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Misuse of Control Premiums in Delaware Appraisals

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  • Sutter Securities Financial Services, San Francisco
Article

Misuse of Control Premiums in Delaware Appraisals

Abstract

In statutory appraisal cases, Delaware Courts sometimes apply premiums that are based on questionable reasoning. They commonly adjust guideline company valuations for an ‘‘implicit minority discount’’, they apply acquisition premiums to subsidiaries, and they often rely upon average premiums in acquisitions as a basis for calculating control premiums. This article discusses the flaws in the reasoning underlying these adjustments.
Misuse of Control Premiums in Delaware Appraisals
by Gilbert E. Matthews, CFA
Abstract
In statutory appraisal cases, Delaware Courts some-
times apply premiums that are based on questionable
reasoning. They commonly adjust guideline company
valuations for an ‘‘implicit minority discount’’, they
apply acquisition premiums to subsidiaries, and they
often rely upon average premiums in acquisitions as a
basis for calculating control premiums. This article
discusses the flaws in the reasoning underlying these
adjustments.
Introduction
Delaware corporate law is preeminent in establishing
standards for corporate valuations because a majority of
publicly traded companies are incorporated in Delaware.
Valuations in numerous dissenting shareholder appraisals
have been adjudicated under the Delaware appraisal
statute. The appraisal statute states that ‘‘the Court shall
determine the fair value of the shares exclusive of any
element of value arising from the accomplishment or
expectation of the merger or consolidation’’ giving rise
to the appraisal proceeding.
1
A large body of Delaware
case law has developed interpreting the statute’s mandate
to ‘‘determine the fair value of the shares’’ in Delaware
dissenting shareholder cases. The result is that the fair
value standard for the subject company’s value is to be
ascertained on a ‘‘going-concern’’ basis:
[F]or many decades, the Delaware courts have embraced a
standard of valuation in appraisal cases that awards dis-
senting stockholders their proportional share of the value
of the ‘‘going concern.’’
2
In this article, we address the Delaware courts’ use of
control premiums in appraisal cases and explain why
both the underlying theory and resulting practice are no
longer valid. In three important legal articles, the courts’
application of control premiums has been criticized for
deviating from going-concern value. The first, by Profes-
sor Richard Booth (University of Maryland School of
Law)
3
in 2001, was followed in 2003 by an article by
Professor William Carney (Emory University School of
Law) and Mark Heimendinger (Milbank, Tweed, Hadley
& McCloy).
4
The most recent work is a thoughtful and
thorough law review article by Professors Lawrence
Hamermesh (Widener University School of Law) and
Michael Wachter (University of Pennsylvania Law
School).
5
This article continues the questioning of the Delaware
courts’ use of control premiums, but from a business
valuation perspective. This author has been addressing
these issues for more than a decade,
6
but commentators
have expanded the dialogue in the last few years. This
article will attempt to incorporate their ideas as it dis-
cusses three concepts concerning the application of con-
trol premiums that Delaware Courts have adopted:
The concept that market prices of shares include an
inherent minority discount, thereby requiring the
Court’s addition of a control premium to valuations
that are based on guideline companies;
The concept that a subsidiary of a company should
be valued by adding a control premium to reflect
the parent’s control of its subsidiaries; and
The concept that it is appropriate to take average
acquisition premiums and apply them to guideline
companies that are not acquisition targets, as well as
to subsidiaries of subject companies.
The Delaware courts have unfortunately accepted the
concept that guideline company valuations in appraisal
cases should be adjusted upward to offset an implicit
minority discount (IMD).
7
They have done so based on
both expert witness testimony and the mid-1990s writ-
ings of well-respected authors who have since changed
their views. Since 1995, the Chancery Court has added a
control premium to offset the IMD in a substantial
majority of the decisions in which it relied on guideline
companies. In fact, in every case where petitioner’s
expert adjusted for an IMD, the Court accepted the
concept. The Court’s preference for IMD adjustments is
illustrated in the following Delaware appraisal decision
1
8 Del. Code Ann. tit. 8, §262(h).
2
Lawrence A. Hamermesh and Michael L. Wachter, ‘‘The Short and
Puzzling Life of the ‘Implicit Minority Discount’ in Delaware Apprais-
al Law,’’ 156 U. Pa. L. Rev. 1 (2007), pp. 3–4. Professor Hamermesh, a
prominent commentator on Delaware law, was a partner of a major
Delaware firm and litigated appraisal cases.
3
Richard A. Booth, ‘‘Minority Discounts and Control Premiums in
Appraisal Proceedings,’’ 57 Business Lawyer 127 (2001).
4
William J. Carney and Mark Heimendinger, ‘‘Appraising the Nonex-
istent: The Delaware Courts’ Struggle with Control Premiums,’’ 152 U.
Pa. L. Rev. 845 (2003).
5
Lawrence A. Hamermesh and Michael L. Wachter, ‘‘The Short and
Puzzling Life.’’
6
Several of the writer’s relevant publications are cited herein.
7
The IMD is sometimes called an ‘‘inherent minority discount’’ or an
‘‘implied minority discount.’’
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where, in fact, neither expert’s valuation included an
IMD, but the Court felt constrained by ‘‘precedent’’ to
apply it.
Delaware law recognizes that there is an inherent minority
trading discount in a comparable company analysis be-
cause ‘‘the valuation method depends on comparisons to
market multiples derived from trading information for
minority blocks of the comparable companies.’’ The equi-
ty valuation produced in a comparable company analysis
does not accurately reflect the intrinsic worth of a corpo-
ration on a going-concern basis. Therefore, the court, in
appraising the fair value of the equity, ‘‘must correct this
minority trading discount by adding back a premium
designed to correct it.’’ ... [T]he recent appraisal cases
that correct the valuation for a minority discount by
adding back a premium ‘‘that spreads the value of control
over all shares equally consistently use a 30% adjustment.
Relying on recent precedents, the court will adjust the ...
per share value by adding a 30% control premium’’
[emphasis added].
8
The regrettable result is that the Court ends up adjusting
guideline company valuations based on its questionable
concept that market prices of publicly traded companies
bear an implicit minority discount and therefore are
inherently ‘‘undervalued.’’
The components of the Court’s IMD theory are that:
(a) publicly traded companies’ shares trade below
their pro rata portion of going-concern value;
(b) they do so because these shares trade below
financial control value, so that
(c) it is necessary for the court to add a ‘‘control
premium’’ to valuations based on guideline com-
panies.
Because most acquisitions of control of public com-
panies are at share prices above market, the Chancery
Court erroneously concludes that shares of all public
companies are generally trading below their control
value. In order to compensate for this perceived under-
valuation in appraisal cases, the Court adds a premium
when applying the guideline company method. The
Court determines the size of the control premium for
companies (or in some cases, subsidiaries) by reference
to the average premiums over market paid in acquisi-
tions. This article explains why both the theory and
practice are wrong.
Control Premiums and Levels of Value
Any discussion of control premiums must begin with
a discussion of ‘‘levels of value,’’ a model that has
evolved over the past eighteen years as a result of the
financial community’s thinking. The model is presented
and explained by two leading valuation authorities in
recent editions of their books: Shannon Pratt’s Valuing a
Business
9
and Z. Christopher Mercer’s Business Valua-
tion: An Integrated Theory.
10
Pratt’s levels of value chart shows five levels of value
for publicly traded companies: synergistic (strategic)
value, value of control shares, market value of freely
traded minority shares, value of restricted stock, and
value of nonmarketable shares.
11
The latter two levels
are not relevant in a Delaware appraisal because market-
ability discounts are not permitted under Delaware law.
Mercer illustrates the levels of value in Figure 1.
12
In
this diagram, Strategic Control Value (Pratt’s ‘‘synergis-
tic value’’) is the business’s value to a party that could
achieve synergistic benefits if it had control. Financial
Control Value (Pratt’s ‘‘value of control shares’’) does
not include anticipated synergies, but includes ‘‘the abil-
ity of a specific buyer to improve the existing operations
or run the target company more efficiently.’’
13
Market-
Figure 1
Levels of Value
8
Doft & Co., Inc. v. Travelocity.com, Inc., 2004 Del. Ch. LEXIS 75
(May 21, 2004) at *45–*47 [footnotes omitted].
9
Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of
Closely Held Companies. 5th ed. (New York: McGraw-Hill, 2008).
