Delaware shareholder dissent case disputes “circular logic” when valuing the business

The Delaware Chancery Court found the majority owners of a large, privately owned alcohol distributor authorized a merger to “freeze out” a 15% minority shareholder by using a process that was “anything but fair.” A fairness opinion, obtained a week prior to the merger, was an “afterthought,” the court noted, “pure window-dressing” to justify the majority’s objective.

In determining whether the merger price was fair, the court considered evidence from opposing experts. In their DCF calculations, both agreed that a size premium applied. Both used Ibbotson data, but the majority expert selected 5.78% from the tenth decile and the minority expert chose 3.47% from the ninth to tenth deciles. The problem for the court went beyond a mere divergence of opinion, however.

Specifically, Ibbotson assumes “one already knows or has an estimate” of a company’s market cap before deciding which decile it falls into and then selecting the size premium, the court explained. When the company’s value is disputed and the DCF analysis is the proposed solution, “the appropriate risk premium cannot be taken as exogenous. That is, a [DCF] both values the size of a company (and thus points to the appropriate Ibbotson premium to use) and relies on the appropriate Ibbotson premium to determine the value of the company,” the court said, with emphasis. The process is circular; does the valuation of the company or the selection of the Ibbotson risk premium come first?

For the answer to the court’s question—and its perspective on the DCF analysis generally—read the complete digest of In re Sunbelt Beverage Corp. Litigation, 2010 WL 92519 (Jan. 5, 2010), in the next Business Valuation Update™; the full-text of the court’s opinion will be available at BVLaw™. It’s a lengthy and thoughtful decision, and besides questioning the logic behind size premia, the court also opines on several other critical issues, including:

• The company-specific risk premium (hint: the Delaware Chancellors are still highly skeptical without empirical, quantitative support);
• The effect of a post-merger conversion S corporation (both experts adjusted their values upward, requiring the court to intervene “in a rare harmony”); and
• What makes a comparable “truly comparable” under the market approach.