Gilbert E. Matthews, C.F.A.
Chairman and Senior Managing Director
Sutter Securities Incorporated
1 Sansome Street, Suite 3950
San Francisco, CA 94104
Business Valuations for the Legal Practitioner
American Bar Association Center for Continuing Legal Education, 2001
April 2, 2001
OPINIONS ........................................................................................... 1
WHY ............................................ 1
LITIGATION .............................................................................. 1
OPINIONS ..................................................................................... 2
DETERMINED ........................................................................ 3
VALUATION ................................................................................... 10
EAKNESSES IN THE
FAIRNESS ............................................................................... 13
ISSUES ................................................................. 17
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A fairness opinion is a document which states whether a transaction, or the
consideration payable in a transaction, is fair, from a financial point of view, to a particular
group of investors. Fairness opinions are most often issued by investment banking firms,
but also by commercial banks, accounting firms, and entities specializing in valuation.
The opinions are normally addressed to equity investors, sometimes to all common
shareholders or limited partners, and sometimes to a specific subgroup, e.g., public
shareholders, or shareholders other than an interested party. Fairness opinions serve two
purposes: (i) they provide key decision-makers with information which may affect their
decisions, and (ii) they can serve as evidence in litigation that the decision-makers used
reasonable business judgment in approving a transaction.
WHO REQUESTS FAIRNESS OPINIONS AND WHY
Businesses use fairness opinions in numerous types of situations. A Board of
Directors of a company being acquired, either for cash or securities, generally requests a
fairness opinion to help demonstrate that they are acting for the benefit of shareholders.
A Board often will ask for a fairness opinion in the case of the sale or spin-off of material
assets, divisions or subsidiaries. The Boards of Directors of an acquiror may request an
opinion if an acquisition is material to the acquiror. Boards occasionally request fairness
opinions in connection with the repurchase of securities by a company.
For a transaction between a company and a related party, it is customary for the
fairness opinion to be requested by a committee of independent directors. General
partners may ask for fairness opinions for transactions affecting the limited partners of a
partnership. An indenture trustee may be required to obtain a fairness opinion when a
transaction triggers an indenture provision. Governmental regulatory agencies sometimes
request fairness opinions, e.g., for the conversion of mutual banks or insurance
companies into corporations, or medical organizations from non-profit to for-profit status.
IMPORTANCE IN LITIGATION
An important role of a firm giving a fairness opinion is defending the opinion in the
event of litigation. In selecting a firm, it behooves the retaining party to understand the
qualifications and skills of the firm it engages and of the senior people who will be
responsible for the assignment.
Boards of Directors of corporations and General Partners of limited partnerships are
required to act with informed business judgment when considering a proposed
transaction. Whether or not informed business judgment was used is often a central issue
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In Smith v. Van Gorkom,
the Delaware Supreme Court ruled that the Directors of
Trans Union Corporation were grossly negligent in not obtaining adequate information as
to the value of the company when they approved a cash acquisition of Trans Union. The
Court criticized the Directors for not seeking “any valuation study or documentation of the
$55 price per share as a measure of the fair value of the Company in a cash-out context.”
They relied primarily on information provided by officers of the company and failed to
request any advice from independent advisors. Although the merger price was at a
substantial premium over the market price of Trans Union’s stock, and although the
experienced and reputable Directors were not charged with acting with malice, the
Directors were adjudged liable to the plaintiff stockholders for damages. While the Court
did not hold that, as a legal matter, directors must always obtain an outside valuation
study, a fairness opinion would have helped the Trans Union Directors to demonstrate
that they had made an informed business decision.
Numerous courts have ruled that directors are entitled to rely on the opinion of an
independent investment bank in fulfilling their fiduciary obligations.
have a duty to inquire as to the basis of an opinion, and are not entitled to rely on an
opinion given in conclusory terms without supporting documentation.
There are situations where a Board of Directors would prefer not to receive a
fairness opinion. When there is an unsolicited bid for a company, the Board and
management may prefer to resist the takeover attempt. In that event, an investment
banker may be asked to render an “inadequacy opinion.” As the name indicates, an
inadequacy opinion is a letter which concludes that the price offered is inadequate, giving
the Board a basis for resisting and for seeking alternatives.
Such opinions are usually needed in a short time frame, because the tender offer
rules require that the offer be commenced within seven days of the announcement of the
purchaser’s intent, and a prompt reply by the target company is needed. The short time
frame would make it difficult for a firm which is not familiar with the company to arrive at
an opinion, and the assignment is ordinarily given to a firm with a historical relationship
with the target company.
No legal standards as yet exist as to what “inadequacy” is, but “inadequate” is not
synonymous with “unfair.” In practice, a bid price which is within a range of fairness, but
near the low end, can be deemed inadequate, even though it could also be considered
fair. It would be difficult to argue, however, that a price above the midpoint of a fairness
range was inadequate, unless there was a sound basis for determining that the timing of
The author would like to thank M. Mark Lee, Dr. Michelle Patterson, and Dr. Shannon P. Pratt for
their helpful comments.
488 A.2d 858 (Del. 1985).
E.g., Samjens Partners I v. Burlington Industries, Inc., 663 F. Supp 614 (S.D.N.Y. 1987); Horwitz
v. Southwest Forest Indus. Inc., 604 F. Supp. 1130 (D. Nev. 1985); Nebenzahl v. Miller, C.A. No.
13,206 (Del. Ch. Nov. 8, 1993), reprinted in 19 Del. J. Corp. L. 834; Pogostin v. Rice, 480 A.2d 619
(Del. 1984). See also 8 Del C. §141(e).
Hanson Trust PLC v. ML SCM Acquisition Inc., 781 F.2d 264 (2d Cir. 1986).
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the bid could be attributed to temporarily depressed market conditions or to a short-term
deterioration in the target’s performance.
HOW FAIRNESS IS DETERMINED
The first matter to be addressed in determining the fairness of a transaction is the
relative value of the consideration to be received in comparison to what is being given up.
It is necessary, therefore, to reach a conclusion as to the going-concern value of a
company’s equity. Going-concern value is customarily calculated using three basic
(a) multiples of the most recent historical income account data and of
forecasts, based on the multiples of comparable companies (the
“comparable company” or “guideline company” method),
(b) multiples of the most recent historical income account data based on
comparable mergers and acquisitions (the “comparable acquisition”
(c) discounted cash flow ("DCF").
