September 2012 | Issue 60
A Delaware Chancery Court case, In Re: Appraisal of The Orchard Enterprises, Inc. (July 18, 2012) delves deeply into some of the finer points of corporate finance theory. In so doing, it provides some very helpful guidance to those seeking to determine the fair value of a business for Delaware appraisal purposes.
The Orchard Enterprises, Inc. (“Company,” or “Respondent”) was a publicly-traded company (NASDAQ). It sold music rights from its catalog through digital stores. Dimensional Associates, LLC was the controlling shareholder of Orchard. Dimensional took Orchard private in July of 2010 in a cash merger, paying $2.05 per share.
A group of minority shareholders (“Petitioners”) claimed that each Orchard share was worth $5.42 as of the date of the going private merger. Orchard responded by contending that the merger price was generous and that the Orchard shares were actually worth only $1.53 apiece as of the date of the merger. The parties ended up in Chancery Court before Chancellor Strine.
The Preferred Stock
One of the issues in the case was deciding how to deal with a $25 million issue of convertible preferred stock that Orchard had outstanding. Orchard argued that the $25 million liquidation value of the preferred should be deducted from the enterprise value of the Company, thus reducing the equity value by a like amount. Petitioners argued to the contrary. Since the situation with the preferred was an unusual one, I will not comment further on it except to say that the court sided with the Petitioners on this issue and did not deduct the liquidation value of the preferred in coming up with its value for the common equity.
Each party had a valuation expert. Petitioners’ expert determined value by using a discounted cash flow approach (DCF). This involved making a projection of the future cash flows of the Company and discounting the future cash flows to present value using an appropriate discount rate.
Respondent’s expert also used a discounted cash flow approach, but supplemented it with another analysis based on the prices of what he believed were comparable public companies and comparable merger transactions.
The Court’s Analysis
The first major decision made by the Court was to set aside the comparable company and comparable transaction approaches to value, and to rely solely on the DCF approach. It did this for two reasons. First, it believed that Orchard was a unique company pursuing a unique niche business. Therefore, it felt that none of the so called comparable companies were really comparable to Orchard.
Secondly, it observed that although Orchard’s expert had calculated various valuation multiples from the comparables, he then chose multiples to apply to Orchard that were well below the mean and median multiples for each group, and did this without providing a “sensible explanation.”
Having decided to rely exclusively on the DCF approach, the court then turned to the DCF analyses prepared by each party. It was happy to find that there was little dispute between the parties about the core input to the DCF approach, the projections themselves. They had been prepared by Orchard management.
The largest disagreement between the parties was over what discount rate to use. Each side’s expert used three different methods to calculate a discount rate. Two of these methods are versions of the so-called “build-up” model. The third method used by each of the experts was based on the capital asset pricing model (CAPM).
The court rejected the build-up method because, it said “it is larded with subjectivity, and incorporates elements that are not accepted by the main stream of corporate finance scholars.” It contrasted it to the third method used by each of the experts, the CAPM, which “remains the accepted model for valuating corporations.” It went on to note with approval that the experts “used a modified CAPM method that takes into account academic acceptance that the size of a corporation affects the expected rate of return and should be factored into the calculation of a corporation’s discount rate.”
The Equity Risk Premium
A key input to the CAPM in determining a rate of return on equity is the equity risk premium (ERP). The ERP represents the amount by which an equity rate of return exceeds the risk free rate. It is the payment to the investor for assuming the risk of an equity investment. The ERP is most commonly calculated by looking at the historical return on common stocks and comparing it to the return on risk-free bonds. The difference between the two rates of return is the equity risk premium.
Some analysts will then further refine the ERP calculation by removing from the premium the portion of return that is derived from changes in the general level of price-earnings ratios. The argument is that these changes are more or less “one off” and can’t be counted on to repeat themselves. This type of adjusted ERP is referred to as the supply-side equity risk premium.
The court elected to use the supply-side equity risk premium, noting that use of the supply-side equity risk premium “is supported by relevant professional and academic literature and prior decisions of this court in appraisal proceedings [.]”
Company-specific Risk Factor
Orchard’s expert, in carrying out his CAPM analysis applied an additional increment to the equity discount rate, called a company-specific risk factor. His argument in doing so was that this factor compensated for elements of risk to be found in Orchard’s business that weren’t present in the general run of companies whose investment returns were used to calculate the ERP. The court rejected this as being “inconsistent with the CAPM method.”
After applying the adjustments described above, the court arrived at a discount rate under the CAPM method of 15.3%. Applying this to the projected cash flow, it arrived at a value of $4.67 per share for Orchard.
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.