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Stock Market Value and Deal Value in Appraisal Proceedings

In a new article, I consider two methods of valuing public companies in appraisal proceedings under Section 262 of the Delaware General Corporation Law: the unaffected market price of the company’s shares and the deal price (less synergies, as applicable) that the acquirer pays in the merger.

Following their decisions in the DFC, Dell, and Aruba cases, the Delaware courts have strongly favored market-based methods of valuation in appraisal proceedings, and they have used both the unaffected market price and the deal price in appropriate cases. To be sure, each of these methods is reliable only when certain assumptions are fulfilled. In particular, valuing a company based on the unaffected market price of its shares assumes that the shares trade in an efficient market and there was no material information concerning the company that was unavailable to the market at relevant times. Valuing the shares based on the deal price (minus synergies, as applicable) assumes that the target’s sales process was sufficiently robust. When the assumptions underlying one method are fulfilled but those underlying the other are not, there is a powerful argument for relying on the method whose assumptions are fulfilled in the case at hand. But what should courts do when, as is often the case, the assumptions underlying both methods are fulfilled? In such cases, both methods appear to be reliable indicators of value, but they typically suggest quite different valuations, for, as is well known, deal prices (even when there are no synergies to back out) tend to be much higher, often up to 50 percent higher, than unaffected market prices.

The question of which of these prices to use depends on how we understand takeover premiums. In my article, I argue that, although in any particular case many factors may be in play (such as synergies or the acquirer’s having material non-public information about the target), nevertheless because deal prices are almost always substantially above unaffected market prices, there must be an explanation for this phenomenon at work in almost all cases. By far the best explanation, as argued by Stout and Booth, among others, is that shares of publicly-traded stocks have downwardly-sloping demand curves, because investors, even when they all have the same information about a company, inevitably value companies somewhat differently. On this view, when investors value the shares, some conclude they are worth more, others conclude they are worth less, and so the first group tends to buy and the second group tends to sell. As new information hits the market, investors re-value the stock, with some selling and others buying, based on their respective updated valuations. At any time, the observed market price is the price at which the marginal seller sells to the marginal buyer; that is, the price at which an investor who holds the stock but values it a little less than the market price sells to an investor who values the stock a little more than the market price. On this view, the deal price will almost always be much higher than the unaffected market price, for the deal price is the amount that someone must pay to induce a large majority of those who already hold the stock to sell it. Put another way, while the market price must be above the reserve price of only the current holder who values the shares the least, the deal price must be above the reserve price of a large majority of the current holders.

Although discussed in the literature for decades, the idea that publicly-traded stocks have downwardly-sloping demand curves has not appeared in a significant way in Delaware law. Perhaps one reason for this is that commonly-used financial models such as the CAP-M assume that investors have homogeneous expectations (i.e., will all assign the same value to the shares) and thus imply that the demand curves for publicly-traded shares are flat. While the homogeneous-expectations assumption greatly simplifies the mathematics in financial models, it is patently unrealistic, and many important financial models can be, and have been, generalized to allow for heterogeneous expectations. Idzorek, Kaplan and Ibbotson, for example, have generalized the CAP-M in the Popularity Asset Pricing Model or PAP-M. Since such models are now generally accepted in the financial community, there is no reason that they should not inform Delaware law.

My article considers the implications of allowing for heterogeneous expectations and downwardly-sloping demand curves in appraisal proceedings and argues that, in cases where both the unaffected market price and the deal price would be reliable indicators of fair value, the deal price (minus synergies, as applicable), rather than the unaffected market price, should be the usual standard of fair value in appraisal proceedings.

This post comes to us from Professor Robert T. Miller at the University of Iowa College of Law. It is based on this recent article, “Stock Market Value and Deal Value in Appraisal Proceedings,” available here.

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