10
Z. Christopher Mercer and Travis W. Harms. 2007, Business Valua-
tion: An Integrated Theory. 2nd ed. (New York: Wiley, 2007).
11
Pratt, op. cit., p. 384. The restricted stock level is for shares that are
not currently marketable but will become marketable with the passage
of time.
12
Mercer and Harms, p. 71. Mercer’s current view as to the relation-
ship between Marketable Minority Value and Financial Control Value
is discussed later in this article.
13
Id., p. 73.
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able Minority Value is the market value of freely traded
minority shares.
14
Under Delaware case law, companies must be ap-
praised on an ‘‘as is’’ basis. A Delaware appraisal values
a company as a going concern based on the way it is
being managed at the time of the valuation—a concept
called ‘‘operative reality.’’ Going-concern value based on
operative reality does not include potential benefits such
as cost savings that an acquirer may achieve, such as
eliminating the costs of being a public company or
reducing excessive management compensation.
The company, with all of its warts and diamonds, is
valued in terms of the discounted free cash flow generated
by the company’s assets and reinvestment opportunities.
In measuring the value of the warts and diamonds, the
warts are valued as warts and the diamonds as diamonds.
The minority shareholders cannot claim that if the compa-
ny were run differently, or if it were owned by a third-
party, the warts would become diamonds. That may be
correct as a factual matter, but is irrelevant to the issue.
The minority’s claim is equal to the value of the shares
into the future, and that value is a mix of the existing
warts and diamonds.
Similarly, the controller cannot claim that the diamonds
are really warts. More specifically, if the company already
has reinvestment plans that would fix current problems in
the future, the value of those plans are part of the value of
the company as an operating concern.
15
Delaware appraisal value generally would equal Mar-
ketable Minority Value. In situations when market prices
are depressed and shares trade below their going-concern
value, then the going-concern value of a company under
Delaware appraisal law would be higher than Marketable
Minority Value. In situations where there are any cost
savings available to an acquiror, the going-concern value
of the company being appraised would be lower than
Financial Control Value. If the expert believes that
going-concern value in a particular situation is not equal
to Marketable Minority Value, the expert’s testimony
should address the market and financial factors that
justify the conclusion.
Although Delaware law requires the Court to find
value according to the ‘‘going-concern’’ standard of fair
value, the Court is, in fact, currently using two different
levels of value depending on which valuation method it
elects to employ. When the Court uses the guideline
company method to calculate going-concern value and
adjusts for IMD, it is determining the inherent minority
discount by reference to premiums paid in acquisitions
(excluding synergies). Thus, the guideline company val-
uation that results from the Court’s addition of a control
premium to offset the IMD is, in fact, Financial Control
Value.
In contrast, when the Court uses the discounted cash
flow method to calculate going-concern value based on
operative reality (which excludes cost savings that a
financial buyer might consider), it calculates Marketable
Minority Value. There is no dispute in Delaware that the
projections used in a DCF valuation cannot be adjusted
for changes that an existing management does not intend
to undertake. Under Delaware law, no adjustments are
permitted for changes that might be made by a new
control shareholder, and the company must be valued as
a going concern as it is being run by existing manage-
ment. Thus, a Delaware Court’s going-concern DCF
valuations arrive at a different level of value than its
guideline company valuations adjusted for IMD.
In Delaware, ‘‘control premium’’ has more than
one meaning
The Court uses the term ‘‘control premium’’ to de-
scribe three different premiums. To the extent that the
Court concludes that market prices of publicly traded
shares include a minority discount, it makes an adjust-
ment by adding a ‘‘control premium’’ to arrive at its
determination of going-concern value (fair value). Here,
the term ‘‘control premium,’’ as used by the Court for this
adjustment, is the premium that Mercer’s diagram calls
the ‘‘Financial Control Premium’’—it is the inverse of the
diminution in market price attributable to IMD. The
Court usually bases its determination on testimony as to
average premiums in acquisitions; it makes an adjustment
to eliminate the impact of synergies and then applies this
‘‘control premium’’ to offset a perceived minority dis-
count in valuations based on guideline companies.
Confusingly, however, Delaware decisions have also
used the phrase ‘‘control premium’’ with two other
meanings. The phrase has been used by the Court of
Chancery not only to describe the inverse of the minor-
ity discount, but also to portray the premium above the
Financial Control Value that would be paid by a syner-
gistic buyer for control of a company.
16
This premium—
the Strategic Control Premium—is impermissible in a
Delaware appraisal (except, inexplicably, in valuing
subsidiaries of holding companies, as discussed below).
14
As discussed in detail later in this article, (a) publicly traded shares
may trade at prices higher or lower than Financial Control Value, and
may even sometimes trade above Strategic Control Value, and (b) many
commentators believe that most actively traded shares are usually
priced close to Financial Control Value.
15
Hamermesh and Wachter, ‘‘The Fair Value of Cornfields in Delaware
Appraisal Law,’’ 31 J. Corp. Law 119 (2005), pp. 143–144.
16
E.g., Le Beau v. M.G. Bancorp., Inc., 1998 Del. Ch. LEXIS 9 (Jan.
29, 1998), aff’d M.G. Bancorp., Inc. v. Le Beau, 737 A.2d 513 (Del.
1999).
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In addition, the Court has used the term ‘‘control
premium’’ in yet a third way: to describe the sum of
the Financial Control Premium and the Strategic Control
Premium.
17
This premium, the difference between Mar-
ketable Minority Value and Strategic Control Value, is
more accurately known as the ‘‘acquisition premium.’’
18
It is the difference between the market prices of shares
prior to a transaction and the price paid for the shares in
a change-of-control transaction, and it includes the pre-
mium, if any, paid for synergies. These acquisition
premiums are the data points published in sources such
as Mergerstat Review that are commonly used by testi-
fying experts. This is the only premium that is directly
observable in the market, so that it becomes necessary
for experts and the Court to estimate (or speculate) as to
the portion attributable to synergies.
The Delaware courts could avoid the ‘‘control premi-
um’’ ambiguity by using the levels-of-value model and
the terminology developed by the financial community.
The Court could then conceptualize and use the terms
‘‘Financial Control Premium’’ and ‘‘Strategic Control
Premium’’ as in the diagram above, and employ ‘‘Ac-
quisition Premium’’ to describe the difference between
Marketable Minority Value and Strategic Control Value.
If the Court, authors, and expert witnesses shared a
common and consistent language, they could concentrate
with greater precision on any true differences in the
appraisal valuation.
The Court adds premium for change of control
to values of subsidiaries
The Delaware Supreme Court opened the door to a
use of premiums for change of control in Rapid Amer-
ican in 1992, when it applied premiums to valuations of
subsidiaries.
19
Rapid American was a holding company
whose three subsidiaries operated in widely different
industries. The trial court had valued each subsidiary
based solely on guideline companies. The Delaware
Supreme Court concluded that the lower court had
effectively ‘‘treated Rapid as a minority shareholder in
its wholly-owned subsidiaries’’ because the market pric-
es of the guideline companies ‘‘do not reflect a control
premium.’’
20
Its reasoning was that the inherent value of
the parent holding company included the control value
of the 100 percent–owned subsidiaries.
21
On remand, the trial court applied acquisition premi-
ums (called ‘‘control premiums’’ in the decision) of 45%,
20%, and 30% to the three subsidiaries, which were the
average premiums paid in acquisitions in the subsidiar-
ies’ respective industries as determined by petitioners’
expert.
22
The Chancery Court did not indicate whether it
had reduced these average acquisition premiums for
synergies, so that these control premiums apparently
increased the valuation of the subsidiaries to the Strate-
gic Control Value level. This ambiguity illustrates the
confusion caused by the failure of expert witnesses and
the Courts to clarify the meaning of ‘‘control premium’’
and to specify the level of value being discussed.
The IMD enters Delaware case law
The IMD was first considered (and rejected) by the
Court of Chancery in 1991, when plaintiff’s expert in
Radiology argued that her DCF valuation should be
adjusted upward by 30% to eliminate an implicit minor-
ity discount.
23
The Court rejected this adjustment, stat-
ing, ‘‘The discounted cash flow method purports to
represent the present value of Radiology’s cash flow.
... The discounted cash flow analysis, as employed in
this case, fully reflects this value without need for an
adjustment.’’
24
The application of an IMD to a guideline company
valuation was rejected shortly afterwards in a valuation
of Interstate Bakeries.
