«) IN RE: APPRAISAL OF THE ) ORCHARD ENTERPRISES, INC. ) C.A. No. 5713-CS ) MEMORANDUM OPINION Date Submitted: May 30, 2012 Date Decided: July 18, ...»
EFiled: Jul 18 2012 3:55PM EDT
Transaction ID 45415789
Case No. 5713-CS
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
IN RE: APPRAISAL OF THE )
ORCHARD ENTERPRISES, INC. ) C.A. No. 5713-CS
Date Submitted: May 30, 2012
Date Decided: July 18, 2012
Ronald A. Brown, Jr., Esquire, Marcus E. Montejo, Esquire, PRICKETT, JONES & ELLIOTT, P.A., Wilmington, Delaware, Attorneys for Petitioner Merlin Partners LP.
John G. Harris, Esquire, BERGER HARRIS, LLC, Wilmington, Delaware; Samuel J.
Lieberman, Esquire, SADIS & GOLDBERG LLP, New York, New York, Attorneys for Petitioners Quadre Investments, L.P., Matthew Giffuni and Christopher Yeagley.
Philip Trainer, Jr., Esquire, Toni-Ann Platia, Esquire, ASHBY & GEDDES, P.A., Wilmington, Delaware; Kenneth J. Pfaehler, Esquire, SNR DENTON US LLP, Washington, District of Columbia, Attorneys for Respondent The Orchard Enterprises, Inc.
I. Introduction This is the post-trial decision in an appraisal arising out of a merger in which the common stockholders of The Orchard Enterprises, Inc. were cashed out at a price of $2.05 per share by Orchard’s controlling stockholder, Dimensional Associates, LLC (the “Going Private Merger” or the “Merger”). Relying upon a discounted cash flow (“DCF”) analysis, the petitioners, who together owned 604,122 shares of Orchard’s common stock, claim that each Orchard common share was worth $5.42 as of the date of the Going Private Merger.1 By contrast, the respondent Orchard contends that the Merger price was generous and that Orchard common shares were worth only $1.53 a piece as of the date of the Merger.
The largest part of this value disparity stems from the parties’ differing treatment of a $25 million liquidation preference that is owed by Orchard in certain circumstances to the holders of its preferred stock. Not by coincidence, Orchard’s preferred stock is held almost entirely by Dimensional, which initiated the Going Private Merger, and constituted part of the equity votes that gave Dimensional majority control of Orchard before the Merger. Orchard’s position regarding the liquidation preference is simple and is based on the practical reality that the “Certificate of Designations” governing the preferred stock required the payment of the $25 million liquidation preference to Dimensional upon a dissolution of the company, a sale of all or substantially all of Orchard’s assets leading to a liquidation of the company, or a sale of control of Orchard
begrudging manner one could ever conceive) that the liquidation preference was not triggered by the Going Private Merger and that Dimensional in fact still owns the preferred stock and may obtain the liquidation preference in the future, Orchard claims that as a market reality, Dimensional could demand the liquidation preference as a precondition to any third-party merger and that therefore the full $25 million liquidation preference must be deducted from the enterprise value of Orchard before calculating the value of its common stock in this statutory appraisal.
The petitioners rightly contend that Orchard’s position is wrong as a matter of law.
They correctly point out that the liquidation preference was not triggered by the Going Private Merger, as was indicated by Orchard in the proxy statement in support of the Merger (the “Proxy Statement.”).3 Whether the liquidation preference would ever be triggered in the future was entirely a matter of speculation as of the Merger date, because that turned on whether one of the events triggering it under the Certificate of Designations would occur. Unlike a situation where a preference becomes a put right by contract at a certain date,4 the liquidation preference here was only triggered by unpredictable events such as a third-party merger, dissolution, or liquidation.5 Most important, according to settled law as originally set forth by the Delaware Supreme Court 2 JX-5 (Certificate of Designations) §§ 2(a), 2(c).
