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Delaware Appraisal Finding is $6 Million Lower than the Merger Price

June 2012 | Issue 58

Background

Just Care, Inc., a South Carolina based prison healthcare services company was acquired on September 30, 2009 by GEO Care, Inc. for $40 million in cash.  In January 2010, a group of Just Care shareholders filed a petition for appraisal with the Delaware Court of Chancery, claiming that the $40 million price was too low.  The petitioners included the company’s CEO and CFO.  They contended that the company was worth $55.2 million.  The company responded that its fair value was only $33.6 million.  After a trial, Vice Chancellor Parsons found the company’s value to be only $34.2 million.  The petitioners went home empty-handed.  All of this is described in Gearreald v. Just Care, Inc., C. A. No. 5233-VCP (Del. Ch. Apr. 30, 2012).

Dueling Experts

From the standpoint of a valuation practitioner, there were a number of interesting facets to this case.  It featured dueling experts, as these cases usually do.  Both experts used a discounted cash flow (DCF) approach to value, which has become pretty much the norm in Delaware appraisal cases.  The experts relied on projections that had been prepared by company management.  These projections contemplated the future opening of a new out-of-state health care facility in Georgia.

The petitioners’ expert incorporated the out-of-state facility’s projected revenue and cash flow into his DCF analysis.  Both the respondent’s expert and the court deleted the out-of-state projections, taking a skeptical view as to whether these out-of-state revenues would be certain enough of being realized as to warrant their inclusion in the valuation of the company as of the merger date.  There was doubt about whether this expansion was part of the “operative reality” of the company. The company had operated only one facility in its 11 years of existence.

The court was also troubled by the fact that the projections relied on by the experts had been prepared by management “outside of the ordinary course of business.”  Before the creation of these projections, Just Care’s management had never created projections beyond the current fiscal year.  These projections were made at a time when there was a possibility of an appraisal proceeding.  The court concluded that these management projections were “not entitled to the same deference usually afforded to contemporaneously prepared management projections.”

Discount Rate

Both experts and the court used the Capital Asset Pricing Model (CAPM) to develop the discount rate used in their DCF analysis.  The parties differed in their selection of an equity risk premium, with the petitioners’ expert selecting the “supply side” model rather than the historical model.  The court opted for the supply side model, pointing out that while the Chancery Court has traditionally applied the historical equity risk premium, the academic community has in recent years “gravitated toward greater support for utilizing the supply side equity risk premium.”

The largest disagreement between the experts over the discount rate was on the size of the equity size premium to add to the company’s cost of equity.  Petitioners’ expert applied a substantial downward adjustment to the size premium in order to eliminate the “well-documented liquidity effect” contained within it.  The court rejected the adjustment, pointing out that while a liquidity discount related to the marketability of a company’s shares is prohibited, the liquidity effect the petitioners were seeking to eliminate arose in transactions between the company and its suppliers of capital.  This kind of liquidity effect is part of Just Care’s value as a going concern and should be considered in the valuation.

Conclusion

After dealing with the matters discussed above, and a few other less significant differences between the experts, such as choice of beta, and capital structure, the court applied its selected inputs to the DCF model, producing a value conclusion of $34,244,570.  The value conclusion was based solely on the DCF analysis.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.