisal value. Rather, the fair value in an appraisal is to be determined based on the subject company’s going concern value. The Court therefore held that the preferred stockholders’ share of Orchard’s going concern value at the time of the merger was equal to the preferred stock’s as-converted value, not the liquidation preference payable to the preferred stockholders if a post-merger, speculative liquidation event were to occur.
Following resolution of the liquidation preference issue, Chancellor Strine engaged in the analysis of the battle of the experts familiar to statutory appraisal proceedings. He first addressed the appropriate valuation methodology. Petitioners’ expert relied solely on a discounted cash flow (“DCF”) analysis. Orchard’s expert employed a DCF analysis as well as comparable companies and comparable transactions analyses. Despite the Court’s expressed preference in other decisions to triangulate among the common valuation methodologies, the Chancellor rejected the comparable companies and comparable transactions methodologies in this case and relied solely on the DCF analysis. The Chancellor found that none of the comparable companies selected by the Company’s expert were similar to Orchard. Also, he was highly concerned that the Company’s expert did not even rely on his sample of comparable companies or transactions, but instead chose his own multiples “in a directional variation from the median and mean that serve[d] his client’s cause.” Because, among other reasons, the Company’s expert was unable to justify his subjective judgment in selecting multiples skewed in his client’s favor and different than those calculated from his samples, the Court found that Orchard failed to meet its burden that its comparables-based analyses were reliable.
The remaining issues addressed by the Chancellor were the proper projections and the appropriate discount rate to use for the DCF analysis. The Court adopted the projections modified by the Company’s financial advisor with management input and used in its fairness opinion because those projections were prepared closest to the transaction and therefore were “the best indicator of Orchard management’s then-current estimates and judgments.” The selected projections included a base case and an aggressive case. The Court gave 90% weight to the base case projections and 10% weight to the aggressive case projections because the base case projections were more in line with Orchard’s actual results for the twelve months preceding the merger. With respect to the discount rate, the Court adopted the CAPM method over the build-up rate model and the Duff & Phelps Risk Premium Report model because, among other reasons, CAPM is generally accepted by the corporate finance community and involves less subjectivity than the other methods. In calculating the discount rate, the Court followed its reasoning in Golden Telecom and adopted the supply-side equity risk premium over the historical equity risk premium. The Court rejected the use of a company-specific risk premium because it is not an addition to CAPM accepted by corporate finance scholars and explained that any company-specific risk should generally be accounted for by making adjustments to the projections. Finally, the Court recognized that a size premium is an accepted part of CAPM and adopted a size premium in its discount rate calculation. However, the Court declined the Company’s request to adjust the size premium because the supply-side rather than the historical equity risk premium was used in the discount rate calculation. The Court relied on a valuation treatise to support its finding that the size premium calculated using the historical equity risk premium should not be adjusted if the supply-side equity risk premium is used to calculate the discount rate, though the Chancellor recognized that “the academic and practitioner thinking [in] this area seems to be in a period of active evolution.”