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(Article from Securities Law Alert, June 2017) 

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On May 26, 2017, the Delaware Chancery Court held that the deal price was the best evidence of the fair value of a company’s shares where the merger was the result of a “robust pre-signing auction among informed, motivated bidders.” In re Appraisal of PetSmart, 2017 WL 2303599 (Del. Ch. 2017) (Slights, V.C.). The court declined to rely on aggressive management projections that were not prepared in the ordinary course of business to calculate fair value using a discounted cash flow (DCF) analysis.

The court observed at the outset that the parties presented “two vastly different valuations . . . based on two binary views of the most reliable means by which to determine fair value—deal price versus a discounted cash flow analysis.” The court noted that the $4.5 billion difference in the parties’ proposed valuations left “much room for compromise.” However, the court found no “path in the evidence to reach a fair value somewhere between the values proffered by the parties.” The court explained that accepting petitioners’ proposed valuation “would be tantamount to declaring that a massive market failure occurred . . . that caused [the company] to leave nearly $4.5 billion on the table.” The court found the evidence instead demonstrated that the company ran a “well-constructed and fairly-implemented auction process” in which none of the entities involved “colluded with or otherwise favored any bidder during the entirety of the process.”

Although the court was “confident that the deal price in this case [was] a reliable indicator of fair value,” the court nevertheless “approached the DCF valuations . . . with an open mind.” The court explained that “[t]he first key to a reliable DCF analysis is the availability of reliable projections of future expected cash flows, preferably derived from contemporaneous management projections prepared in the ordinary course of business.” The court emphasized that “if the data inputs used in the [DCF] model are not reliable, then the results of the analysis likewise will lack reliability.”

In the case before it, the court found that the management projections were “not reliable statements of [the company’s] expected cash flows” for several reasons. First, the company “had not historically created five-year projections prior to the creation of the auction-related projections.” Second, the company’s management “did have a history of preparing short-term forecasts that did not accurately predict [c]ompany performance.” Third, the court found that “management did not believe that the projections they were preparing actually offered reliable projections of future performance.” Lastly, the court noted that “the projections were created to be aggressive and extra-optimistic about the future of the [c]ompany” in order to “aid [the company] in its pursuit of strategic alternatives, including a sale of the [c]ompany.” The court concluded that “[a]ny DCF analysis that relie[d] upon the [m]anagement [p]rojections . . . would produce ‘meaningless’ results.”