A decision earlier this year out of the Delaware Court of Chancery (In re: Appraisal of The Orchard Enterprises, Inc., C.A. No. 5713-CS, Decided: July 18, 2012) addresses certain fundamental questions about how a target company’s stock should be valued for purposes of statutory appraisal in a merger. The court’s opinion clarifies, but has also created some uncertainty around, how liquidation preferences of preferred stock affect such appraisals, and has led many to question previous assumptions about how liquidation preferences are to be factored into appraisal values.
The court in this case issued its post-trial decision in an appraisal arising out of a merger where the common stockholders of The Orchard Enterprises, Inc. were cashed out by Orchard’s controlling stockholder, Dimensional Associates, LLC. Orchard is in the retail music business—commercializing its licensed music catalogue and other digital content and selling through digital stores such as Amazon and iTunes. The company was traded on The Nasdaq Stock Market (Nasdaq) until 2009 when Dimensional (a private equity firm then holding 42.5% of the common and practically all of the preferred stock of Orchard, effectively giving Dimensional 53% voting power over Orchard’s outstanding capital stock) acquired the remaining common stock of Orchard that it did not already own as part of a “going private” merger.
Pursuant to the terms of the merger, the other common stockholders of Orchard were cashed out by Dimensional at a price of $2.05 per share. The petitioners, however, claimed that each share of Orchard common stock was worth $5.42 as of the date of the merger. The disparity in value was attributable to the differing treatment of a $25 million liquidation preference in favor of the holders of Orchard preferred stock. Under the company’s Certificate of Designations, a liquidation preference would be owed to the holders of Orchard preferred stock upon (i) a liquidation, (ii) a sale or exclusive license of all or substantially all of the company’s assets leading to liquidation, or (iii) a sale of control of the company to an unrelated third party. Liquidation preferences are common among companies backed by private equity or venture capital and provide investors with a first bite at the apple to receive a specified return upon the occurrence of a liquidity event. Orchard claimed that a $25 million liquidation preference owing to the preferred stock upon a liquidity event must be deducted from the enterprise value of the company before calculating the value of its common stock in the statutory appraisal. The petitioners argued, however, that because the liquidation preference was not triggered by the merger and the preferred stock continued to be outstanding following the merger, the $25 million liquidation preference should not be deducted from the enterprise value before calculating the value of the common stock.#
The court sided with the petitioners by first citing established precedent from the Delaware Supreme Court (Cavalier Oil Corporation v. Harnett, 564 A.2d 1137 (Del. 1989)), which would entitle the petitioners to their pro rata share of the value of Orchard as a going concern rather than on a liquidated basis. The court relies on the same precedent for the proposition that the company must be valued without regard to post-merger events or other possible business combinations. Despite the fact that Dimensional continued to hold the outstanding preferred stock of Orchard and the liquidation preference had not been triggered by the merger, Orchard argued that for purposes of calculating the common stock value in the appraisal, the $25 million liquidation preference should not be included in the enterprise value of Orchard because the holders of such preferred stock could demand the liquidation preference as a condition to any thirdparty merger.
The court was not persuaded by this argument and found that whether the liquidation preference would ever be triggered in the future was entirely speculative. The court states that to follow Orchard’s line of reasoning, one would need to “speculate that transactions will occur that are not supposed to be the basis for appraisal value—such as merger or liquidation—and to base the appraisal award on the assumption that such a transaction would occur and that the economic pie should be divided as it would be when such a transaction did occur.”1 The court goes on to cite additional precedent for the proposition that “fair value” in an appraisal proceeding is the value of the company to the stockholder as a going concern, not its value to a third party as an acquisition.2
The court found that although the holder(s) of Orchard preferred stock continued to have important control rights and economic protections such as the liquidation preference, their only right to share in cash flow distributions by Orchard (if paid out in the form of dividends while the company continued as a going concern) was to receive dividends on an asconverted- to-common-stock basis. As such, the court held that the preferred stock should be valued on an as-converted-to-common-stock basis because that is the only basis on which the preferred stockholders would share in cash flows of Orchard as a going concern. “The proper way to value the petitioners’ shares is to value Orchard as a going concern, and to allocate value to the preferred and common stock based on the allocation made by the Certificate of Designations in that context.”3 Under this approach, the court applied a discounted cash flow (DCF) method of valuation and, by allocating such DCF value in accordance with the dividend formula contained in the company’s Certificate of Designations, arrived at a per common share value of $4.67, which was more in line with the petitioners’ claimed valuation.
The court’s opinion came as a surprise to many practitioners. Some commentators have noted that the court’s holding casts doubt on whether liquidation preferences of preferred stock will be taken into account for appraisals in general, not just those that share a fact pattern similar to Orchard. For instance, in light of the Orchard case, how will liquidation preferences be treated in an appraisal action for a merger in which liquidation preferences are triggered? A more expansive interpretation of Orchard may lead one to conclude that in such situations, going concern means going concern—not liquidation value. Based on such a rationale, a court could find that liquidation preferences should be disregarded in an appraisal regardless of whether any liquidation preference has been triggered by the merger.
A narrower and more reasoned interpretation, however, would limit Orchard to its facts and not expand the holding to encompass appraisals in mergers where liquidation preferences are triggered. In fact, the court specifically contrasts the facts of Orchard with the court’s earlier 2012 decision involving a liquidation preference, which was a firm obligation of the company to pay six months following the merger.4 In that case, the court held that the going-concern value of the target company should take into account the non-speculative obligation of the company to pay out the liquidation preference in six months. Thus, in cases where a merger triggers the liquidation preference, the occurrence of such event should be deemed non-speculative and lead a court to deduct such preference amount from the enterprise value of the company before calculating the value of the common stock in a statutory appraisal.
Nevertheless, acquirers need to be mindful of Orchard if they wish to avoid unexpected stock valuations and the corresponding obligations arising out of appraisal proceedings in Delaware. If a merger leaves the target’s preferred stock in place, the liquidation preferences of the preferred stock should be examined closely. If the preferences are not triggered by the merger and occurrence of the triggering events remains speculative, Delaware courts will likely ignore such preferences for purposes of statutory appraisal.