The concept underlying the comparable company methodology is simple: it is
valuation by analogy. To apply the method, the analyst determines which publicly traded
companies are similar to the company being valued, calculates the multiples at which
these companies sell, and applies the appropriate multiple reflecting qualitative and
quantitative differences between the comparable companies and the subject company.
The selection of comparable companies, however, can be difficult. Although there
are some industries in which numerous good comparables may be found (e.g.,
supermarkets), more often the selection is limited. Most often, a first step in selecting
comparables is to review companies with the same SIC code.
Management may be of
assistance by identifying its competitors, but these companies may have different overall
product ranges that limit their comparability. As companies broaden their range of
activities, it is often not possible to find other companies with the same mix of businesses.
It may be necessary to rely on companies which could be described as “secondary
comparables,” i.e., companies with significant similarities but which differ in certain
substantive respects from the subject company. Sometimes companies which make
different products than the subject company produces, but which serve the same markets,
can be useful as comparable companies.
Descriptive and financial information on public companies is included in filings with
the Securities and Exchange Commission (S.E.C.). Documents filed with the S.E.C. are
available on the Internet at sites such as FreeEDGAR.com. Annual reports on Form 10-K
include audited financial statements, descriptions of the company, and much more. Other
useful documents include quarterly reports, prospectuses, proxy statements for mergers
Standard Industrial Classification (SIC) codes classify businesses according to their primary type
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and annual meetings, and documents with respect to tender offers. Although financial
data can be obtained from certain computer services, such as Compustat, the analyst
working on a fairness opinion should use source documents in order to adjust
appropriately for such items as unusual charges, nonrecurring gains and losses, and
factors affecting reported taxes. Earnings estimates for many public companies, compiled
from published research reports, are available from several sources, such as First Call
and I/B/E/S (Institutional Brokers Estimate Service).
After the comparable companies have been selected and data compiled, the analyst
calculates the relationship between the market value of each comparable company and its
financial data. The numerator for such comparisons is either the market price of the
shares or the aggregate market value (“AMV”) of a company’s capital structure.
Market price of common stock
times: Number of shares outstanding, fully diluted
plus: Long-term debt (including capitalized lease obligations)
plus: Short-term debt
plus: Preferred stock (if any)
plus: Minority interest (if any)
less: Cash and cash equivalents (excluding any restricted cash).
Debt is normally valued at par, unless it bears an interest rate materially below market.
Preferred stock may be valued at liquidation value or fair market value; it seldom is
material to the analysis. Minority interest, if any, is valued at book value. Care should be
taken to avoid double-counting any convertible debt or preferred stock included in a
company’s fully diluted shares.
The principal bases of valuation are (a) EBITDA (earnings before interest, taxes,
depreciation and amortization), (b) EBIT (earnings before interest and taxes), and (c) net
income. The principal multiples used are the ratios of AMV to EBITDA and to EBIT, and
the ratio of market price to earnings per share (“P/E”). Other multiples which may be
utilized are the ratio of AMV to revenues (often used for companies which have not yet
attained profitability) and of market price to book value (particularly for financial
institutions). In certain cases, other market ratios might be applicable. A ratio which has
been used for the airline industry is AMV to EBITDAR (EBITDA plus rentals); in this
context, AMV must be adjusted to include the imputed principal in the underlying leases.
It is customary to calculate multiples of data for the latest 12 months (“LTM”).
Multiples of prior periods are less relevant. For cyclical industries, average data over a
period of time may be useful. When available, multiples of projected future results should
be calculated. It is helpful to look at ratios based on estimated earnings for the year in
progress and for the following year.
Once the various multiples of the comparable companies have been computed,
averages are calculated. If the sample of comparable companies is sufficiently large, a
median is commonly used. The arithmetic mean is commonly used, but it is upwardly
biased. As discussed below in P
, the harmonic mean, which is
seldom used by investment bankers, is statistically preferable and should be adopted
AMV is also known as “total value of invested capital” or as “market capitalization.”
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At this point, qualitative differences should be considered. Relative growth rates are
particularly important; other factors include, inter alia, profit margins, competitive position,
and size. There are also industry-specific factors, such as revenues per passenger mile
and load factors for airlines.
Since the comparable company method is based on the market value of publicly
traded shares, the resultant value may include a minority discount. The Delaware Court
of Chancery has accepted that there may be an “implicit minority discount” in the value of
publicly traded shares,
but a minority discount is not applicable in all situations.
have been few relevant acquisitions in an industry, or if the multiples of the comparable
companies are similar to multiples paid in comparable acquisitions, it would be
inappropriate to assume that market prices implicitly include a minority discount.
Comparable acquisitions are used for valuation in the same manner as comparable
companies. It should be recognized, however, that acquisitions normally take place at a
premium over market. The amount of the premium, sometimes called a control premium,
can result from a combination of factors. The acquiror may foresee significant synergies
from the transaction, or it may wish to preempt a competitive bid. The premium paid is
often a function of whether the target’s shares are underpriced in relation to its value to an
acquiror. The difference between average multiples paid in acquisitions and average
market multiples is an indication of the current attractiveness to acquirors of a particular
business sector. Moreover, buyers may overvalue the target company, particularly in
competitive bidding situations.
Detailed information on acquisitions of public companies is available in public filings
with the S.E.C. For private companies, limited financial data is often published at the time
of the announcement or in later public filings by the acquiror. After data compilation, the
methodology is essentially the same as in the comparable company approach.
be noted, however, that a comparable acquisition is valued as of the date that the terms of
the deal were agreed upon. If market or industry conditions have changed materially
since then, consideration must be given to the impact of these changes on the data used.
The discounted cash flow (DCF) method is based on the premise that the value of a
company is equal to the present value of its future net cash flows. Projected future free
cash flows are discounted to present value based on the appropriate cost of capital given
the risks of the business. (Free cash flow is the amount of cash available for distribution,
i.e., all cash generated from operations after taxes, less capital expenditures and any
increment in working capital during the period.)
Kleinwort Benson Limited v. Silgan Corp., C.A. No. 11,107 (Del. Ch. June 15, 1995), reprinted in
14 Bank & Corp. Gov. L. Rptr. 949.
With different facts, no implicit minority discount was recognized in Salomon Brothers, Inc. v.