25
The respondent’s expert disput-
ed the petitioner’s expert’s contention that market value
of publicly traded companies ‘‘is inevitably less than
intrinsic value’’
26
and the Court rejected the petitioner’s
position.
Later in 1992, the Court of Chancery accepted an
IMD for the first time in Spectrum Technology, where
the expert for the respondent (who had unsuccessfully
argued for an IMD as plaintiff’s witness in Radiology)
added a 30% adjustment for IMD to her guideline
company valuation, even though she was working for
the side that logically should have argued for a lower
value.
27
Hamermesh and Wachter commented:
[Her testimony] of course met no opposition from the
petitioner, and the court did not reject the adjustment sua
17
E.g., Agranoff v. Miller, 791 A.2d 880 (Del. Ch. 2001) at 899.
18
Pratt, Business Valuation Discounts and Premiums (New York:
Wiley, 2001), 60; Pratt, Valuing a Business, 5th ed. (2008), 384.
19
Harris v. Rapid-American Corp., 603 A.2d 796 (Del. 1992), revers-
ing the denial of control premiums in Harris v. Rapid-American Corp.,
1990 Del. Ch. LEXIS 166 (Oct. 2, 1990) and remanding the case.
20
Id. at 804.
21
Id. at 804.
22
Harris v. Rapid-American Corp., 1992 Del. Ch. LEXIS 75 (Apr. 1,
1992). The unaffected market price of Rapid-American had been
$17.25 per share, the going-private consideration (primarily in deben-
tures) was worth approximately $28 per share, the initial appraisal
value was $51 per share, and the ultimate appraisal with the control
premiums was $73.29 per share.
23
In re Radiology Associates, A.2d 485 (Del. Ch. 1991).
24
Id. at 494.
25
Salomon Bros. v. Interstate Bakeries Corp.,1992Del.Ch.LEXIS
100 (May 1, 1992).
26
Id. at *15.
27
Hodas v. Spectrum Technology, Inc., 1992 Del. Ch. LEXIS 252
(Dec. 7, 1992).
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sponte. To the contrary, the adjustment was incorporated
in the final valuation result without comment or evaluation
by the Vice Chancellor. Thus, the IMD was first planted
in Delaware valuation doctrine not by adversarial process
and judicial evaluation, but by default.
28
The Vice Chancellor did not explicitly discuss an
IMD, but a review of the Court’s valuation demonstrates
that it included an adjustment for IMD.
29
The Court’s next appraisal using a guideline company
analysis was Kleinwort Benson Ltd. v. Silgan Corp.
30
in
1995. Here the petitioner’s expert added an 86% premi-
um. The Court-appointed expert testified that ‘‘the pre-
mium necessary to remove the minority discount
inherent in publicly traded stock is somewhere between
zero and the control premium which [petitioner’s ex-
pert’s] study places between 34–48%.’’
31
Although Sil-
gan Corp. argued that no reliable proof of an IMD had
been presented, its own expert testified that it was
reasonable to use a minority discount of 10–15%. The
Court, noting respondent’s expert’s accord on the IMD
issue, used the midpoint of his range and applied a
12.5% adjustment.
32
The Court noted that it had rejected
an IMD in valuing Interstate Bakeries, but explained that
‘‘our different conclusions result from differences in the
records [i.e., the testimony] presented by the parties in
the respective cases.’’
33
The Court again adds control premiums to
valuations of subsidiaries
In two 1998 cases, M.G. Bancorp. and Hintmann,
34
the Court, relying on Rapid-American, added control
premiums to valuations of subsidiaries in which the
experts used the guideline company method. (This writer
criticized these adjustments at the time.
35
)
The Chancery Court rejected the respondents’ guide-
line company valuation of M.G. Bancorporation, a hold-
ing company with two bank subsidiaries, because the
Vice Chancellor concluded that respondents’ valuation
did not adjust for an IMD. He pointed out that a book
co-authored by respondents’ expert Robert Reilly (the
then-current 3rd Edition of Valuing a Business) support-
ed the position that guideline companies include a mi-
nority discount.
36
The Court also cited Christopher
Mercer’s Valuing Financial Institutions on this point.
37
The Court based its valuation of M.G. Bancorpora-
tion on guideline transactions (a method usually rejected
in Delaware appraisals), thereby effectively including an
acquisition premium and valuing the subsidiaries at the
Strategic Control Level. The Court followed Rapid-
American in reasoning that, since the parent controlled
its two bank subsidiaries, acquisition value was an
appropriate measure. The respondent unsuccessfully ar-
gued that although Rapid-American permitted premiums
in valuing subsidiaries, it applied only to conglomerates,
not to a single-industry holding company. The Supreme
Court upheld the lower court’s decision to apply acqui-
sition premiums to the bank subsidiaries.
The trial court in Hintmann treated the company as a
holding company even though it operated primarily
through a single subsidiary. Petitioners’ expert found
that the mean and median acquisition premiums for
publicly held companies were 45% and 55%, respective-
ly. The Court adjusted the premium down to 20% to
eliminate synergies, and it applied the 20% premium to
the mean of the guideline company and DCF values.
38
No prior or subsequent appraisal decision has applied a
control premium to a discounted cash flow valuation
(see discussion infra), but the Chancery Court has con-
tinued to apply premiums to guideline company valua-
tions.
The Court applies an adjustment for IMD—but
not always
In the decade since the Chancery Court’s decisions in
M.G. Bancorp. and Hintmann, it has repeatedly demon-
strated its acceptance of the IMD concept, commonly
using a 30% premium. Whenever the dissenting share-
holders’ expert adjusted for an IMD, the Court did so as
well. In one decision (Prescott, discussed below), the
Court added a premium to offset IMD over the respon-
dent’s objection.
39
Indeed, in one case (Doft, quoted in
the opening section of this article), the Court added a
premium even though neither expert did so (see further
discussion below).
28
Hamermesh and Wachter, ‘‘The Short and Puzzling Life,’’ pp. 18–
19.
29
Professor Hamermesh, who was counsel for respondent in Hodas,
has kindly clarified the Court’s calculations in correspondence with the
writer.
30
1995 Del. Ch. LEXIS 75 (June 15, 1995).
31
Id. at *11–12.
32
Id. at *12. It is not clear from the decision whether the Court added a
12.5% premium or adjusted for a 12.5% discount (i.e., added a 14.3%
premium).
33
Id. at *9.
34
Hintmann v. Fred Weber, Inc., 1998 Del. Ch. LEXIS 26 (Feb 17,
1998).
35
Gilbert E. Matthews, ‘‘Delaware Court Relies on Comparable Ac-
quisition Method: LeBeau v. M.G. Bancorporation, Inc.,’’ Business
Valuation Update, March 1998; Matthews, ‘‘Delaware Court Adds
Control Premium to Subsidiary Value: Hintmann v. Fred Weber, Inc.,’’
Business Valuation Update, May 1998.
36
Le Beau at *25, citing Shannon P. Pratt, Robert F. Reilly, and
Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal
of Closely Held Companies, 3rd ed. (Irwin, 1996), 194–195 and 210.
37
Z. Christopher Mercer, Valuing Financial Institutions (Irwin, 1992),
198–200 and Ch. 13.
38
Hintmann at *31.
39
Prescott Group Small Cap, L.P. v. Coleman Co., 2004 Del. Ch.
LEXIS 131 (Sept. 8, 2004).
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The Court has chosen to use the guideline company
method in approximately half of its valuations under the
Delaware appraisal standard,
40
and it has adjusted for
IMD in nine of those 14 decisions (including Prescott
and Doft). These cases are briefly discussed below. In
five cases in which an IMD adjustment was not included
in either side’s valuations, the Court applied no premi-
um.
41
The seven cases where respondents did not object
to the IMD concept are:
Borruso:
42
Both experts used a 30% control premi-
um to offset IMD, and the Court adopted that
figure.
43
The Court wrote that ‘‘the comparable
company method of analysis produces an equity
valuation that inherently reflects a minority dis-
count, as the data used for purposes of comparison
is all derived from minority trading values of the
comparable companies.’’
44
Bomarko:
45
The Court accepted plaintiffs’ expert’s
30% adjustment to offset IMD. The defendants’
expert conceded that a guideline company analysis
reflects an IMD, but argued unsuccessfully that no
party would pay a premium to acquire the troubled
subject company.
