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Kendall Hoyd & Silver v. Trussway Holdings, 2019 Del. Ch. LEXIS 72, 2019 WL 994048 (Feb. 28, 2019)

Several standard valuation methods were in play in a statutory appraisal case arising out of the minority shareholder’s petition to the Delaware Court of Chancery for a fair value determination. Neither the aborted sales process nor the market approach produced reliable indicators of fair value, the court found. Instead, it relied on a discounted cash flow (DCF) analysis and, in so doing, discussed and resolved disagreements between the parties’ experts over various inputs, including management projections, beta, and residual value. As the subject company was not a public company, the Delaware Supreme Court’s Dell and DFC Global decisions did not guide the Court of Chancery’s analysis.

Nine-year projections. The dispute related to the conversion of a corporation into a limited liability company. Trussway Holdings Inc. (Trussway) had a wholly owned subsidiary, Trussway Industries Inc. (TII), that was the leading manufacturer of prefabricated trusses and other components for the multifamily housing market. TII was the company whose value was in dispute. It had six manufacturing facilities in the U.S. and approximately 930 employees.

In mid-2016, TII contemplated a sale and hired an investment firm to develop a valuation of the company. The financial adviser came up with a value range of $202 million to $298 million. It contacted over 75 parties. At the end of 2016, TII made presentations to seven interested parties. The focal point was nine-year projections (2017 to 2025). The projections envisioned revenue for 2016 to be $218.2 million, increasing in 2017 to $235.9 million. Afterward, revenue was expected to grow from 2.2% to 14.9% annually through 2025. These numbers were very optimistic compared to the numbers appearing in internal management projections for 2015 and 2016. For example, the 2015 projections anticipated an increase from $196 million in 2015 to $204 million in 2016 and an annual decline thereafter, to $132.76 in 2019. The record showed one board member foresaw declines in multifamily housing starts. Internal five-year projections for 2016 also anticipated a decline in revenue through 2020.

A company representative said in his deposition that the nine-year projections were adjusted downward during the sales process “because the business wasn’t performing as was anticipated.”

Importantly, the nine-year projections added to the base case projected costs, revenue, and EBITDA related to four strategic initiatives. The effect was an increase in revenue and EBITDA. By 2025, the initiatives accounted for 39% of revenue and 43% of EBITDA in the nine-year projections.

In December 2016, Trussway’s board of directors approved a merger that transformed Trussway and its subsidiaries, including TII, into LLCs. The transaction was driven by one majority shareholder that owned about 95% of the company’s stock. Two minority shareholders held roughly 5% of the company’s stock and did not vote on or consent to the merger. Instead, the minority shareholders filed for statutory appraisal under section 262 of the Delaware appraisal statute.

While the merger went forward, the negotiations over the sale of TII were ongoing. In February 2017, one offer emerged. The bidder offered $170 million. It later withdrew the offer, and the sale went nowhere.

The parties agreed to the value of the corporate assets and liabilities but did not agree on the value of TII. Ultimately, one minority shareholder settled in principle with Trussway (the respondent). The other shareholder’s petition went to trial in the Delaware Court of Chancery.

Both the petitioner and the respondent offered expert valuation testimony.

Applicable law. Section 262 of the Delaware appraisal statute entitles dissenting shareholders to petition the Delaware Court of Chancery for a determination of the fair value (intrinsic value) of their shares as of the merger date. The fair value determination must exclude “any element of value arising from the accomplishment or expectation of the merger.” The court “should first envisage the entire pre-merger company as a ‘going concern,’ as a standalone entity and assess its value as such.” Under the statute, the court must undertake a case-by-case analysis that considers “all relevant factors.” Both parties have the burden of proving their valuation positions.

Court rejects market approach. In a nutshell, the petitioner’s expert determined the petitioner’s interest in Trussway was $387.82 per share, which was made up of the value of TII, plus the agreed-upon value of the corporate assets, minus the agreed-upon amount of liabilities.

The company’s expert (respondent’s expert) arrived at a fair value of $225.92 per share.

The petitioner’s expert performed a DCF analysis to which he assigned 60% of the weight, a comparable companies analysis that he weighted at 30%, and a precedent transactions analysis that he weighted at 10%.

The company’s expert relied on the results of two DCF analyses. One analysis was based on the nine-year management projections. In a second analysis, the expert modified the nine-year projections to become five-year projections. He assigned a 25% weight to the DCF using the nine-year projections and a 75% weight to the DCF based on the five-year projections.