Interstate Bakeries Corp., C.A. No.10,154 (Del. Ch. May 1, 1992), reprinted in 18 Del. J. Corp. L.
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In order to reduce the impact of capital structure on a valuation, the DCF
methodology is normally used to calculate AMV based on pro forma cash flows in a debt-
free capital structure, i.e., excluding interest payments and their tax effect. In certain
circumstances however, it may be appropriate to calculate equity value based on cash
flows after interest and taxes, particularly if there is a complex financing structure or a
locked-in structure that cannot be easily changed.
A company’s projections of future results commonly are for a period of five years or
less. In addition to calculating the present value of the expected free cash flows over the
projection period, it is necessary to estimate the value of the company at the end of the
period, the “terminal value.” The valuator then must discount the future value to present
value as of the date of the opinion. The valuation of a company based on DCF is the sum
of the present value of the projected free cash flows and the present value of the terminal
The DCF approach is most useful for companies in industries which tend to have
reasonably predictable earnings. Although the DCF methodology has limitations and can
overvalue a business, a DCF calculation can be useful as a check on other
methodologies. Any approach which implies a valuation greater than the calculated value
based on discounted cash flow should be examined carefully, since the DCF approach
normally provides an upper limit on value.
In order to perform a DCF calculation, one starts with a set (or sets) of projections,
decides upon an appropriate discount rate, and decides how to estimate terminal value.
In practice, the subjectiveness of the assumptions can lead to errors in valuation, as
discussed below in P
The calculation of DCF should be based on projections prepared by management or
by other parties who are appropriately familiar with the company. It is helpful when the
projection used for a fairness opinion has been developed in the ordinary course of
business, rather than specifically in relation to the transaction as to which the opinion is
The firm preparing a fairness opinion is rarely in a position to generate reliable
projections itself, but should perform due diligence to understand the assumptions
underlying the forecasts. It should also take into account the purpose for which the
projections were made. Projections given to institutional lenders tend to be more
conservative than those prepared for the purpose of selling a business.
Companies often develop forecasts using different scenarios, such as an optimistic
case, a moderate case, and a worst case. Alternatively, analysts should consider
performing a sensitivity analysis to consider the impact of changes in certain of the
assumptions underlying the projections. It can be helpful to perform DCF calculations
based on the various scenarios. By taking into account the relative likelihood of each
scenario, a weighted average DCF value can be computed.
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The discount rate to be used in a debt-free DCF analysis is a blend of the cost of
equity and the cost of debt for the company. The Capital Asset Pricing Model (“CAPM”) is
the method taught in business schools for determining the appropriate discount rate. The
cost of equity is determined by adding the risk-free rate of return (the yield on U.S.
Treasury securities) to a measure of common stock market return. The latter is usually
determined based on historical calculations published by Ibbotson Associates. For a
company, the market return in excess of the risk-free rate of return is multiplied by a factor
called β (“Beta”), which is a measure of volatility relative to the market. This cost of equity
may be increased by a company-specific risk factor and by a premium for small
The cost of debt is the company’s long-term borrowing rate, reduced by its marginal
tax rate. The weighted average cost of capital ("WACC") is calculated using the relative
amount of debt and equity in the capital structure. Based on the situation, the appropriate
capital structure may be either a normalized industry structure or that of the company
A valuator’s own experience and judgment as to the discount rates required by
investors should be used to test the reasonableness of the calculated cost of capital. The
CAPM approach often produces a lower discount rate than would be acceptable to
purchasers. Experienced investment bankers and valuators are aware of the rates of
returns expected by their clients in M&A transactions and of the high targets set by
leveraged-buyout or venture capital investors. It is preferable to use the discount rates
required by investors in the contemporaneous transactions when justified by experience
In the academic community, terminal value is calculated by using a growth model.
Most widely used is the Gordon Growth Model, in which terminal value is calculated by
taking the normalized free cash flow in the final year of the projection (with capital
expenditures appropriately higher than depreciation), increasing it by the expected growth
rate in the following year, and dividing by the difference between the discount rate and the
long-term growth rate.
In the investment banking community, however, terminal value is customarily
determined by applying a multiple of EBIT or EBITDA to the projected data point in the
final year of the projection. The multiple selected is ordinarily derived from the current
multiples of comparable companies. This method of determining terminal value has been
criticized by some commentators as intermingling the comparable company and DCF
methodologies. The growth model is often not appropriate, however, because the
company may not be mature or in a steady state at the end of the forecast period being
The two approaches to determining terminal value calculation may be used to check
each other. If the growth model is used, the implied market multiples that result from the
A similar method shown in Ibbotson is the rate build-up approach, which adds the risk-free rate,
the equity risk premium and other risk premiums, such as a size premium and an industry
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terminal value can be calculated. If market multiples are used, the implied growth rate
can be calculated.
The terminal value is adjusted to present value by discounting it by the cost of
capital. It is common for the present value of terminal value to represent the major portion
of a DCF valuation.
Although liquidation value is generally not accepted as a valuation approach in a
statutory appraisal, it can be a relevant standard for a fairness opinion. If a firm’s
liquidation value is higher than its value by any other methodology, it sets a floor on the
value for fairness.
Asset value is another aspect of fairness. Asset value is the aggregate market value
of the components of a corporation. The aggregation value of a company is the sum of
the value of its parts; if a company is involved in different businesses, they can be valued
separately, and the value of the company as a whole would be measured by the
aggregate of its parts, including corporate assets and net of corporate liabilities. If
company is in a single business but has idle or underutilized assets, the net incremental
value of these assets should be added to the amount determined by other valuation
Book value is an accounting concept, in which fixed assets are valued at historical
cost less depreciation, and assets generally are valued at the lower of cost or market.
Book value thus represents neither going-concern value, market value nor liquidation
value. The use of multiples of book value was discussed above under C
. The relevance of book value varies by industry. As an indicator of value, it is
most relevant in industries such as insurance and banking, in which book value has a
more direct relation to earning power.
In considering fairness, the market prices of the shares in the weeks and months
prior to the potential transaction are a factor. If the transaction price is at a price lower
than the shares have sold for in the recent past, the analyst should consider whether a
material change in market conditions, in industry conditions, or in the company itself, can
justify a lower price.
Market prices can be affected by announcements, rumors, or even the pending
transaction that is the subject of the opinion, as well as by general market conditions.
