Are merger-related projections ever a valid starting point for the DCF?

BVWireIssue #134-1
November 6, 2013

The Delaware Court of Chancery prefers contemporaneously prepared management projections for cash flow in a discounted cash flow (DCF) analysis. But what if the only time management prepared a long-term forecast was in the context of merger talks and with an eye to the possibility of litigation? Are the projections automatically unreliable? A recent decision tackles this and other DCF issues and serves as a primer on valuation and the corresponding case law.

Suddenly, long-range projections: A profitable biometrics technology company that provided fingerprint identification technology to various government agencies went public in September 2004 and four years later retained Credit Suisse and Goldman Sachs to explore “strategic alternatives.” The future buyer was a conglomerate of global technology companies, which, in 2010, made a verbal offer to the company that prompted its CFO to prepare bottom-up five-year financial projections for 2010 through 2015. Until then, the company had only created projections for the current year. In December 2010, the target and buyer finalized the merger. The target’s shareholders challenged the transaction and requested a statutory appraisal from the Chancery to determine the fair value of their stock on the merger date.

Both sides presented experts who used the DCF to establish the target’s going-concern value at the time of merger. A major dispute arose between the parties about the reliability of the five-year projections. The petitioners asked the court to reject them and adopt their expert’s two scenarios: 1) an “industry growth scenario” that assumed an industry growth rate through 2015 of 17%; and 2) a “cash deployment scenario” that assumed the target would spend $396 million of its cash on acquisitions. The company’s experts advocated in favor of the court’s use of the projections, notwithstanding minor adjustments.

The Chancery acknowledged that its own decisions prescribed a skeptical attitude in circumstances in which “management had never prepared projections beyond the current fiscal year” and “the possibility of litigation such as an appraisal proceeding was likely.” Another factor to consider was whether the projections were the work of directors or officers of the target who risked losing their jobs if the transaction succeeded. These very circumstances were present here, said the court. On the other hand, in this case the CFO had no reason to fear for his job if the merger went through and also was not involved in an alternative bid. This last factor was significant, said the court, because neither the Chancery nor the Delaware Supreme Court ever adopted a bright-line test that declared projections created during a merger inherently unreliable. Moreover, the petitioner expert’s “cash deployment scenario” was too speculative and there was insufficient evidence for the expert’s “industry growth scenario.”

Another takeaway: Again and again, the court credits the expert who is able to provide a cogent explanation for his selections by reference to the prevailing valuation literature. 

Find a discussion of Merion Capital, L.P. v. 3M Cogent, Inc., 2013 Del. Ch. LEXIS 172 (July 8, 2013) in the December issue of Business Valuation Update; the court opinion will be available soon at BVLaw.

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