3 JX-9 (Proxy Statement) at 25 (“There will be no liquidation payment to the holders of [preferred stock] under the [Going Private Merger] agreement.”).
4 Compare Shiftan v. Morgan Joseph Hldgs., Inc., 2012 WL 120196, at *9 (Del. Ch. Jan. 13, 2012).
5 See In re Appraisal of Metromedia Int’l Group, Inc., 971 A.2d 893, 906 (Del. Ch. 2009).
2 in Cavalier Oil Corporation v. Harnett,6 the petitioners are entitled to receive their pro rata share of the value of Orchard as a going concern.7 This means that the value of Orchard is not determined on a liquidated basis,8 and the company must be valued “without regard to post-merger events or other possible business combinations.”9 Although Dimensional, as a holder of Orchard’s preferred stock, had important control rights and economic protections in the event of a third-party merger, dissolution, or liquidation, its only right to share in cash flow distributions made by Orchard while the company was a going concern (i.e., dividends) was on an as-converted basis.10 That is, Dimensional’s entitlement to dividends was based on the number of common shares into which the preferred shares could be converted. As a matter of law, therefore, Orchard’s argument fails in the face of Cavalier Oil. The proper way to value the petitioners’ shares is to value Orchard as a going concern, and to allocate value to the preferred and common stock based on the allocation made by the Certificate of Designations in that context. This approach marries perfectly with the DCF method of valuation, which is based on the notion that a corporation’s value equals the present value of its future cash flows. By allocating the DCF value of Orchard in accordance with the dividend formula in the Certificate of Designations, as the petitioners did in this appraisal action, the
After I address the parties’ arguments regarding the liquidation preference, I address the technical corporate finance valuation issues that commonly arise in appraisal proceedings decided by law-trained judges. The first major decision I make is to concentrate solely on the DCF method in reaching my determination of fair value.
Although Orchard purports to rely upon both the comparable companies and comparable transactions methods in coming to its position on value, its analyses based on these methods are not reliable. None of those comparables is really similar to Orchard – a unique business in a niche in the music industry – in the way that, say, Bank of America is to Citigroup. What is more important to me, though, is that Orchard’s expert generated an array of comparables from which valuation multiples in the form of medians and means could be derived, but then chose multiples well below the median and mean for each analysis without providing a sensible explanation. At bottom, the expert did not draw any reasoned inference about the value of Orchard from his comparables. Rather, all he did was come up with a sample of comparables, conclude that Orchard was a much worse performer than any of them for reasons that are inconsistent with the data in his own analysis and then subjectively pick a lower multiple to justify an outcome. I cannot embrace that approach.
Because Orchard failed to make a convincing case for the use of a comparable companies or comparable transactions analysis, I focus my determination of value on the
input to that method – the financial projections – is relatively minor, as the parties largely agree on the reliability of the projections provided by Orchard management, with only a minor skirmish about which set of projections to use, certain adjustments to be made to the chosen set of projections, and what weight to give to management’s aggressive and base case scenarios. I find for Orchard for the most part on these issues, giving 90% weight to the base case and only 10% weight to the aggressive case, and using the projections most current as of the date of the Going Private Merger.
The largest disagreement between the parties over DCF value is over the discount rate to use. Each side’s expert used three different methods to come to a discount rate.
Two of these methods are versions of the so-called “build-up” model. The build-up model is a method larded with subjectivity, and it incorporates elements that are not accepted by the mainstream of corporate finance scholars. By contrast, the third method each of the experts used is based on the capital asset pricing model (“CAPM”) that remains the accepted model for valuating corporations. The experts used a modified CAPM method that takes into account academic acceptance that the size of a corporation affects the expected rate of return and should be factored into the calculation of a corporation’s discount rate.