Moreover, market prices may unreliable as a measure of value because of either low
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trading volume or because of abnormal buying or selling. Daily or weekly price and share
volume should be reviewed in comparison with the proposed transaction price and in
comparison with either market indices or the market prices of shares of stock of
comparable public companies. In addition, any other offers for the company or its stock
and any prior written valuations should be reviewed.
The ambiguous term “control premium” can be used in more than one way. The
term is frequently applied to the difference between the price paid for control and the
market price of publicly traded shares. This premium over market is commonly used by
investment bankers in reviewing transactions, and the average premium over market is
sometimes used as a standard of fairness. The fallacy of this approach is discussed
below in P
The difference between the price paid for a control block and that block’s pro rata
share of the aggregate value of the company is also sometimes called a control premium.
The payment of a control premium to a major shareholder may be fair to the other
shareholders, provided that, based on the facts and circumstances, it is not an
unreasonable percentage of the total value of the company.
A control premium is normally not applicable to a discounted cash flow valuation,
because a DCF calculation values the cash flows of the entire company. As discussed
above, the DCF method sets an upper limit on value. If the future cash flows of a
company are worth $10 million, why would anyone pay more? Nevertheless, a buyer
might take into consideration the cash flows that could be derived under better
management, and a synergistic buyer might pay a premium reflecting part of the
anticipated incremental cash flow from synergies.
In some industries, there are rules of thumb which are widely applied, e.g., value per
subscriber for a cable television company. Such rules of thumb are occasionally helpful.
If a formula is widely used in an industry and, importantly, if it has a justifiable economic
basis, it may usable as a confirmatory method for a fairness opinion and for litigation. The
use of a rule of thumb was endorsed in Neal v. Alabama By-Products Corp.,
appraisal case, where the Vice Chancellor utilized value per recoverable ton of coal
reserves as a valuation method.
C.A.. No. 8,292 (Del. Ch. Aug.1, 1990), reprinted in 5 M&A & Corp. Gov. L. Rptr. 238.
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PITFALLS IN VALUATION
Litigators and experts may be called upon to critique fairness opinions. Some of the
problems that the author has encountered are discussed below.
It is important that comparable companies have characteristics that do not make
them dissimilar in the eyes of investors. The fact that companies are in the same general
industry category does not necessarily make them comparable. Companies in the
electronics, computer and semiconductor sectors include innovative, fast-growing
companies with strong patent and market positions, bur also include mundane
manufacturers of commodity-type products, such as memory chips and electrical
On the other hand, companies making dissimilar products but using similar
manufacturing processes or supplying the same end-markets could be deemed
comparable to the extent that they are subject to similar market forces. For example,
there are marked similarities between manufacturers of different kinds of components for
automobiles, all of which are dependent on the success of automobile companies and the
state of the auto industry.
Arithmetic means of ratios with price in the numerator, such as AMV/EBITDA and
P/E, give greater weight to higher multiples and lower weight to lower multiples. The
median, the midpoint of the group, is a better measure of central value, but it effectively
eliminates information contained in the remaining multiples. In any event, the median can
be unreliable with small samples. The harmonic mean, which is calculated by taking the
arithmetic mean of the reciprocals of the market multiples, is statistically a better measure
of central value. The harmonic mean gives equal weight to equal dollar investments, while
the arithmetic mean gives greater weight to stocks with higher price/earnings ratios.
As an example, take two hypothetical companies selling at $40 per share: Company
X has earnings of $4.00 per share and Company Y has earnings of $1.00 per share. The
P/E’s of the two companies are 10x and 40x, respectively, and the arithmetic mean is 25x.
The harmonic mean is calculated by taking the reciprocals of 10x and 40x (0.10 and
0.025), averaging the reciprocals (0.625), and then taking the reciprocal of 0.625 to get a
harmonic mean P/E of 16x.
If a person invests an equal amount in each stock, what is the P/E of the portfolio?
Investing $4,000 in 100 shares of Company X buys underlying earnings of $400; $4,000
invested in 100 shares of Company Y purchases underlying earnings of $100. With
$8,000 invested in a portfolio earning a total of $500, the portfolio’s P/E is 16x. As noted
in the previous paragraph, 16x is the harmonic mean.
If, instead, one wished to purchase $400 of the underlying earnings in each
company, one would still buy 400 shares of Company A for $4,000, but would have to
spend $16,000 to buy 1,600 shares of Company B. The total cost of the portfolio would
be $20,000 for $800 in earnings. The price/earnings ratio of this portfolio is 25x, the same
as the arithmetic mean. This demonstrates the greater weight given to stocks with higher
P/E ratios by the arithmetic mean. In fact, the arithmetic mean gives a 40x multiple a
weight which is four times the weight of a multiple of 10x.
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EAKNESSES IN THE
The discounted cash flow method has been over-praised and often misused. The
methodology has significant limitations. It is necessarily highly dependent on discount
rate assumptions, as well as on the methodology used for determining the terminal value.
It is obviously very dependent on the quality of the projections used. In addition, the DCF
method is overly dependent on the final year of a projection, which is less predictable than
early years of a forecast. Because terminal value is a major portion of the calculated DCF
value, the final year of the forecast is by far the dominant factor in the result.
In a majority of industries, it is questionable whether management can reasonably
be expected to project performance several years into the future. Many public companies
have trouble projecting next year’s earnings accurately. How far ahead can one project a
high-tech industry, where management often does not even know what its products will be
in two years? Changes in competitive conditions have made forecasts in retailing more
speculative than they were a generation ago. Many cyclical industries show highly volatile
earnings, but it is rare to see a projection which includes periods of significant downturns.
The number of years in a projection is an element which affects reliability. The outer
years are obviously more difficult to project than the near term. If the growth rate in a
forecast is higher than the discount rate, each added projection year increases the DCF
It is frequent practice, unfortunately, for a management to prepare only a single
projection. Consideration should be given to developing several scenarios, particularly
more conservative ones. The analyst could then compute a DCF value for each scenario,
consider the relative probability of each alternative, and arrive at a weighted result.