46
Agranoff: In calculating fair value, the Court again
made a 30% adjustment for IMD, lower than plain-
tiffs’ expert and higher than defendants’ expert.
47
The Court’s comments were similar to those in
Borruso:‘‘The comparable companies’ analysis
generates an equity value that includes an inherent
minority trading discount, because the method de-
pends on comparisons to market multiples derived
from trading information for minority blocks of the
comparable companies.’’
48
Lane v. Cancer Treatment Centers:
49
The Court’s
guideline company valuation adopted petitioner’s
expert’s 20% premium to offset IMD.
50
Respon-
dent’s expert did not discuss IMD because he
valued the company at zero.
51
Dobler v. Montgomery Cellular:
52
The Court ac-
cepted the 31% premium used by the dissenting
shareholders’ expert in his guideline company anal-
ysis, which was slightly less than the premium used
by company’s expert.
53
Andaloro:
54
The Court applied a 30% control pre-
mium to offset IMD, reducing the 38% premium
used by defendant’s expert because that figure did
not ‘‘exclude any portion of the average premia
from his sample to account for the sharing of
synergies by the buyer with the seller.’’
55
Highfields Capital:
56
Petitioner’s expert used a
30.1% adjustment for IMD and respondent’s expert
used 16.1% in their valuations of The MONY
Group. The Court accepted the respondent’s ex-
pert’s guideline company valuation of MONY’s
asset management business, including his 16.1%
adjustment.
57
(Although MONY was a holding
company, the decision did not address adding con-
trol premiums to valuations of its subsidiaries.)
In the one appraisal where the Court added a control
premium in spite of respondent’s objection, the Court’s
reprimand to respondent clearly conveyed its adherence
to the orthodoxy of the IMD concept. In Prescott,
respondent argued that the adjustment adding a control
premium was inadmissible under Delaware law. The
Court not only rejected respondent’s argument, but ad-
monished, ‘‘This argument runs so blatantly counter to
the settled Delaware precedent on the subject ... as to
call into question Coleman’s good faith in advancing it’’
[emphasis added].
58
Petitioner’s expert’s added a 35%
premium to eliminate IMD in its guideline company
valuation
59
and the Court ruled that this adjustment was
consistent with Delaware law.
60
40
The Court has utilized DCF in most of its appraisal valuations. In
some cases, the guideline company method was not used by the
experts, and in some the Court rejected an expert’s guideline company
valuation.
41
Gonsalves v. Straight Arrow Publishers, Inc., 1996 Del. Ch. LEXIS
144 (Nov. 27, 1996), rev’d in part 701 A.2d 357 (Del. 1997), 793 A.2d
312 (Del. Ch 1998), rev’d in part 1999 Del. LEXIS (Jan. 5, 1999),
2002 Del. Ch. LEXIS 105 (Sept. 10, 2002); Gray v. Cytokine Phar-
masciences, Inc, 2002 Del. Ch. LEXIS 48 (Apr. 25, 2002); Gentile v.
SinglePoint Financial, Inc., 2003 Del. Ch. LEXIS 21 (Mar. 5, 2003).
Taylor v. American Specialty Retailing Group, Inc., 2003 Del. Ch.
LEXIS 75 (July 25, 2003); In re U.S. Cellular Operating Co., 2005
Del. Ch. LEXIS 1 (Jan. 6, 2005).
42
Borruso v. Communications Telesystems International, 753 A.2d
451 (Del. Ch. 1999).
43
Id. at 457–458.
44
Id. at 458.
45
Bomarko, Inc. v. International Telecharge, Inc., 794 A.2d 1161
(Del. Ch. 1999), aff’d. International Telecharge, Inc. v. Bomarko, 766
A.2d 437 (Del. 2000).
46
Id. at 1186–1187.
47
Agranoff at 900.
48
Id. at 892.
49
Lane v. Cancer Treatment Centers of America, Inc., 2004 Del. Ch.
LEXIS 108 (July 30, 2004).
50
Id. at *130.
51
Id. at *33.
52
Dobler v. Montgomery Cellular Holding Co., 2004 Del. Ch. LEXIS
139 (Oct. 4, 2004), aff’d. Montgomery Cellular Holding Co. v. Dobler,
880 A.2d 206 (Del. 2005).
53
Id. at *16, *67. The Court gave a 65% weight to guideline transac-
tions, 30% to discounted cash flow, and only 5% to guideline compa-
nies. Id. at *73. The unusual weight given to guideline transactions
reflected the fact that the principal guideline transaction was a proposed
acquisition of a group of companies that included Montgomery Cellular
itself. Id. at *60–63.
54
Andaloro v. PFPC Worldwide, Inc., 2005 Del. Ch. LEXIS 125 (Aug.
19, 2005).
55
Id. at *69. The Court applied the premium to equity value, rejecting
plaintiff’s overreaching claim that it should apply to enterprise value
including debt.
56
Highfields Capital, Ltd. v. AXA Financial, Inc., 2007 Del. Ch.
LEXIS 126 (June 27, 2007).
57
Id. at 45.
58
Prescott at *99.
59
Id. at *90.
60
Id. at *99–100.
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In Doft, an extreme example of the Court’s accep-
tance of the IMD concept, it made an arbitrary adjust-
ment for IMD even though neither expert had even
mentioned IMD in his report. The decision discussed
the investment banker’s fairness opinion presentation
showing that the average premium in minority squeeze-
outs was 50%, but noted that Travelocity.com was not
directly comparable to any of the companies in those
minority squeeze-out transactions.
61
The Court cited
Agranoff, Bomarko, and Borruso and applied the often-
used 30% adjustment for IMD.
62
The Court has not applied IMD to DCF
valuations—except once
The view that the DCF value of a company should
not be adjusted for a control premium is consistent with
generally accepted practice in the financial community.
Pratt explains that a DCF value based on projected cash
flows does not require the addition of a control premi-
um.
63
For a Delaware appraisal, the relevant projections
are those prepared by management, and dissenting
shareholders are entitled to their pro rata share of the
valuation based on management projections which do
not include changes that a third party might make.
Only the Hintmann case (discussed above) has ap-
plied a premium to a discounted cash flow valuation.
The Hintmann decision did not discuss why the Court
believed that a premium should be added to DCF value.
This is an aberrant and illogical holding, inconsistent
both with other cases and with valuation practice. Hint-
mann did not discuss whether terminal value had been
calculated using a multiple or a growth model.
Although Delaware has adjusted guideline company
valuations for IMD on numerous occasions (as discussed
previously), they have never applied a control premium to
a terminal value calculated by using multiples derived
from guideline companies. A control premium on terminal
value was rejected in 1991 in Radiology Associates.Sub-
sequently, the Court has used multiples to calculate termi-
nal value in four appraisal opinions, but no premiums were
proposed by petitioners’ experts in any of these cases.
64
However, there is an inconsistency between adjusting
for IMD in guideline company valuations and not ad-
justing terminal values based on multiples derived from
guideline companies. The Court’s first recognition of
this contradiction was in 2006, when the Court stated
that ‘‘an exit multiple based on minority trading data ...
[is] a less favored technique [for determining terminal
value] that raises questions about whether it embeds a
minority discount.’’
65
This point was addressed by Ha-
mermesh and Wachter, who argued that any adjustments
for IMD were improper:
[T]he Delaware courts’ application of the IMD has ren-
dered their valuation jurisprudence internally inconsistent.
Even as they have recently come to insist on adjusting for
the putative IMD when using a [guideline company ap-
proach], the Delaware courts have consistently (and prop-
erly) declined to make any such upward adjustment to the
results of discounted cash flow (DCF) analysis.
66
Hamermesh and Wachter noted, ‘‘It appears that Vice
Chancellor Strine, the author of the PNB Holding opin-
ion, has recognized the inconsistency we point out.’’
66
It is undisputed in Delaware that no premium should
be applied when terminal value is determined using a
growth model (the academically preferred approach).
Premiums to DCF valuations using growth models were
explicitly rejected in 2004 in both Dobler and Cancer
Treatment Centers, even though the Court adjusted for
IMD in its guideline company valuations in both cas-
es.
68
The Court in Dobler, citing Pratt’s Lawyer’s Busi-
ness Valuation Handbook, said:
[DCF] value should represent the full value of the future
cash flows of the business. Excluding synergies, a compa-
ny cannot be worth a premium over the value of its future
cash flows. Thus, it is improper and illogical to add a
control premium to a DCF valuation.
