DE Chancery confirms ‘default’ preference for supply-side ERP, but sides with Pratt/Grabowski on adjusting size premium

BVWireIssue #119-4
August 21, 2012

A private equity group sought to cash out its controlling interest in The Orchard Enterprises, an online music provider. When no prospective buyer agreed to pay a $25 million liquidation fee that the sale would trigger, the PE group engineered a going private merger at just over $2 per share. A group of dissenting stockholders petitioned the Delaware Court of Chancery for a statutory appraisal, claiming their shares were worth $5.40 per share.

To start, the court (in an opinion by V.C. Strine) found the $25 million liquidation preference was too speculative to include in any going concern valuation. It also rejected the market approach utilized by the company’s expert, finding his selection of comparables and multiples was geared solely to “justify an outcome.” As in recent cases, the court showed a distinct preference for the discounted cash flow (DCF) approach, but made several important decisions related to the derivation of the discount rate:

  • The court rejected the build-up method (BUM), finding that it was “larded with subjectivity” and failed to find support among “mainstream of corporate finance scholars.”
  • As a result, rather than average the experts’ results under the BUM, the court used only the capital asset pricing method (CAPM).
  • Since both experts agreed the underlying management projections were sound, any application of a company-specific risk premium was inconsistent with the CAPM approach and would, in fact, “infect” it with the subjectivity of the build-up model, the court said.
  • Given the “default” acceptance of the supply-side equity risk premium (ERP) in recent decisions such as Golden Telecom and Gearreald v. Just Care, the court rejected the historic ERP.

Finally, only the company’s expert claimed—citing a 2008 article by James Hitchner—that using the supply-side ERP required an upward adjustment to Ibbotson’s size premium. The shareholders’ expert cited Cost of Capital, by Shannon Pratt and Roger Grabowski, to persuade the court that no such adjustment was necessary in this case, leading to its ultimate valuation of $4.67 per share. Read the complete digest of In re: Appraisal of The Orchard Enterprises, Inc., 2012 Del. Ch. LEXIS 165 (July 18, 2012) in the October Business Valuation Update. The court’s opinion will be posted soon at BVLaw.

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