A discounted cash flow valuation is significantly influenced by the choice of discount
rate. Although the Capital Asset Pricing Model has been widely accepted for portfolio
applications, its reliability for calculating discount rates for individual companies is subject
to question. Certain elements in the determination of a discount rate can be quite
judgmental. Volatility of a given company relative to the market (Beta) can be difficult to
determine, and is occasionally a matter of contention. For any given publicly traded stock,
several sources can be used, and they rarely agree. Moreover, since Beta is based on
historical market prices, it can fluctuate depending on when it is calculated and can be
quite different at different dates. Moreover, there is disagreement in the academic
community over the relevance of Beta.
Company-specific risk is an arbitrary matter of judgment in any given situation.
Because it does not lend itself to mathematical calculation, it is often totally omitted from
the determination of equity discount rates.
E.g., see Fama, Eugene F., and French, Kenneth R., Industry Cost of Equity, 43 J. Fin. Econ.
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There is also disagreement as to how the small company premium is determined
and even as to whether it should be applied. The argument for not applying a small
company discount is based on the relative performance of small companies in the recent
bull market. The recent drop in the prices of NASDAQ equities serves to refute this
General practice in academic theory is to apply the small company premium based
solely upon the equity value of a company, with no regard to the size of other companies
in its industry. The small company premium should be based, at least in part, on a
company’s size in relation to the size of other entities in the industry in which it
Another factor affecting discount rates that may be overlooked is the impact on
discount rates of leveraging a capital structure. As a company’s leverage increases, its
cost of equity rises because the equity risk increases, and the interest rate payable on its
increased debt increases because the quality of the debt declines. As debt increases, the
cost of debt approaches the cost of equity.
The final year of a forecast is used for determining terminal value. The final year is
necessarily subject to a higher margin of error than earlier periods. A small variation in
the final year forecast can have a major impact on the DCF value, far greater than the
effect of a variation in any earlier year.
Calculation of terminal value using the Gordon Growth model is highly sensitive both
to the assumed growth rate and to the discount rate used. The analyst should be aware
that a distorted result could be obtained using the Gordon Growth Model when the growth
rate is close to the cost of capital. If the discount rate equals the expected growth rate,
use of the Model results in an infinite terminal value. If the expected growth rate is 2%
lower than the discount rate, it values a company at 50x free cash flow. The terminal
value obtained using the Model can be checked for reasonableness by computing the
implied multiples of EBITDA, EBIT and earnings that the terminal value yields for the final
year of the forecast.
When a multiple of EBIT or EBITDA is utilized for calculating terminal value, the
current multiples for comparable companies should be considered. However, the analyst
should consider whether an adjustment is necessary, e.g., because a current multiple is
based on a current growth rate, which may decline as an industry matures.
In applying a growth model to projected free cash flow, it is necessary to consider
the relationship between depreciation and capital expenditures. If projected capital
expenditures substantially exceed depreciation, the calculated terminal value will be
understated. If, on the other hand, depreciation exceeds capital expenditures (an
impossibility over any extended period), the result is an overstatement of terminal value.
In a growing company, capital expenditures must exceed depreciation. Assuming a
constant growth rate and that all capital expenditures are depreciated over the same
period, annual capital expenditures would exceed annual depreciation by the following
Excess of Capital Expenditures Over Depreciation
2% 3% 4% 5%
10 year life 10.2% 15.5% 20.9% 26.3%
15 year life 15.6% 23.8% 32.3% 41.0%
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Frequently, more than 80% of a calculated DCF value is attributable to the present
value of the terminal value. Because terminal value dominates most DCF valuations, it is
clearly inaccurate to describe the methodology as capitalizing the future cash flows of a
business. When terminal value represents the major portion of a DCF calculation, the
resultant value is misnamed as “discounted cash flow value.” In fact, that resultant value
is predominantly the present value of capitalized future earnings in a specific year based
on a comparable company or acquisition approach and, frequently, aggressive
An approach sometimes used in considering fairness is to compute the average
historical premium in similar acquisitions and compare that to the premium over market in
the subject transaction. This methodology is of little value because the average premium
in other acquisitions is not a relevant standard for determining fairness. The average
premium over market paid in acquisitions is biased upward because it only includes
purchases of companies which were perceived as undervalued, and therefore as
attractive targets for acquirors. The average premium in acquisitions excludes companies
which acquirors considered overpriced and did not pursue.
Another problem is that market prices fluctuate regularly. A company’s shares may
increase in reaction to an acquisition of a competitor. The premium does not determine
the buyer’s price, but instead results from the buyer’s valuation. Acquisition premiums
depend on the specific factors of each transaction. For example, assume that (i) there are
two identical companies trading in the market at $30, (ii) one is acquired at $45, a
premium of 50%, and (iii) in reaction, the stock price of the second company then rises to
$40 per share. It defies logic to argue that fairness would require a 50% premium to a
$60 level for the second company. The premium in a prior transaction does not determine
fairness in a subsequent transaction.
STANDARDS OF FAIRNESS
A minimal standard of fairness is the direct effect on shareholders. A shareholder
should be at least as well off after a transaction as before it. In addition, other
shareholders should not benefit in a materially disproportionate manner.
The standards of fairness and the related appraisal standards are matters of state
law. Anyone rendering a fairness opinion should be familiar with the standards applicable
in a company’s state of incorporation, and should obtain advice of counsel if necessary.
Stock-for-stock deals are often preferred by target companies because, unlike when
cash or debt is received, the transaction can be structured to be tax-free.
What is commonly called a “tax-free” transaction is more accurately described as “tax-deferred,”
since sale of the stock received would be a taxable event.
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standard for fairness in a stock-for-stock transaction is not based on the absolute price of
the shares being received, but rather on relative measures.
Mergers in which shareholders receive common stock of another company are
viewed differently from acquisitions for cash or debt, because shareholders receive a
continuing economic interest in the surviving firm. This different standard for stock-for-
stock transactions has long prevailed in Delaware, based on the major 1952 decision,
Sterling v. Mayflower Hotel Corp.
