April 2014 | Issue 73
Trados, Inc. was sold to another company for $60 million in July of 2005. The sale proceeds were distributed as follows; Trados management received $7.8 million, preferred shareholders received $52.2 million and common stockholders received nothing.
Certain common stockholders sued. The story is told in a Delaware Chancery matter called In Re Trados Incorporated, Consol. C.A. No. 1512-VCL (Aug. 16, 2013). Here are some of the valuation highlights of this very interesting case.
Trados Inc., founded in 1984, is a software company. By the late 1990s it held a dominant position in the desktop language translation software market. In early 2000, the company sought venture capital financing to facilitate its growth into new markets, and to help position itself for an IPO. At that time, the company was enjoying annual revenues of about $14 million.
Over the next three or four years, the company concluded some $35 million of equity financing from about a half dozen venture capital firms. These financings, for the most part, took the form of convertible preferred stock issued in various series, ranging from Series A to Series FF. The preferred stock generally carried a cumulative dividend of 8%, and in some cases was participating with the common stock.
In the first quarter of 2004, the board, for various reasons, began to consider a sale of Trados.
The Management Incentive Plan
In order to incentivize the senior management team in the effort to sell the company, the Trados board, in December of 2004, introduced a Management Incentive Plan (MIP). Under the plan, which included the three top managers, participants would receive an escalating percentage of the proceeds from the sale of the company, depending on the valuation achieved.
The Sale to SDL
After considerable negotiation and discussion, in April of 2005, Trados entered into an agreement to sell itself to a software company called SDL. The purchase price was $60 million; $50 million in cash and $10 million in SDL stock. The Trados shareholders approved the merger on June 17, 2005. Under the MIP, the first 13% of proceeds ($7.8 million) went to key management. At the time of the merger, the total liquidation preference on the preferred stock was $57.9 million, including accumulated dividends. The proceeds remaining after the MIP payments, approximately $52.2 million, went to satisfy the liquidation preference of the preferred. Each of the preferred shareholders received less than their full liquidation preference but more than their initial investment. The common stockholders received nothing.
The Plaintiff Sues
Marc Christen owned about 5% of the Trados common stock. On July 21, 2005, he sought appraisal for his 1,753,298 shares. On July 3, 2008 he filed a second lawsuit, individually and on behalf of a class of Trados’s common stockholders, alleging that the former Trados directors had breached their duty of loyalty by approving the merger.
The Court’s Review of the Transaction
Vice Chancellor Laster examined the transaction, noting among other things, that a majority of the directors had conflicts, that no independent committee of the board had examined the transaction and that no fairness opinion had been sought. For these and other reasons, the court concluded that, to pass muster, the transaction was required to meet Delaware’s “entire fairness” standard. This requires that the defendants establish that the transaction was the product of both fair dealing and fair price. Not even an honest belief by the board that the transaction was fair will establish entire fairness. The transaction must be objectively fair, independent of the board’s beliefs.
The Court’s Review of the Price
Both sides presented expert testimony at trial. Plaintiffs’ expert was William Becklean. He valued Trados using three alternative methods. First, he valued the company using multiples of revenue derived from comparable public companies. This produced an implied value for Trados of $43 million. To this, he added a 25% control premium, producing a value of $53.7 million. Second, he valued Trados using revenue multiples generated from a survey of transactions in the Capital IQ database of companies in the “enterprise software” industry. This produced a value for Trados of $68.2 million. Third, Becklean valued Trados using a comparable-of-comparables analysis based on investment banker fairness opinions for target companies deemed comparable to Trados. This produced a value of $85.4 million.
The court had a number of problems with Becklean’s analysis. For the methods based on merger transaction data, Becklean was faulted for not removing the effects of synergy from the valuation. The court also felt that Becklean had not demonstrated that the reference companies were sufficiently comparable to Trados.
The defendants employed Gregg A. Jarrell as their expert at trial. He believed that there were not sufficient comparable company transactions to permit use of the comparable company approach to valuation. He relied exclusively on a discounted cash flow (“DCF”) analysis based on a February 2005 business plan prepared by management. These projections showed a revenue growth rate of 24% from 2004 to 2007 with an average EBITDA margin of 15.4%. Jarrell then added a secondary growth period from 2007 to 2012 which lowered the growth rate evenly over the years to reach a terminal growth rate of 7% per annum. The cash flow from these projections was then discounted at a rate of 18.5%, producing a going-concern value for Trados of $51.9 million. This was less than the deal price of $60 million.
The judge commented on Jarrell’s work as follows; “Jarrell’s DCF valuation addressed the central question of fairness presented by this case. Jarrell made reasonable and plaintiff-friendly assumptions, yet his valuation still did not generate any return for the common.”
The judge concluded that the defendants had proved that the transaction was fair. If the common stock had no economic value before the merger, then the common stockholders received the substantial equivalent in value of what they had before, and the merger satisfies the test of fairness.
The court also pointed out that cash generated by Trados in the future was not likely to produce value for the common shareholders, as it would probably be swallowed up by the 8% dividend requirement of the preferred. As he put it “Trados likely could self fund, avoid bankruptcy, and continue operating but it did not have a realistic chance of generating a sufficient return to escape the gravitational pull of the large liquidation preference and cumulative dividend.”
The defendants skated close to the edge here by going into this transaction without forming an independent committee or commissioning a fairnesss opinion. Their bacon was saved only because their valuation expert was able to convince the judge that the common stock had no value.
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