Fairness opinions are a long-established fixture of the public M&A deal process. Smith v. Van Gorkum, the landmark case in Delaware corporate law that sparked the proliferation of fairness opinions, requires that a board of directors receive “adequate information regarding the intrinsic value of the [c]ompany” in a change of control transaction. Therefore, before the board of a public company target approves a sale of the company, the board will receive a fairness opinion from an investment bank or other financial advisor stating that the sale price is fair from a financial point of view to the shareholders. However, although customary, fairness opinions have detractors among both M&A commentators and practitioners. These detractors deride fairness opinions as rubber stamps undermined by alleged conflicts of interest stemming from the way financial advisor compensation is structured and a surreptitious desire to gain the favor of a buyer that may be a once and future client. In an infamous allusion to the Peanuts comic strip during a 2007 hearing before the Delaware Court of Chancery, fairness opinion providers have been compared to “Lucy sitting in the box: ‘Fairness Opinions, 5 cents.’”
Some of the criticism of fairness opinions stems from missing the point ofSmith v. Van Gorkum. An opinion provides little comfort to a board that fails to properly digest, or even worse, neglects to even review, the financial analyses regarding the intrinsic value of the company that underlie the opinion. The key to unlocking the full value of a fairness opinion for a board is for the board to understand the financial analyses. This requires placing less importance on the opinion “punch line” and elevating substance over form, a shift that most experienced and capable financial advisors would welcome.
The financial analyses that a financial advisor performs to support a fairness opinion are customarily presented to the board in the form of a “board book.” A prudent board, even one with modest financial sophistication, will not simply defer to its financial advisor and accept the board book at face value. Rather, the contents of the board book should be reviewed and understood by the board, and the board should insist that the financial advisor go over the board book in an oral presentation to the board. This oral presentation should not be a brief, cursory overview. For both substantive and process reasons, the board should strive to review the board book before hearing the financial advisor’s presentation and take the time during the presentation to test the presumed rigor of the financial analyses with questions. By engaging with the financial advisor in this way, the board bolsters its satisfaction of the duty of care imposed on it by state corporate governance law and also mitigates the concerns of conflict of interest and subjectivity that might otherwise undermine the wisdom of the board’s reliance on the fairness opinion.
Below are a few specific considerations for a board in assessing a financial advisor’s analyses. In the context of an all-cash sale, the three valuation methodologies customarily performed in connection with a fairness opinion are the Comparable Companies Analysis, the Precedent Transactions Analysis and the Discounted Cash Flow Analysis.
A. Considerations When Assessing the Comparable Companies Analysis and the Precedent M&A Transactions Analysis
To assess the Comparable Companies Analysis and the Precedent Transactions Analysis, it is important for the board to understand the criteria applied by the financial advisor when selecting the companies and the transactions utilized for comparative purposes. Hopefully, the board already knows the company’s primary competitors and other companies that might be comparable. Scrutiny should also be applied to the financial metrics that the financial advisor chooses to derive valuation multiples and how the multiples of the selected companies and the selected transactions compare with the multiple ranges actually used by the financial advisor to value the company. For example, if Wall Street research analysts covering the selected companies emphasize financial metrics such as revenue, EBITDA and/or EPS that are different from or in addition to those used by the financial advisor, then the board should understand why the financial advisor did not utilize the same metrics. The board should also understand whether or not any material adjustments have been made (or should have been made) to the data of the selected companies or the selected transactions, or have been made (or should have been made) to the company’s data, in order to facilitate comparison on an “apples to apples” basis. These adjustments are justifiable when needed to account for one-time items that may otherwise skew results in a misleading way. On the other hand, adjustments are sometimes challenged as attempts at manipulation, so it is important for the board to understand what adjustments were made and why.
B. Understanding the Determination of the Discount Rates Used in the Discounted Cash Flow Analysis
A DCF analysis is a method of valuing a company by estimating the present value of the projected future cash flows that are forecasted to be generated by the company. Briefly, present value is obtained by discounting future amounts back to the present using a discount rate that takes into account estimates of risk, the opportunity costs of capital and other factors. In performing a DCF analysis, the financial advisor will utilize a range of discount rates, and it is important that the board, commensurate with the level of financial sophistication possessed by its directors, have a reasonable level of understanding as to how the discount rates used in the DCF analysis were determined.
Although the process for determining discount rates is complex, there are common issues that a board should consider. Investment banks most commonly use discount rates based on the weighted average cost of capital calculated under the capital asset pricing model (CAPM), and this approach is accepted by the courts. However, Delaware courts have been critical when financial advisors profess to utilize CAPM but then apply a company-specific risk premium. The financial advisor should be basing its discount rates on widely accepted empirical data and supportable inputs, and a board should be skeptical of adjustments that do not appear to have a reasonable basis. Inconsistencies should also be questioned. For example, if the financial advisor uses a “beta” based on public companies that are different from the selected companies in the Comparable Companies Analysis, then the board should ask the financial advisor to explain why. The board should consider asking whether the financial advisor determined the discount rates in a manner consistent with its standard practices. Deviations from standard practice should be discussed and explained.
C. The Importance of Projections
A financial advisor’s analyses and fairness opinion depend in a fundamental way on the quality of the financial projections for the company that were utilized. It is therefore impossible for a board to consider a fairness opinion on an informed basis without assessing the projections on which the financial analyses are based. Financial advisors themselves do not take responsibility for the projections and take great pains to disclaim any responsibility. It falls upon the board to take the necessary steps to inform itself, chiefly with the assistance of management, regarding the projections. The board should guard equally against projections that are too conservative, on the one hand, or too aggressive as to be unrealistic, on the other hand. Any problems with the projections should be addressed as early in the process as possible, since last-minute changes to the projections will likely be questioned by both plaintiffs and the courts.
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In a change of control transaction, a target company’s board relies in part on a fairness opinion to help satisfy its duty of care. This is the primary legal purpose of the opinion, and this purpose is furthered when a board treats the receipt of the opinion and the underlying financial analyses as a practical tool for validation of the negotiated purchase price rather than as merely a “box to be checked” for purposes of complying with state corporate governance law. The prudent board will take the necessary steps to ensure that it has relied upon a fairness opinion on an informed basis by exercising a degree of engagement regarding the financial advisors’ analyses that most financial advisors would embrace.
This article was originally published in Directors & Boards, November 17, 2015.