In Sterling, the Delaware Supreme Court stated:
If plaintiffs' contention should be accepted it would follow that upon
every merger of a subsidiary into its parent corporation that involves
a conversion of a subsidiary's shares into shares of the parent, the
market value of the parent stock issued to the stockholders of the
subsidiary must equal the liquidating value of the subsidiary's
] On its face this proposition is unsound, since it attempts
to equate two different standards of value. In the case of many
industrial corporations, and also in the instant case, there is a
substantial gap between market value and the liquidation value of
the stock; and to apply to the merger of such corporations the
proposition advanced by plaintiffs would be to bestow upon the
stockholder of the subsidiary something which he did not have
before the merger and could not obtain – the liquidating value of his
In judging the fairness of a stock-for-stock transaction, the financial analyst should
perform a “has-gets” analysis, i.e., look at what a shareholder has on a per-share basis
before the proposed transaction and what he would get on a pro forma basis if the merger
were consummated. The pro forma data should be adjusted to take into account any
synergistic benefits expected to result from the merger. One should consider not only
quantitative factors, e.g., earnings, dividends, and assets, but also factors such as growth
rates, market position, and quality of management.
In mergers where a smaller company is absorbed into a larger one, it is common for
the proposed exchange ratio to offer a premium over the market price of the smaller
company prior to the announcement of the transaction. In mergers of equals, the benefits
to shareholders frequently derive from the anticipation that the combined company will be
more profitable than the two companies separately, and this type of merger seldom offers
a material premium to either side.
If there is no competing offer, a Board of Directors may exercise its business
judgment to conclude that, even though the value of the shares being received is less
than the amount that might be received in a cash transaction, it prefers a non-taxable
stock-for-stock transaction. If there is a genuine cash offer that is materially higher,
however, it may become difficult to render a fairness opinion on the stock proposal.
Delaware case law distinguishes between situations which would result in a change
of control and those which do not result in a change of control. Where there would be a
change of control, a Board of Directors is required, according to Paramount
93 A.2d 107 (Del. 1952).
Author’s note: In today’s context, the phrase “liquidating value” is equivalent to a shareholder’s
pro rata share of the value of the entire company in a cash transaction.
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Communications, Inc. v. QVC Network, Inc.,
to quantify non-cash consideration and
compare it objectively to a cash offer. If there is no change of control, however,
Paramount Communications Inc. v. Time Inc.
permits a Board to favor a transaction
which it believes to be consistent with its long-range objectives.
If there are two all-cash bids, it is clear that a lower cash bid is not fair, from a
financial point of view, unless there is a risk that the higher bidder may not be able to
close the transaction.
The picture is different when comparing cash to securities. In Citron v. Fairchild
the Delaware Supreme Court ruled that a Board of Directors, in its
business judgment, could elect to take a cash offer with a value lower than a non-
convertible preferred stock offer from a different bidder. It is therefore possible that a
fairness opinion could be issued with respect to either of two offers, one in cash and the
other in equity, regardless of which is higher. The decision as to which offer to accept
must be made by the Board. Similarly, two equity offers can both be fair, and it is for the
directors to decide which to recommend.
The ability of a buyer to close a transaction may be an element in a fairness opinion.
An opinion-giver should not conclude that an offer is unfair solely because of a higher
competitive proposal if there is a risk that the higher proposal could prove to be
The amount that dissenting shareholders to a transaction would be likely to receive
in a statutory appraisal action can serve to set the minimum level of financial fairness.
The valuation methods for determining this amount, as well as the applicability of certain
discounts, varies from state to state.
In Delaware, neither control premiums, minority discounts, nor discounts for lack of
marketability may be considered when determining the value of shares in appraisal
actions. The Delaware Supreme Court firmly established this position in Cavalier Oil
Corporation v. Harnett, 564 A.2d 1137 (Del. 1989). Some states have long taken the
and several other states recently have adopted that position, in some
cases reversing long-standing precedent.
637 A.2d 34 (Del. 1994).
571 A.2d 1140 (Del. 1990).
569 A.2d 53 (Del. 1989).
E.g., Iowa: Woodward v. Quigley, 133 N.W.2d 33 (Iowa 1965); Richardson v. Palmer
Broadcasting, 353 N.W.2d 374 (Iowa 1984).
E.g., Missouri: Swope v. Siegel-Robert, Inc., No. 99-3114 (8th Cir. Feb. 26, 2001), reversing
Swope v. Siegel-Robert, Inc., 74 F. Supp. 2d 876 (E.D. Mo. 1999); King v. F.T.J., Inc., 765 S.W.2d
301 (Mo. App. 1989); Georgia: Blitch v. People’s Bank, 540 S.E.2d 667 (Ga. App. 2000), reversing
Atlantic States Construction, Inc. v. Beavers, 314 S.E.2d 245 (Ga. App.1984); Kansas: Arnaud v.
Stockgrowers State Bank of Ashland, C.A. No. 82,909, 1999 Kan. LEXIS 645 (Kan Nov. 5, 1999),
reversing Moore v. New Ammest, Inc., 630 P.2d 167 (Kan. 1981).
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There are states in which case law still permits (but does not mandate) either a
discount for lack of marketability,
a minority discount,
Some states, such as
Florida, have no legal precedent. The least generous appraisal standard is that of Ohio,
which awards only fair market value of the shares before the transaction, generally their
public market price.
A 1998 Delaware decision stated that directors have “the fiduciary duty . . . to pay
shareholders who are cashed out the fair value of their stock as that term is defined in
Based on this Delaware standard, a transaction (other than stock-for-
stock) would not be fair if the consideration is materially below the price which likely would
be awarded in an appraisal action, whether or not the structure of the transaction permits
shareholders to avail themselves of the appraisal remedy.
In some transactions, different consideration may be offered to certain shareholders,
even though their shares have identical rights. For example, cash may be offered to
public shareholders, while stock in the acquiror is offered to management and other inside
shareholders. In judging the fairness of such a structure, one looks at the relative value of
the two forms of consideration. It is not necessary that the alternatives have equal value,
but any difference should not be material. With respect to amounts payable to
management, it may be necessary to distinguish between the amount paid for shares and
any amount that is attributable to present or future services.
In some cases, shareholders are given the option to select either the cash or stock
alternative. In this situation, fairness should be judged in relation to the blended value of
It is also necessary in any transaction to be aware of any incremental consideration
being paid to any shareholder or group of shareholders above what is being offered to
outside shareholders. If a control shareholder negotiates a transaction in which the
control block receives a higher price per share than other shareholders receive, the
fairness of the transaction may become questionable, even if such differential is permitted
under the applicable state law.
In a going-private transaction or a management buyout, the insiders may obtain an
equity interest in the continuing enterprise, while other shareholders are cashed out. It
may not be possible to value the consideration received by the insiders in a situation
where they receive equity interests in a new entity, which is often highly leveraged. The
test of fairness in these situations is necessarily determined principally by the value of the
consideration received by the outside shareholders.