69
It added, ‘‘A DCF is a final valuation that does not
need any additional correction, such as a control premi-
um.’’
70
The Court in Cancer Treatment Centers ex-
pressed this virtually unanimous position when it
discussed DCF valuation: ‘‘The streams of income here
do not require any adjustment for an impermissible
minority discount.’’
71
The Misuse of Control Premiums
The balance of this article comments on the concep-
tual errors that have crept into Delaware’s application of
61
Doft at *46.
62
Id. at *46–47.
63
Pratt, Business Valuation Discounts and Premiums (2001), 30; Pratt,
Valuing a Business, 5th ed. (2008), 228. Pratt points out that a DCF
value not based on a control party’s projections may not reflect control
value.
64
Gilbert v. MPM Enterprises, 709 A.2d 663 (Del. Ch. 1997); Gray v.
Cytokine Pharmasciences, Inc. 2002 Del. Ch. LEXIS 48 (Apr. 25,
2002); In re U.S. Cellular Operating Co., 2005 Del Ch. LEXIS 1
(Jan. 6, 2005).
65
In re PNB Holding Co. Shareholders Litigation,2006Del.Ch.
LEXIS 158 (Aug. 18, 2006) at *114–*115. The Court chose to use
respondent’s growth model rather than petitioner’s exit multiple for
determining terminal value.
66
Hamermesh and Wachter, ‘‘The Short and Puzzling Life,’’ p. 6.
67
Id., p. 6, footnote 19.
68
Dobler at *72 and *65–*66; Lane v. Cancer Treatment Centers at
*117–118 and *129.
69
Pratt, The Lawyer’s Business Valuation Handbook (American Bar
Association, 2000), 359, quoting Matthews, ‘‘Delaware Court Adds
Control Premium to Subsidiary Value.’’
70
Dobler at *72.
71
Lane v. Cancer Treatment Centers at *117–*118.
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control premiums in appraisals, both in valuing subsidi-
aries of holding companies and in adjusting for implied
minority discounts. It also addresses a related issue—the
misuse of average acquisition premiums.
Is a business worth more if it is a subsidiary?
The Delaware Supreme Court has approved the valu-
ations of subsidiaries at a Strategic Control Level (thus
including synergistic premiums), even though they do
not permit operating companies to be valued at the same
level. For operating companies, we have seen that the
Court mistakenly adjusts for an assumed IMD, which
results in appraisal values being increased by the Court’s
‘‘control’’ augmentation. For subsidiaries, however, the
Court leapfrogs higher and awards a ‘‘strategic’’ or
‘‘synergistic’’ premium.
The Supreme Court valuations approved in Rapid-
American and M.G. Bancorp. were arrived at by apply-
ing average premiums in acquisition transactions to the
calculated values of the subsidiaries with no adjustments
to eliminate the effect of synergies on the data. The
result thus represents the Strategic Control level of
value. The average premiums necessarily derive from
acquisition prices that include potential synergies. Syn-
ergies can only be realized upon completion of a trans-
action. Thus, the Court’s use of acquisition values
appears to be contrary to the appraisal statute’s mandate
that ‘‘the Court shall determine the fair value of the
shares exclusive of any element of value arising from
the accomplishment or expectation of the merger or
consolidation.’’
72
The premium that was added in Hintmann to the
wholly owned subsidiary would not have been added if
the business had been a division. However, the value of
an operating business is not increased if it operates as an
incorporated subsidiary of a corporate parent rather than
as a division or, indeed, as the sole operating business of
the company being appraised. In 2001 Vice Chancellor
Leo Strine recognized this anomaly:
It seems a fine point to conclude that the value of the
entity as a going concern includes the potential to sell
controlled subsidiaries for a premium but not the potential
to sell the entity itself.
73
Professors Hamermesh and Wachter commented on
the concept of placing a premium on a subsidiary’s value:
It takes little imagination to see that this rationale, carried
to its logical conclusion, compels the inclusion of a
control premium, measured by a hypothetical third-party
sale value, in all share valuation cases, not just in situa-
tions in which the corporation owns its operating assets
through controlled subsidiaries. A corporation’s control of
directly owned assets is at least as great as it would be if
those assets were held through controlled subsidiaries.
74
Since third-party sale value for an operating company
would include an ‘‘element of value arising from ... the
merger,’’ most Delaware appraisal decisions have explic-
itly rejected valuations based on acquisition value. The
principal exceptions are the Rapid-American, LeBeau
and Hintmann cases that involved subsidiaries of hold-
ing companies. Applying control premiums to the value
of subsidiaries emphasizes form over substance: as dis-
cussed previously, an operating business is not worth
more as a subsidiary than as a division.
Commentators reject theory that most market
prices include an IMD
Is it appropriate to assume that the market prices of
guideline companies always include an IMD? No, it is
not. Shares may trade in the market at prices that are
higher or lower than the value of the company as a
whole. There are clear examples of periods when most
companies in certain industries trade at prices that exceed
the price that any cash buyer would pay. An obvious and
conspicuous example was the ‘‘dot.com’’ euphoria in the
late 1990s, when market prices of Internet shares com-
monly exceeded Financial Control Value and therefore
precluded most acquisitions (other than stock-for-stock
mergers with similarly priced companies).
Several professors of corporate law have questioned
the assumption that most market prices include an IMD.
Professor Booth wrote, ‘‘[I]t is not necessarily the case
that actual market price is always less than fair market
price. If it were, then there would be no such thing as a
fair market price.’’
75
Booth commented, ‘‘A stock that is
permanently depressed is presumably just worth less.’’
76
He observed:
[A]lthough it is always appropriate to ask whether there is
some reason to distrust the market price in any given case,
it is clear that the market price is not always low [empha-
sis in original]. ... Indeed, in 1999 the Wall Street
Journal reported several takeovers at negative premiums.
Apparently, in the case of these companies the market had
risen to a price in excess of control value.
77
Professors Hamermesh and Wachter concur that pre-
miums in acquisition transactions are not a rational basis
for assuming that market prices necessarily include
implied minority discounts:
72
8 Del. Code §262(h).
73
Agranoff at *51, footnote 45.
74
Hamermesh and Wachter, ‘‘The Short and Puzzling Life,’’ p. 15.
75
Booth, p. 130.
76
Id., p. 150.
77
Id., p. 149.
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[I]t is incorrect to make the logical jump that these
premiums [paid in acquisitions] reflect some kind of
IMD. The fallacy is obvious and analogous to the ‘‘dogs
that don’t bark’’ metaphor: there are lots of dogs, and most
of the time, most dogs are not barking. Similarly, in any
given year, the vast majority of companies are not in-
volved in a change of control transaction.
78
They point out that generally accepted financial theo-
ry is that market prices of liquid securities in informed
markets represent going-concern value. They conclude,
‘‘There is no evidence that such [market] prices system-
atically and continuously err on the low side, requiring
upward adjustment based on an ‘implicit minority dis-
count.’’’
79
Professor Carney as well strongly argued against
assuming that market prices of most publicly traded
shares include a significant IMD:
[C]ontrol premiums only occur in transactions involving a
transfer of control, where there are thought to be gains
from trade, either because of a perception by the purchaser
that the transaction offers some opportunity to create new
value within the target firm or because the bidder believes
that the market value of the target’s shares is depressed
and it can earn an abnormal return by holding target
shares until the market price reflects full value [footnotes
omitted]. Even if all values, both present and potential, are
valued in the market price for the firm’s shares, one would
not expect to find a discernible control premium in a
widely held firm that is well managed and appears to offer
little probability of a transfer of control. Any small prob-
ability of a control transaction will already be reflected in
the market price, because absent a dominant shareholder,
all shareholders expect to have an equal opportunity to
share in any such premium, should it appear. Absent an
actual transfer of control, control premiums represent
probabilities of a control transfer at a premium. Where
the probability is close to zero, so is the premium.
80
Eric Nath, a San Francisco–based valuation expert,
was the first to question the presumption of an implied
minority discount in publicly traded share prices. Nath
presented this view in a pioneering 1990 Business Valu-
ation Review article in which he argued that market
prices generally already reflected control value. He
pointed out that the freely traded market prices of a
company already had incorporated in them the com-
pany’s financial control positives or negatives.
