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In re Appraisal of AOL Inc., C.A. No. 11204-VCG (Del. Ch. Feb. 23, 2018)

February 23, 2018

In this post-trial memorandum opinion, the Court of Chancery appraised the fair value of AOL Inc.’s (“AOL” or the “Company”) stock at the time of its merger with Verizon Communications Inc. (“Verizon”) at $48.70 per share, $1.30 below the $50.00 merger price. The Court declined to defer to the merger price, finding the sales process was not “Dell Compliant,” but used that price as a check against its discounted cash flow valuation analysis.

In late March 2015, after initial discussions concerning a possible business relationship, Verizon proposed obtaining majority ownership of AOL. The AOL board of directors did not consider the Company as “for sale” and declined to put the Company up for sale, even after Verizon raised the possibility of acquiring 100% of the Company in April 2015.  On May 8, 2015, Verizon made an offer for the Company at $47.00 per share.  After additional negotiations, on May 11, AOL and Verizon agreed to a price of $50.00 per share.  The transaction was structured as a medium-form merger under Section 251(h) of the Delaware General Corporation Law, with a first-step tender offer.

Shortly after the merger was announced, AOL’s CEO gave his “word” in a public interview that the deal would be consummated. The merger agreement included certain deal protections, including a no-shop provision, a 3.5% termination fee of $150 million, and matching rights.  No topping bidder emerged and the merger closed on June 23, 2015.  In response to the merger, six appraisal petitions were filed and those proceedings were subsequently consolidated.

In light of the Supreme Court’s Dell decision, the Court began its analysis by determining whether the transaction was “Dell Compliant.”  According to the Court, “[a] transaction is Dell Compliant where (i) information was sufficiently disseminated to potential bidders, so that (ii) an informed sale could take place, (iii) without undue impediments imposed by the deal structure itself.”  The Court indicated that to the extent the transaction satisfied these criteria, it would be inclined to find that the deal price is the best evidence of fair value.

The Court held that AOL’s sales process was not Dell Complaint despite determining that it satisfied the first two prongs of the test.  According to the Court, the transaction failed the third prong of the test because the no-shop provision combined with (1) AOL’s CEO publicly declaring his intent to consummate a deal with Verizon after the deal was announced, (2) the CEO’s prospect of future employment with Verizon, (3) unlimited three-day matching rights, and (4) Verizon’s having already had ninety days between expressing interest and signing the merger agreement, including seventy-one days of data room access, created a “considerable risk of information and structural disadvantage that would dissuade any prospective bidder.”  While acknowledging that the 3.5% termination fee and a forty-two day window between the signing of the merger agreement and closing “would probably not deter bids by themselves,” the Court concluded that, on balance, the transaction was not Dell Compliant and declined to give any weight to the transaction price in determining fair value.

Instead, the Court applied a DCF analysis to determine fair value. Petitioners’ expert opined that the fair value of AOL stock was $68.98 per share.  AOL’s expert proffered a fair value of $44.85 per share.  The Court adopted the Company’s model as the starting point for its own DCF model, noting that Petitioners seemed content to use that model with adjustments they proposed.  The Court identified four areas of disagreement between Petitioners and AOL over inputs that significantly impacted valuation:  (1) the proper cash flow projections for the DCF; (2) the operative reality of AOL assumed in the DCF with regard to two prospective deals with Microsoft and one with Millennial Media, Inc.; (3) the proper projection period and terminal growth rate; and (4) how much of AOL’s cash balance must be added back after the DCF.

The experts presented the Court with three options for the proper set of cash flow projections: (1) management’s long-term plan for 2015 (the “Management Projections” or “LTP”) that were approved by AOL’s board and disclosed to stockholders, and which the Company’s expert relied on; (2) a set of ten-year projections that AOL submitted to Deloitte for a tax impairment analysis (the “Deloitte Projections”); and (3) a set of projections that AOL sent to Verizon’s advisors in April 2015, during the sale process (the “Disputed Projections”), which contained significant differences in working capital requirements compared to the Management Projections. The Court determined that the Management Projections, created in the regular course of business, were the best and most reliable estimate of the Company’s future cash flows.  The Court declined to use the Deloitte Projections because they were prepared for Deloitte to perform a goodwill impairment valuation and not for non-tax purposes.  The Court also declined to use the Disputed Projections, determining that the record indicated that they were “aspirational” and created as a “marketing tool” to use in AOL’s efforts to sell itself to Verizon.

The Court considered three pending transactions at the time of the merger to determine if they were part of the Company’s operative reality. The Court determined that two pending deals with Microsoft, a “Search Deal” and a “Display Deal,” were part of AOL’s operative reality because they were originally scheduled to close before the merger closed but were delayed until after the transaction.  The Court determined that the Display Deal was an accretive transaction not represented in the LTP and valued it as adding $2.57 per share.  The Court determined the Search Deal was also accretive to the Management Projections but declined to ascribe it any value because the record lacked a principled basis to account for it.  With regard to the third deal, the Court found that the record evidence demonstrated that the acquisition of Millennial Media was too uncertain at the time of the merger to be part of the Company’s operative reality and thus ascribed it no value. 

With respect to the proper projection period and perpetuity growth rate, the Company’s expert advocated the use of a two-stage DCF model applying a 3.25% perpetuity growth rate at the end of the four-year projection period. Petitioners’ expert applied a three-stage DCF model that applied a 15% growth rate in years 1 through 4 before stepping down to 3% in perpetuity in year 10.  The Court adopted the Company’s two-stage model, finding it more appropriate and noting that it was “particularly brazen” to use a ten-year projection period, three-stage DCF model “in a fast-paced industry with significant fluctuations, where management is hesitant to project beyond four years.”  According to the Court, however, the LTP did not adequately capture the “hypergrowth” of two of AOL’s business lines at the end of the projection period, causing the Court to increase the terminal growth rate to 3.5% to reflect that growth. 

Finally, the Court agreed with the Company that it would need $150 million of working capital to achieve the projected performance, and withheld that amount from the cash added back to its DCF value. In so doing, the Court rejected Petitioners’ argument that it should add all of the Company’s $554 million cash balance at closing, finding the $150 million working capital figure reserved by AOL’s expert to be reasonable and supported by documentary evidence in the record. 

The full opinion is available here