In determining the fair value of stock of a privately held corporation at the time of a cash-out merger in connection with an appraisal action by minority stockholders—where one of the minority stockholders’ experts proffered a fair value greater than eight times that provided by the company’s expert—the Delaware Court of Chancery found that the valuation method used by the company’s expert was unreliable. The Court held that in this case the discounted cash flow analysis is the most reliable indicator of fair value because (1) the company’s stock is not publicly traded, (2) historical sales of stock are not reliable indicators of fair value, and (3) no comparable company valuation exists.
In In re ISN Software Corp. Appraisal Litigation, C.A. No. 8388-VCG (Del. Ch. August 11, 2016) (Glasscock, V.C.), petitioners Polaris Venture Partners (“Polaris”) and Ad-Venture Capital Partners (“Ad-Venture”), former minority stockholders of ISN Software Corp. (the “Company”), each filed a Verified Petition for Appraisal pursuant to 8 Del. C. § 262 in connection with a cash-out merger (the “Merger”) between the Company and its wholly owned subsidiary with the Company surviving the merger. The Company provides a subscription-based online contractor database designed to help users meet internal and governmental record keeping and compliance requirements, with subscriptions comprising the majority of its revenues from a variety of industries across more than 70 countries. The Company experienced substantial growth in the years leading up to the Merger. In connection with the Merger, which occurred January 9, 2013, the Company provided those stockholders being cashed out with the right to receive merger consideration in the amount of $38,317 per share of common stock. To determine that price, the majority shareholder used a valuation created by a third party in 2011, which he adjusted based on his expectations of the Company’s outlook. The Company did not engage a financial advisor or an investment bank to determine the price, and it did not obtain a fairness opinion.
At trial, each of the three parties proffered experts who opined on the fair value of the Company at the time of the merger. The Court noted the “alarming” range among the valuations: the Company’s expert testified to a valuation of $106 million ($29,360 per share), Ad-Venture’s expert testified to $645 million ($222,414 per share), and Polaris’ expert testified to $820 million ($230,000 per share). The experts relied on a variety of valuation methods, weighting each as they determined appropriate, including (1) the discounted cash flow (“DCF”) method, (2) the guideline public companies (“GPC”) method, (3) the direct capitalization of cash flow (“DCCF”) method, and (4) a past-transactions valuation method. The Court noted that it has “significant discretion to use the valuation methods it deems appropriate, including the parties’ proposed valuation frameworks, or one of the Court’s own making” to determine the fair value of the Company “as a going concern” as of the date of the merger. The Court also noted that to determine “fair value,” the Court must value the corporation as a going concern based on the corporation’s “operative reality” as of the date of the Merger, “…take into consideration all factors and elements which reasonably might enter into the fixing of value,” and account for “facts which were known or which could be ascertained as of the date of merger.” The Court analyzed the reliability of each of the valuation methods in turn.
First, the Court analyzed the GPC method, which was used by all three experts. Because the Company has no public competitors and the Company’s industry includes “various and divergent software platforms,” the Court found that the GPC method is less reliable than the DCF method of determining the Company’s fair value. Second, the Court reviewed the Company’s use of the DCCF method. The Court noted that the DCCF method assumes that a company will grow in perpetuity at a long-term growth rate and is best used with Companies that have reached a steady state or when no other valuation methods are appropriate. The Court determined that the DCCF method is less reliable than the DCF method, because the Company was in a growth stage at the time of the Merger and other valuation methods exist. Next, the Court determined that the past-transactions method, which was used only by the Company’s expert, is unreliable because the Company’s stock is privately held and not regularly traded; there was no indication the stock was shopped to multiple buyers in connection with the prior transactions; and each of the prior transactions involved potentially different motivations and complicated and incompatible forms of consideration, such as financial options and real estate.
Consequently, the Court relied exclusively on the DCF method. The Court explained that the DCF method determines the fair value of a company by estimating the company’s future cash flows and discounting for present value. Although each party’s expert utilized the DCF valuation method, they each used different “projection periods” in their analysis: the Company’s expert used a 5-year period, Polaris’ expert used a 6-year period, and Ad-Venture’s expert used a 10-year period. To determine the appropriate projection period, the Court “balance[d] [the Company’s] current stage within its lifecycle, the length of time it will remain in that stage, and the reliability of the projections available to estimate future cash flows.” Ultimately the Court used a standard 5-year projection period in connection with its DCF valuation primarily because of disagreement among the experts regarding the remaining length of the Company’s growth stage coupled with a lack of long term financial projections by the Company. Thus, the Court used the framework of the Company expert’s DCF valuation analysis, making certain modifications it deemed appropriate after examining disagreements among the experts, including removing an annual cash flow adjustment for incremental working capital given that the Company had historically operated with a negative working capital balance, adjustments for deferred revenue and a tax refund, and adjustments to a size premium and cost of capital. After modifying the Company’s DCF valuation analysis accordingly, the Court determined the fair value of the Company at the time of the Merger to be $357 million ($98,783 per share), more than triple the Company expert’s valuation and more than half of the highest petitioner expert’s valuation.
The Court then analyzed whether Ad-Venture was entitled to statutory interest. A petitioner in this case is entitled to interest at the statutory rate from the effective date of the merger through the date the judgment is paid, unless the Court exercises discretion to determine otherwise “for good cause shown.” The Company argued that Ad-Venture should be denied statutory interest because the Merger did not cash out Ad-Venture’s shares; it only entitled Ad-Venture to a statutory right to appraisal. The Court disagreed with the Company’s argument and held that Ad-Venture perfected its right to statutory interest with its demand for appraisal on January 31, 2013, and that interest accrues from that date.
Petitioners also alleged that the Company acted in bad faith to frustrate a fair valuation of the Company and sought compensation for attorney’s fees and expenses. Although the Court did not rule on the issue in its Letter Opinion in the event it clarified issues pertaining to the claim, it noted that the Petitioners did indeed face difficulty in obtaining discovery that should have been easily rendered by the Company.