81
Nath’s
theory stimulated a great deal of debate and reconceptu-
alization and, despite much initial resistance in publica-
tions and seminars, has become widely accepted by
leading valuation experts. Mark Lee, an experienced
and well-respected valuation expert, pointed out in 2001:
If there is no M&A market available to sell a company at
a premium to its stock market value, then there is little or
no acquisition premium, much less a ‘‘theoretical’’ premi-
um based on an average of acquisitions of dissimilar
companies.
82
Lee also pointed out in 2004 that ‘‘the acquisition
value of a company may be equal to or below its market
value,’’ explaining, ‘‘While a company may be viewed
as very attractive to a purchaser of a minority interest in
the public market, the company as a whole may be
perceived as too risky at its publicly traded market
price.’’
83
In a recent book about fairness opinions, Philip
Clements and Philip Wisler took the same position,
stating, ‘‘The control value of a company may not differ
greatly [from] and may even be below its publicly
traded minority share value.’’
84
The Court relied upon authors who no longer
support IMD
Although the Court of Chancery is becoming aware
that the IMD assumption is being questioned, many of
their recent IMD decisions continued to rely on experts’
now-abandoned or modified theories. In 2007, Vice
Chancellor Lamb noted that there is a debate about
IMD, citing the Hamermesh & Wachter and Booth
articles which both ‘‘argu[e] that the implicit minority
discount has not gained general acceptance in the finan-
cial community.’’
85
In 1996, when Shannon Pratt wrote that the guideline
company method ‘‘usually requires some adjustment from
the publicly traded minority stock value equivalent to
account for control,’’ that was the accepted view of the
financial community.
86
At that time, the Delaware Court
rightly relied upon the financial community’s accepted
view of an implied minority discount since they were
following Weinberger’s injunction to make their valua-
tions in accordance with accepted financial theory.
Within three years, Pratt had come to modify his
view. In a 1999 article he stated, ‘‘Valuation analysts
who use the guideline public-company valuation method
78
Hamermesh and Wachter,‘‘The Short and Puzzling Life,’’ p. 33.
79
Id.,p.2
80
Carney and Heimendinger, p. 860.
81
Nath, ‘‘Control Premiums and Minority Interest Discounts in Private
Companies,’’ Business Valuation Review, June 1990. He reiterated this
position in ‘‘TheTaleofTwoMarkets,’’ Business Valuation Review,
September 1994, and in ‘‘How Public Guideline Companies Represent
‘Control’ Value for a Private Company,’’ Business Valuation Review,
December 1997.
82
M. Mark Lee, ‘‘Control Premiums and Minority Discounts: the Need
for Economic Analysis,’’ Business Valuation Update, August 2001, 4.
83
M. Mark Lee, ‘‘The Discount for Lack of Control and the Ownership
Control Premium,’’ in The Handbook of Business Valuation and Intel-
lectual Property Analysis, Robert F. Reilly and Robert P. Schweihs,
eds. (New York: McGraw-Hill, 2004), 37.
84
Philip J. Clements and Philip W. Wisler, The Standard & Poor’s
Guide to Fairness Opinions. (New York: McGraw-Hill, 2005), 94.
85
Highfields Capital at *67, footnote 72.
86
Pratt, Reilly, and Schweihs, Valuing a Business. 3rd ed., p. 210.
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and then automatically tack on a percentage ‘control
premium’ ... had better reconsider their methodolo-
gy.’’
87
Pratt included this comment in the Fourth Edition
of Valuing a Business in 2000, but the Court apparently
was not aware of this change. In Agranoff (2001), the
Court again relied on Pratt’s 1996 view as expressed in
the 3rd Edition and on Mercer’s 1992 book. The Court
stated, ‘‘The comparable companies analysis generates
an equity value that includes an inherent minority trad-
ing discount, because the method depends on compari-
sons to market multiples derived from trading
information for minority blocks of the comparable com-
panies.
88
In 2001, Pratt further clarified his position in Business
Valuation Discounts and Premiums. After an extensive
discussion of various articles and seminars regarding the
issue of whether market prices reflect control value, Pratt
quoted extensively from Lee’s incisive 2001 article and
then concluded, ‘‘In any case, it is obvious that, given
the current state of the debate, one must be extremely
cautious about applying a control premium to public
market values to determine a control level of value.’’
89
However, as late as 2005 in the Andaloro decision,
the Court continued to cite Pratt’s 1996 book in support
of an adjustment for IMD.
90
The same Court was clearly
aware of Pratt’s 4th Edition (2000) because, in the same
Andaloro decision, it cited the more recent 4th Edition
in its discounted cash flow discussion.
91
It is unclear
why the Court did not use Pratt’s modified view of an
implied minority discount in his more recent 4th Edition.
Mercer was also coming to the conclusion that market
prices are often close to control value. He addressed the
issue directly in 2004 in the important 1st Edition of The
Integrated Theory of Business Valuation.
92
After having
disagreed with Nath in the early 1990s, he conceded that
Nath had been right, and that the financial control
premium (the difference between Financial Control Val-
ue and Marketable Minority Value) could be zero.
93
Mercer’s 2004 book included a modified levels-of-value
diagram (see Figure 2) that showed Marketable Minority
Value overlapping Financial Control Value.
94
He uses
that model to make the point that ‘‘unless there are cash
flow-driven differences between the enterprise’s finan-
cial control value and its marketable minority value,
there will be no (or very little) minority interest dis-
count.’’
95
Mercer presented an elaborated diagram (see Figure
3) reconciling his levels of value with Nath.
96
This
diagram also shows that public market prices may ex-
ceed Strategic Control Value at a level he calls ‘‘Appar-
ently Irrational’’ (as in the ‘‘dot.com’’ phenomenon in the
late 1990s).
Thus, although citations from Pratt and Mercer sup-
ported pre-1999 decisions regarding IMD, since 1999
neither of these prominent authors has supported the
concept that publicly traded shares customarily include
implied minority discounts.
Testing for IMD
It is not the writer’s position that it is never appropri-
ate to adjust for IMD. In fact, the valuator should
determine empirically if IMDs exist in the guideline
companies’ prices. Only if it can be demonstrated that
the prices of guideline companies include IMDs is it
appropriate to add a control premium to offset those
Figure 2
Modified Levels of Value
87
Pratt, ‘‘Control Premiums? Maybe, Maybe Not—34% of 3rd Quarter
Buyouts at Discounts,’’ Business Valuation Update, January 1999, pp.
1–2. This article is cited in Pratt, Reilly and Schweihs. Valu i n g a
Business: The Analysis and Appraisal of Closely Held Companies.4th
ed. (New York: McGraw-Hill 2000), 357.
88
Agranoff at 892. The footnote to this sentence cites Le Beau at *25
and includes the references to the Pratt and Mercer books.(See
footnotes 36 and 37 herein.)
89
Pratt, Business Valuation Discounts and Premiums (2001), 40.
90
Andaloro at *65. See the discussion of this case in Matthews, ‘‘A
Review of Valuations in Delaware Appraisal Cases, 2004–2005,’’
Business Valuation Review, Summer 2006, 59–60, comparing the dis-
cussion of control premiums in the 3rd and 4th Editions of Valuing a
Business. Hamermesh and Wachter compare those two editions in ‘‘The
Short and Puzzling Life’’ on pp. 51–53.
91
Id. at *36.
92
Mercer, The Integrated Theory of Business Valuation (Baltimore:
Peabody, 2004). This book innovatively showed the interrelation
among various approaches to valuation, discounts, and premiums.
93
Id., p. 101.
94
Id., p. 110. This diagram is reproduced in Pratt, ValuingaBusiness,
5th ed. (2008), 387.
95
Id., p. 108.
96
Id., p. 376.
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IMDs. Analysis is required to quantify the adjustment.
IMD is fact-specific in each valuation and it cannot be
determined by using a generic rule of thumb.
97
Nath
wrote in 1990:
It would seem that an appraiser could utilize a control
premium only if it could be convincingly demonstrated
that the comparative stocks being utilized are undervalued,
and a reasonable estimate of the magnitude of undervalu-
ation can be established for each stock, individually. This
will be theoretically impossible in an efficient market.