Rather than (i) use methods that involve great subjectivity and lack firm grounding in corporate finance theory, and (ii) shroud my determination of fair value in the false precision of averaging the results of three different methods of calculating cost of capital in coming to a single discount rate, I choose to determine the discount rate using only the
supported by relevant professional and academic literature and prior decisions of this court in appraisal proceedings, is applied, and Orchard’s decision to include a companyspecific risk factor that is inconsistent with the CAPM method is put to the side, as it should be, the petitioners and Orchard agree that the discount rate under the CAPM method is 15.3%.
After making these and some other minor decisions about the inputs to the DCF analysis, I arrive at a per common share value of $4.67 for Orchard, subject to confirmation by the parties because of the uncertainties that come with making changes to both experts’ inputs and plugging them into one expert’s DCF model, which I supplement with an award of interest at the statutory rate.
A. Orchard’s Business And Capital Structure Before The Merger With Dimensional Orchard primarily makes money from the retail sale (through digital stores such as Amazon and iTunes) and other forms of exploitation of its controlled, licensed music catalogue, which includes artists ranging from the rapper Pitbull to jazz musician Wynton Marsalis. As of 2010, this core business made up 90% of Orchard’s total revenue, with the other revenue coming from the distribution of other digital content. Until Dimensional, a private equity investor, cashed out Orchard’s common stockholders in the Going Private Merger, Orchard was traded on the NASDAQ.
Orchard’s capital structure before the Going Private Merger consisted of (i) common stock, which was 42.5% owned by Dimensional, and (ii) preferred stock, which
power of Orchard’s outstanding capital stock, because the preferred stock could vote on an as-converted basis.
The rights and preferences of the preferred stock are set forth in the Certificate of Designations. The preferred stock has no set dividend rights, but is entitled to participate in any dividends declared by Orchard on its common stock on an as-converted basis.
Specifically, each share of Orchard’s preferred stock is convertible at the option of the holder at any time into 3.33 Orchard common shares, subject to adjustments for stock splits, combinations, and distributions.
Upon the occurrence of certain events described in § 2 of the Certificate of Designations, the preferred stock is entitled to a liquidation preference of $25 million.
These events are limited to: (i) a “voluntary or involuntary liquidation, dissolution, or winding up” of Orchard;12 (ii) “the sale or exclusive license of all or substantially all of [Orchard’s] assets or intellectual property,” in which case the company is required to liquidate, dissolve and wind up” as soon as possible thereafter;13 and (iii) a “Change of Control” transaction “in which the stockholders of [Orchard] will receive consideration from an unrelated third party.”14
In 2008, Orchard’s business was suffering along with many others in a declining economy. Dimensional looked to exit from Orchard by selling the company, but
any value to the common stock. According to Dimensional, no buyer emerged that would pay a value that would result in an attractive price for the common stock on that basis. Thus, Dimensional turned into a buyer from a potential seller, claiming that it “had no option … but to try to facilitate the transaction [itself] and actually pay out [the] common shareholders” by taking Orchard private.15 In other words, Dimensional chose to deepen its investment in Orchard’s future but only on the condition that it could run Orchard as a private portfolio company without other investors.
In October 2009, Dimensional therefore informed Orchard’s board of directors that it was making an offer for the outstanding shares of Orchard’s common stock that it did not already own. In response, the board formed a special committee of independent directors to review and evaluate any offer made by Dimensional. The special committee hired Fesnak and Associates, LLP as its financial advisor.
After negotiations, Dimensional and the special committee reached agreement that Dimensional would cash out the other holders of Orchard’s common stock at a price of $2.05 per share. Fesnak and Associates reviewed the fairness of this consideration by performing a variety of financial analyses, including a comparable companies analysis, a comparable transactions analysis, and a DCF analysis. On March 15, 2010, Fesnak and Associates delivered a fairness opinion to the special committee that a price of $2.05 per share was fair, from a financial point of view, to Orchard’s common stockholders. The Going Private Merger was then approved by both the special committee and Orchard’s
annual meeting on July 29, 2010, a majority of the minority stockholders of Orchard voted in favor of the Going Private Merger and the Merger became effective.