E.g., Colorado: WCM Industries, Inc. v. Wilson, 948 P.2d 36 (Colo. App.1997); M Life Ins. Co.
v. Sapers Wallack Ins. Agency, No. 99CA0847 (Colo. App. Feb. 1, 2001).
E.g., Mississippi: Hernando Bank v. Huff, 609 F. Supp. 1124 (N.D. Miss. 1985), aff’d. 796 F.2d
803 (5th Cir. 1986).
E.g., Illinois: Stanton v. Republic Bank, 581 N.E.2d 678 (Ill. 1991).
Armstrong v. Marathon Oil Company, 513 N.E.2d 776 (Ohio 1987); English v. Artromick Intl.,
Inc., C.A. No. 69 App-578, 2000 Ohio App. LEXIS 3580 (Ohio App. Aug. 10, 2000).
Metropolitan Life Ins. Co. v. Aramark Corp., C.A. 16,142 (Del. Ch. Feb. 5, 1998), transcript p.
215 (bench ruling).
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If a company has both high-vote and low-vote shares, it may be fair for a premium to
be paid for shares of the high-vote class. The key issue to consider is whether the
holders of high-vote shares have the ability to transfer their control position.
In a majority of public dual-class companies, the value of high-vote shares is limited
by a legally binding provision which prevents the sale of control at a premium to the price
received by other shareholders. For example, there is often a provision that high-vote
shares cannot be transferred outside the control group unless they are converted to low-
vote shares, or an agreement that the holders of high-vote shares cannot sell control of
the company unless all shareholders receive the same consideration.
The price paid in the public market for high-vote shares does not measure the value of
control. The market price relative to low-vote shares of the same issuer is a function of
several factors, such as liquidity, dividend expectations, restrictions on the rights and/or
transferability of the high-vote shares, and the possibility of a transaction in which high-
vote shares might receive a premium. The market price of high-vote shares seldom, if
ever, is a direct function of the value of incremental voting power of the shares owned by
public shareholders. Without shares owned by insiders, purchasers of high-vote shares in
the market cannot acquire voting control.
There have been a limited number of transactions in which premiums have been given
to holders of high-vote shares with voting control. The premium for voting control should
not be calculated on a per-share basis, but should be determined as a percentage of the
value of the entire company allocated to the class of high-vote shares. This concept has
been addressed in a 1999 Tax Court case, in which the Court concluded that a class of
voting shares which owned less than 0.1% of the total equity was worth a premium of 3%
of the total value of the subject company.
OTHER FAIRNESS OPINION ISSUES
In preparing a fairness opinion, it is necessary to rely on information from various
sources such as management, auditors, actuaries, real estate appraisers, and public
sources. Moreover, an opinion is given at a specific time and is limited to the facts then
known. It is customary to opine as to “fairness from a financial point of view” in order to
limit the opinion to the area of the opinion-giver’s expertise. A fairness opinion also
normally includes qualifying language in substantially the following form:
In the course of our review, we have relied upon and assumed the
accuracy and completeness of the financial and other information
provided to us by the Company. With respect to the Company‘s
projected financial results, we have assumed that they have been
reasonably prepared on bases reflecting the best currently available
estimates and judgment of the management of the Company. We
Estate of Richard R. Simplot v. Commissioner, 112 T.C.13 (1999).
K - 18
have not assumed any responsibility for the information or
projections provided to us and we have further relied upon the
assurances of the management of the Company that it is unaware
of any facts that would make the information or projections provided
to us incomplete or misleading. In arriving at our opinion, we have
not performed any independent appraisal of the assets of the
Company. Our opinion is necessarily based on economic, market
and other conditions, and the information made available to us, as
of the date hereof.
In arms’-length transactions in which investment bankers are the originators and/or
financial advisors, they frequently have all or a portion of their fee contingent on the
closing of a transaction. It is common practice in arms’-length transactions that
investment bankers who represent a company in a transaction also are retained to give a
fairness opinion. Although some commentators have expressed concern about this
possible conflict of interest, it is often argued that a company’s investment banker is very
familiar with it, and that, in the case of a seller, is losing a client. Stronger arguments for
using the company’s investment banker for a fairness opinion are the fact that the
investment banker participated in the process, the difficulty of hiring an independent
advisor during the secretive period prior to a public announcement, and the frequent need
for promptness in rendering the opinion.
Nevertheless, there is the potential argument by a plaintiff that a fairness opinion
lacks independence when it is given by a firm that may receive a substantial contingent
fee. The use of an independent firm gives greater protection to a Board of Directors.
This potential challenge sometimes leads firms to engage an independent firm for a
In a non-arms’-length transaction, such as going private, it is important that an
independent party be retained for the fairness opinion. Such transactions are more likely
to be contentious and to attract litigation. While there is usually an assumption of fairness
in the typical arms’-length transaction, financial advisors should not make such an
assumption in going-private and other non-arms’-length transactions.
When a non-arms’-length transaction is proposed, the Board of Directors will
customarily appoint a committee of independent directors (usually called a Special
Committee) to review the proposal. This helps to shift the burden of proof if the fairness
issue is litigated. The Special Committee engages independent counsel and an
independent firm to render a fairness opinion. The Special Committee will also be
responsible, if necessary, for negotiations with the acquiring party. In these situations, the
firm giving the opinion frequently also functions as a de facto financial advisor with
respect to the terms of the transaction and may assist in negotiations.
There are occasions, however, when the controlling party may make the selection of
the opinion-giver. In partnership transactions, there rarely is an independent party
representing the outside limited partners. In such a situation, the financial advisor should
remain aware that the opinion is to be addressed to the fairness of the transaction to the
K - 19
non-controlling interests. If the advisor is not engaged by an independent party, the
advisor may be deemed to have greater duties than if it reported to an independent party.
The due diligence for preparing a fairness opinion in a related party transaction has
to be conducted with greater than ordinary skepticism. Because management is likely to
be a beneficiary of the deal, management may take a conservative view of the company’s
prospects. It is often helpful to review forecasts made prior to the gestation of the
proposal, and to review any information provided to parties being asked to assist in
Because of disclosure requirements established by the S.E.C., it is usually
inadvisable for a financial advisor to explicitly disclose its range of fairness to the Special
Committee prior to a final opinion. The S.E.C. unfortunately requires that if such
information is given to a Special Committee, it must be disclosed in the proxy statement.