98
Since the market is sometimes not efficient, IMDs
may arise. In examining whether IMDs are present, the
key factor to be considered is the relation between
market multiples and transaction multiples. It is possible
to estimate IMD (if any) by comparing the average
multiples of guideline companies with average multiples
of guideline transactions. The valuator (and ultimately
the Court) should then consider what adjustment should
be made to multiples of guideline transactions to elimi-
nate the synergistic benefits that should be excluded in a
Delaware appraisal. To the extent that any of the guide-
line transactions were priced at earlier dates under differ-
ent market conditions, further adjustments should be
considered. IMD can be quantified by reference to the
difference between guideline transaction multiples (ad-
justed for synergy and market conditions) and market
multiples of guideline companies. It should also be
recognized that prices paid in acquisitions may include
the benefits of cost savings that would be excluded under
Delaware’s ‘‘operative reality’’ concept.
In the author’s experience, it is not uncommon for
multiples of guideline transactions to be similar to mul-
tiples of guideline companies.
99
If the differences be-
tween multiples of guideline companies and multiples of
guideline transactions (excluding synergies and other
adjustments) are not significant, then there is no basis
for concluding that IMD is relevant to the valuation.
Moreover, if there is an absence of recent guideline
transactions, this fact is evidence that market prices of
guideline companies are not at levels that are attractive to
acquirors and that they therefore have no IMD.
100
Figure 3
Levels of Value Reconciled with Nath
97
The U.S. Tax Court now requires case-specific analyses and rejects
generic discounts for lack of marketability. See, Bernard Mandelbaum
v. Commissioner, T.C. Memo 1995–255 (1995); Pratt, Valuing a Busi-
ness, 5th ed. (2008), 449; Michael A. Paschall, ‘‘The 35% ‘Standard’
Marketability Discount: R.I.P,’’ CCH Business Valuation Alert (Febru-
ary 2005), 3.
98
Nath, ‘‘Control Premiums and Minority Interest Discounts in Private
Companies,’’ 45.
99
See Matthews, ‘‘Fairness Opinions: Common Errors and Omissions’’
in The Handbook of Business Valuation and Intellectual Property
Analysis, Eds. Reilly and Schweihs. (New York: McGraw-Hill, 2004).
215, Exhibit 8–2.
100
The airline industry is an example of a sector in which no cash
acquisitions have been made for many years.
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Average premiums paid in acquisitions are
statistically biased
Testifying experts commonly rely on average premi-
ums paid in transactions as a basis for estimating IMD
and as a measure of acquisition premiums. Regrettably,
there is a widespread failure to recognize that the data
used in calculating the average premiums in transactions
includes a substantial built-in upward bias. Because these
premiums are computed in relation to the market prices
of target companies prior to the announcement of acqui-
sitions, the databases consist primarily of those compa-
nies that acquirors believe to be worth more than they
are trading for in the market. Thus the universe of
guideline transactions includes companies which were
undervalued in the market but necessarily excludes com-
panies that acquirors consider overvalued. Thousands of
companies are publicly traded, but only a small portion
of them are acquired in any specific year. Professor
Bradford Cornell took the position fifteen years ago, that
most market prices do not include an IMD, saying, ‘‘The
fact that most companies do not receive takeover bids
at premiums above market price indicates investors be-
lieve that the shares of those companies are not worth
significantly more than market price’’ [emphasis in orig-
inal].
101
Pratt wrote in 2001:
Out of the tens of thousands of public companies only a
small percentage actually are acquired each year. In recent
years the companies purchased have often been ‘‘best of
breed,’’ making them a very unique subset of the market.
Statistically, it is unlikely that this small, select group is
universally representative of the market as a whole.
102
The Chancery Court’s belief that guideline companies
suffer from IMD, and the Court’s quantifications of
those IMDs, have generally been based on expert testi-
mony as to the average premiums paid in acquisitions.
The Court, therefore, has relied on data that is seriously
flawed and statistically unreliable.
The Courts have been further misled by the fact that
some investment bankers erroneously include average
premiums as one of several measures in arriving at
fairness opinions. Even though the use of average premi-
ums is not statistically valid, the use of average acquisi-
tion premiums has been mistakenly accepted by many in
the financial community. The investment bankers’ analy-
ses are available in proxy statements for mergers and
acquisitions, giving the reliance on average premiums a
fac¸ade of respectability. The author has criticized the use
of average acquisition premiums as a fairness standard in
several publications over the past two decades, as have
Eric Nath, Shannon Pratt and Mark Lee.
103
Conclusion
It is clear that leading legal and valuation commen-
tators have concluded that there is no basis for
assuming that market prices of all publicly traded
shares include an implicit minority discount. The
default assumption should be that publicly traded
shares sell at a company’s going-concern value. If
petitioner’s expert concludes that an IMD is appro-
priate in a given situation, its magnitude should be
based on a comparison between acquisition multi-
ples and market multiples.
The concept that a subsidiary of a company should
be valued with an acquisition premium, even
though an operating company is valued without
such a premium, is illogical: it elevates form over
substance. There is no support in the valuation or
finance literature for this distinction. A business is
not worth more if it is a subsidiary rather than a
division of an operating business. Valuation experts
should apply any relevant premiums without dis-
tinction as to the legal form of the business unless
the distinction leads to a difference in cash flows.
Average acquisition premiums paid for shares of
publicly traded companies are statistically biased
and therefore are a misleading measure of control
premiums in valuations.
Gilbert E. Matthews, CFA, is Senior Managing
Director and Chairman of Sutter Securities
Incorporated in San Francisco, California. The
writer gratefully acknowledges the contribution of
Dr. Michelle Patterson and numerous others who
offered helpful comments.
101
Bradford Cornell, Corporate Valuation (New York: McGraw-Hill,
1993), 243.
102
Pratt. 2001. Business Valuation Discounts and Premiums, 60.
103
See, e.g., Matthews and Lee, ‘‘Fairness Opinions & Common Stock
Valuations,’’ in The Library of Investment Banking, Vol. IV. Ed.
Robert Kuhn, (New York: Dow Jones Irwin, 1990), 407; Nath, ‘‘Con-
trol Premiums and Minority Interest Discounts in Private Companies,’’
41–43; Lee and Matthews, ‘‘Fairness Opinions,’’ in The Handbook of
Advanced Business Valuation. Eds. Reilly and Schweihs (New York:
McGraw-Hill, 2000), 327; Matthews, ‘‘Fairness Opinions,’’ In Business
Valuations for the Legal Practitioner (Chicago: American Bar Associ-
ation Center for Continuing Legal Education, 2001), K14–15; Lee,
‘‘Control Premiums and Minority Discounts: the Need for Economic
Analysis,’’ 2–4; Lee, ‘‘The Discount for Lack of Control and the
Ownership Control Premium’’ and Matthews, ‘‘Fairness Opinions:
Common Errors and Omissions,’’ in The Handbook of Business Valua-
tion and Intellectual Property Analysis. 43 and 214–216; Pratt, Valuing
aBusiness, 5th ed. (2008), 391–392 (quoting the writer).
Page 118 Ó2008, American Society of Appraisers
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... The first is the Delaware appraisal statute which serves as the basis for adjudication of dissenting shareholder suits in mergers and acquisitions. As Matthews (2008) notes, the statute says that " the Court shall determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation. " Matthews goes on to observe that under Delaware law no adjustments are permitted for changes that might be made by a new control shareholder and the company must be valued as a going concern with the assets and opportunities it has currently in place. ...
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There is a long running valuation debate regarding whether a control premium should be added to valuation based on guideline public companies because the share prices of the guideline companies represent marketable minority positions. This paper attempts to resolve that debate by developing a more complete economic model to analyze the issue. Based on the economic model, which highlights the potential motives for acquisitions, I conclude that no adjustment for a control premium is required to appraise a company on a current going concern basis. If the goal is to value a company at its highest value use, including as part of another company, then an adjustment to take account of the benefits of synergies, if there are any, is required. However, historical averages of acquisition premiums will overstate the proper adjustment.
... 3 This article addresses the Delaware Court's misapplication of control premiums from a business valuation perspective. 4 It focuses on why it is inappropriate to assume that the market prices of guideline companies necessarily include an IMD. A method is proposed whereby the valuator, in any specific valuation, can ascertain whether implied minority discounts exist in the relevant guideline company prices. ...