Neither party claimed that the unsuccessful sales process revealed a value that represented fair value. The court said the one bid emerging during the sales process, $170 million, and other indications of interest, at best, served as “a very rough reasonable check.”

The court agreed with the company’s expert that the petitioner expert’s comparable companies analysis did not generate a meaningful value indicator because the companies used as comparables were insufficiently similar to the subject company in regard to size, public status, and products. The company further contended that the court should disregard the result of the opposing expert’s precedent transaction analysis since that analysis was based on only one reliable transaction. The court agreed and used the DCF for its determination of fair value.

DCF disagreements. Here, the experts used a similar methodology to perform their DCFs but had consequential disagreements over a few key inputs, the court noted.

Projections. The issue was how reliable the nine-year management projections were. The petitioner’s expert used them in their entirety, finding they were based on “the best currently available estimates and judgments of the management of the company.”

The company argued that a valuation should use only the base projections, thus ignoring the strategic initiatives. Alternatively, if the strategic initiatives were part of the analysis, the valuation should assign greater weight to the first five years of company projections, as the company’s expert had done.

In discussing the reliability of the nine-year projections, the court noted the company “routinely” created projections. The projections were done in the course of business and, in this instance, the company intended to use them in the context of a sales, the court observed. Sales considerations generated optimistic projections, the court noted. It also found the projections were longer than the common five-year projections. One explanation for the extended period was that the multifamily housing industry was cyclical. The longer projections aimed to correct “cyclic distortion,” the petitioner argued.

The court agreed that the projections were “the best predictor” of the subsidiary’s performance. Moreover, it found that the strategic initiatives were part of TII’s “operative reality” and should be considered in valuing the company as a going concern. “TII had the unilateral choice to pursue the initiatives, and projected that they would do so,” the court noted.

The court acknowledged there was “a degree of huckster’s optimism in these predictions” and noted that the petitioner’s expert seemed to acknowledge as much by adding a 1% risk premium to account for the uncertainty surrounding the forecasts. However, there was no basis for the 1% risk premium adjustment, the court found. It adopted a modified version of the approach the company’s expert took regarding the projections. The court weighted the results of the two DCF-generated values equally. One value resulted from using the nine-year projections and the other from using the same projections but beginning the terminal period after five years. The court said its analyses applied the calculation the company’s expert made from the nine-year projections of management’s projected annual cash flows and expected debt and equity levels.

WACC and beta. Although the experts largely agreed on how to calculate WACC, they disagreed over beta. The petitioner’s expert used adjusted beta, assigning two-thirds of the weight to raw beta and one-third weight to a mean beta of 1.0. The company’s expert used historic beta.

Further, the petitioner’s expert used the Hamada method to unlever and relever beta. In contrast, the company’s expert used the Harris-Pringle method. The methodologies differ in their treatment of debt, which can result in “notably disparate beta calculations,” the court noted.

The petitioner’s expert obtained a WACC of 13.4%, whereas the company’s expert calculated a WACC of 15.4%.

The court disfavored the use of an adjusted beta “for this small, private corporation.” It also said that any error in using a historic beta would be minimized because the court assigned a 50% weight to a DCF that used the nine-year projections with very optimistic growth forecasts.

Also, since the court leaned heavily on the DCF analysis of the company’s expert, it accepted his use of the Harris-Pringle model. The difference in the approaches was de minimus, the court said. The court’s beta was 1.74, and its WACC was 15.4%.

Residual value. To calculate the terminal value, both experts used the Gordon growth model. However, the plaintiff’s expert also used the exit multiples approach, which the opposing expert said doing so improperly increased the residual value. The company’s expert used a 2.3% growth rate, which the petitioner claimed was too low.

The court said use of the exit multiples approach with its high-growth-rate assumptions was inappropriate considering the court already used the optimistic nine-year forecast. Therefore, the court decided to use the Gordon growth model and a 2.3% growth rate.

The court’s inputs generated two values. A DCF analysis based on the nine-year forecast resulted in a value for TII of $197,800. A DCF analysis based on the first five years of the projections resulted in a valuation of $168,800. Weighting each result equally, the value of the company was about $183,300. Adding the other agreed-upon values for assets and liabilities and dividing the result by the shares outstanding, the court obtained a per-share value for Trussway Holdings of $236.52—thus a value close to the fair value calculated by the company’s expert.

Based on its DCF analysis, the court decided the fair value of the company as of the merger date was $236.52 per share.