Even if a proposed price is within the advisor’s range of fairness, the Special Committee
might want to negotiate with a control shareholder for a higher price within or possibly
above the range. This negotiation becomes difficult if the advice to the Special Committee
as to a fairness range will have to be revealed to the control shareholder at a later date.
Discussions between a Special Committee and its financial advisor would be more open
and constructive if advice to the Special Committee prior to a final opinion did not require
disclosure. The required public disclosure would then be limited to describing negotiations
with the control shareholder as well as the ultimate fairness opinion rendered to the
Special Committee and the full Board of Directors. Advice of counsel is particularly useful
during this process.
An effective internal review process can help a firm rendering fairness opinions
ensure the quality of its work. The review process is often conducted through an internal
committee charged with reviewing opinions before they are issued. The internal
committee should consist, at least in part, of regular members in order to maintain
consistency of approach and of methodology. Particularly for transactions in which the
opinion-giver has a contingent fee, the review committee should have members who are
not directly involved in the transaction and who have independence and stature within the
Most fairness opinions address the fairness of the consideration to be paid in a given
transaction. Consideration is not the sole standard of fairness from a financial point of
view. There are situations in which the consideration itself is fair to outside shareholders,
but the transaction is structurally unfair for other financial reasons, e.g., in situations
where certain inside shareholders are receiving materially different consideration. The
advisor should weigh the relative consideration received by various parties, other financial
terms of the transaction, and any financial alternatives which might be available to
shareholders. A financial advisor should not render an opinion that the consideration is
fair if it has reason to believe that the transaction taken as a whole is not fair.
K - 20
A recent Delaware Supreme Court decision
even questioned the fairness of a
transaction in which the majority shareholder and the minority public shareholders
received identical cash consideration per share. The plaintiff asserted that directors
permitted the 80% shareholder to restrict bidders to an all-cash deal and failed to
determine the value of the company as a going concern.
A fairness opinion is usually dated on the date it is orally rendered to a Board of
Directors. If a proxy statement or similar document is sent to shareholders, the mailing
date is often several weeks or more after the opinion was originally given. Changes in
market conditions, changes in the company’s recent operations or prospects, changes in
industry conditions, and other factors could cause a transaction which had been fair to
become unfair by the mailing date. Unless otherwise stated, however, the inclusion of a
fairness opinion in a mailing to shareholders implies, , that the opinion is still valid at that
No published decision has yet established that an investment banker has a legal
obligation to update a fairness opinion. The Delaware Court of Chancery has declined to
rule that a Board’s failure to obtain an update was a breach of its duty,
but it has done so
in cases where it determined that the transactions were fair. What a court would decide if
a transaction becomes unfair with the passage of time prior to mailing remains to be seen.
The author worked on a merger in which a now-defunct investment banking firm did not
update its opinion, but had a memo in its file indicating that the transaction had become
unfair; that firm settled the class action to avoid trial.
A fairness opinion should not only serve to protect directors, but should also serve
the interests of shareholders. To this end, it would be helpful both to directors and to
shareholders if an opinion letter were updated prior to mailing. In the absence of such an
updated letter, directors would be well advised to ascertain whether the firm which
rendered the opinion continues to believe that the transaction would be fair.
Some firms continue to monitor the fairness of transactions until shareholders have
voted, and will withdraw an opinion if material changes occur. For example, in 1984,
Bear, Stearns & Co. withdrew the fairness opinion it had previously given to Far West
Financial Corporation. It did so because a takeover battle for Gulf Oil, in which Far West
had a major investment, resulted in a material increase in Far West’s value subsequent to
the proxy mailing. The shareholders meeting was cancelled and the transaction aborted.
Although there have been a limited number of cases in which investment bankers
have been charged with fiduciary obligations to corporate clients under certain
these cases are the exception. In most situations, courts have declined
McMullin v. Beran, 765 A.2d 910 (Del. 2000).
Glassman v. Unocal Exploration Corporation, C. A. No. 12,453 (Del Ch. June 13, 2000),
reprinted in 24 Bank & Corp. Gov. L. Rptr. 1161; Emerald Partners v. Berlin, C.A. No. 9,700, (Del.
Ch., Feb. 7, 2001), reprinted in 26 Bank & Corp. Gov. L. Rptr. 311.
E.g., In re Daisy Sys. Corp. and Daisy/Cadnetics, Inc., 97 F.3d 1171 (9th Cir. 1996) (investment
banker advising in a merger potentially liable for breach of fiduciary duty because of acquiror’s
K - 21
to attribute fiduciary duties to investment bankers. No case has held that there is a
fiduciary duty to a corporation solely by virtue of rendering a fairness opinion.
Nevertheless, an investment banker may be deemed negligent if its fairness opinion is
given without reasonable belief or without a reasonable basis in fact.
There is also no case in which an investment banker has been deemed a fiduciary
to the shareholders who rely on its fairness opinion. A New York appellate court,
however, rejected an investment banker’s claim that it owed no duty to shareholders in
rendering a fairness opinion because it was not in privity to them.
To the extent that shareholders rely on a fairness opinion in a proxy statement in
deciding how to vote (and whether to seek appraisal), it is difficult to argue that the
opinion-giver has no duty to them. After all, shareholders are the explicit beneficiaries of
fairness opinions. Some opinion letters contain disclaimers in an effort to limit the persons
who may rely on the opinion. These disclaimers have not yet been expressly addressed
by any court.
Opinion-givers can best limit their liability, protect Boards of Directors, and serve
shareholders by performing their work thoroughly and conscientiously, by using
appropriate methodologies properly applied, and by keeping open minds until they have
considered all relevant data.
inexperience in acquisitions); Litton Industries, Inc. v. Lehman Bros., Kuhn Loeb, Inc., 757 F. Supp.
1220 (S.D.N.Y. 1991) (investment banker has fiduciary duty to client not to breach confidentiality).
Herskowitz v. Nutri/System, Inc., 857 F.2d 179 (3d Cir. 1988).
Wells v. Shearson Lehman/American Express, 127 A.2d 200 (N.Y. App. Div. 1987), rev’d. on
other grounds, 526 N.E.2d 8 (N.Y. 1988).