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The cost of capital is a central issue in judicial business valuations in statutory appraisal, stockholder oppression, and “entire fairness” cases. The Delaware courts have effectively set the standards for valuations related to corporate disputes because Delaware law is widely accepted on corporate legal issues. This article primarily discusses Delaware Court of Chancery and Delaware Supreme Court opinions involving the discounted cash flow (DCF) method and its crucial component, the cost of capital. Most of the Delaware decisions discussing cost of capital have come from statutory appraisal cases, and the Court does not differentiate in its approach to cost of capital in fairness cases. The Delaware Court of Chancery has declared its preference for the DCF method of valuation, including all elements of the expanded capital asset pricing model (CAPM) to determine the cost of capital. It has, however, rejected the company-specific adjustment in the calculation of weighted average cost of capital (WACC) unless there are unusual circumstances to validate it.
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This study asks which valuation approaches and analyses are currently being used as the foundation for fairness opinions in stock-for-stock mergers involving US companies. An examination of the SEC's EDGAR database for the years 2009 through 2014 identified 146 proxy statements for stock-for-stock mergers containing 290 fairness opinions and descriptions of the approaches, methods, and analyses employed. We found that most opinions employed more than one approach, and that opinion providers (primarily investment bankers) determined the fairness of stock-for-stock mergers by considering relative analyses as well as customary valuation approaches. More than 90% of the fairness opinions utilized the two traditional ways to quantify going-concern value: the income and market approaches. In addition, more than 90% used one or more relative analyses. Relative analyses, which assess the relative fairness of the exchange ratios in a stock-for-stock merger, are applicable only when target shareholders continue to own an equity interest in the surviving company. Inputs used in the income approach and multiples used in the market approach were reviewed. Also, fees charged for public fairness opinions were examined.
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The question of Control Share Premium, more widely referred to as the " control premium " in the literature on corporate valuations is treated as a curious area of study by the academic and professional circles. This paper addresses the question of CSP primarily from a conceptual point of view. We point out, here, that, 1) corporate value drivers, summarized a " private benefits of control, " that currently are evident and internal to the acquired businesses are the main deterrminant of the value of the CSP; 2) CSP is indeed relevant in Turkish financial markets; and, 3) The most meaningful approach to calculate control premiums in Turkish financial markets, as in other regions, would be to employ DCF methodology on the " set of private benefits " that are identified in the target company to be acquired based on its on corporate and sectoral merits. Another conclusion is that as CPS has a certain impact on the valuation of overall equity value of a firm, it has a significant impact on the position of minority shareholders with respect to the minority protection rights in the target company.
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The cost of capital is a central issue in judicial business valuations in statutory appraisal, stockholder oppression, and “entire fairness” cases. The Delaware courts have effectively set the standards for valuations related to corporate disputes because Delaware law is widely accepted on corporate legal issues. This article primarily discusses Delaware Court of Chancery and Delaware Supreme Court opinions involving the discounted cash flow (DCF) method and its crucial component, the cost of capital. Most of the Delaware decisions discussing cost of capital have come from statutory appraisal cases, and the Court does not differentiate in its approach to cost of capital in fairness cases. The Delaware Court of Chancery has declared its preference for the DCF method of valuation, including all elements of the expanded capital asset pricing model (CAPM) to determine the cost of capital. It has, however, rejected the company-specific adjustment in the calculation of weighted average cost of capital (WACC) unless there are unusual circumstances to validate it.
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This study examined empirically which valuation methods are currently being used in fairness opinions in cash acquisitions and how they are applied. A search of the SEC's EDGAR database for two 12-month periods identified 315 cash acquisitions with 352 fairness opinions containing descriptions of their methods and analyses. The findings showed the discounted cash flow, comparable company, and comparable transaction methods in predominant use, with most opinions employing more than one method and almost half drawing on the much-disparaged “premiums paid” approach. In addition, a comparison of the fairness opinion approaches used in related party transactions with those in arm’s-length transactions found one disparity. We elaborate and provide commentary on these findings. The study then scrutinized specific variables in the income approach, focusing on discount rates and terminal values. Our commentary discusses the broad spreads of the DCF inputs which were found and the consequences thereof. For analyses using the market method, we looked at the multiples applied, finding, among other things, that P/E ratios were used more frequently in comparable company than in comparable transaction analyses. Additionally, we looked at how enterprise value was defined for use in the market method; it is clear that investment banking practice is to deduct cash in calculating enterprise value when enterprise value is the numerator in a multiple. Throughout the study, two other lines of inquiry were investigated: whether valuators applied different approaches when valuing financial institutions and whether there were material differences in practice among the various investment banks rendering opinions.
Chapter
IntroductionDefinition of Control Premium/Minority DiscountDelaware Law, Delaware Courts, Values, and DiscountsSources of the Economic Benefits of ControlEvidence on the Value of ControlCan Practice Be Reconciled with Finance Theory and Evidence?Summary and Conclusions Discussion QuestionsAbout the Author
Delaware Court Relies on Comparable Acquisition Method: LeBeau v. M.G. Bancorporation, Inc.,'' Business Valuation UpdateDelaware Court Adds Control Premium to Subsidiary Value: Hintmann v
  • E Gilbert
  • Matthews
Gilbert E. Matthews, ''Delaware Court Relies on Comparable Acquisition Method: LeBeau v. M.G. Bancorporation, Inc.,'' Business Valuation Update, March 1998; Matthews, ''Delaware Court Adds Control Premium to Subsidiary Value: Hintmann v. Fred Weber, Inc.,'' Business Valuation Update, May 1998.
Pratt points out that a DCF value not based on a control party's projections may not reflect control value
  • Pratt
Pratt, Business Valuation Discounts and Premiums (2001), 30; Pratt, Valuing a Business, 5th ed. (2008), 228. Pratt points out that a DCF value not based on a control party's projections may not reflect control value.
  • Cytokine Pharmasciences
  • Inc
Cytokine Pharmasciences, Inc. 2002 Del. Ch. LEXIS 48 (Apr. 25,
The Short and Puzzling Life
  • Wachter Hamermesh
Hamermesh and Wachter, ''The Short and Puzzling Life,'' p. 6. 67 Id., p. 6, footnote 19.
Control Premiums and Minority Interest Discounts in Private Companies Business Valuation Review He reiterated this position in ''The Tale of Two Markets, and in ''How Public Guideline Companies Represent 'Control' Value for a Private Company
  • Nath
81 Nath, ''Control Premiums and Minority Interest Discounts in Private Companies,'' Business Valuation Review, June 1990. He reiterated this position in ''The Tale of Two Markets,'' Business Valuation Review, September 1994, and in ''How Public Guideline Companies Represent 'Control' Value for a Private Company,'' Business Valuation Review, December 1997.
Control Premiums and Minority Discounts: the Need for Economic Analysis Business Valuation UpdateThe Discount for Lack of Control and the Ownership Control Premium,'' in The Handbook of Business Valuation and Intellectual Property Analysis The Standard & Poor's Guide to Fairness Opinions
  • M Mark Lee
82 M. Mark Lee, ''Control Premiums and Minority Discounts: the Need for Economic Analysis,'' Business Valuation Update, August 2001, 4. 83 M. Mark Lee, ''The Discount for Lack of Control and the Ownership Control Premium,'' in The Handbook of Business Valuation and Intellectual Property Analysis, Robert F. Reilly and Robert P. Schweihs, eds. (New York: McGraw-Hill, 2004), 37. 84 Philip J. Clements and Philip W. Wisler, The Standard & Poor's Guide to Fairness Opinions. (New York: McGraw-Hill, 2005), 94. 85 Highfields Capital at *67, footnote 72. 86 Pratt, Reilly, and Schweihs, Valuing a Business. 3rd ed., p. 210.
) and remanding the case
  • Del
  • Ch
Del. Ch. LEXIS 166 (Oct. 2, 1990) and remanding the case.
The unaffected market price of Rapid-American had been $17.25 per share, the going-private consideration (primarily in debentures) was worth approximately $28 per share, the initial appraisal value was $51 per share, and the ultimate appraisal with the control premiums was $73.29 per share
  • Harris V. Rapid-American
  • Corp
Harris v. Rapid-American Corp., 1992 Del. Ch. LEXIS 75 (Apr. 1, 1992). The unaffected market price of Rapid-American had been $17.25 per share, the going-private consideration (primarily in debentures) was worth approximately $28 per share, the initial appraisal value was $51 per share, and the ultimate appraisal with the control premiums was $73.29 per share. 23 In re Radiology Associates, A.2d 485 (Del. Ch. 1991).