In Manichaean Capital, LLC, et al. v. SourceHOV Holdings, Inc., C.A. No. 2017-0673-JRS (Del. Ch. January 30, 2019), certain minority stockholders of a merging company filed a petition with the Delaware Court of Chancery (the “Court”) to exercise their appraisal rights under Section 262 of the Delaware General Corporate Law (“Section 262”). After reviewing competing valuations prepared by experts of the Company and the minority stockholders respectively, the Court adopted a modified version of the minority stockholders’ expert valuation. In doing so, the Court reiterated its significant discretion to discharge its independent obligation to determine fair market value and instead select one of the parties’ valuation models as a guide.
Beginning in 2014, SourceHOV Holdings, Inc. (the “Company”), a privately-held Delaware corporation providing outsourcing and financial technology services, adopted an acquisition-led growth model. For its acquisitions, the Company regularly produced financial projections. Foremost among these were the Company’s “Equity Case” and “Lender Model”, which each assumed revenue growth of 5% per year. The Company also produced a more conservative “Bank Case”, which projected approximately 2% revenue growth and was seldom used.
To reduce its debt and to secure access to public markets for future equity financings, the Company acquired Novitex Holding Inc., a provider of document management services (“Novitex”). The acquisition was structured as a three-way merger (the “Business Combination”) involving the Company, Novitex, and Quinpario Acquisition Corp., a NASDAQ-listed blank-check special purpose acquisition company (“Quinpario”). Quinpario was the surviving entity and was renamed Exela. As part of the Business Combination, each share of Company common stock, including those held by Manichaean Capital, LLC and other petitioners (collectively, the “Petitioners”), was converted into limited liability company interests in a newly-formed entity, Ex-Sigma LLC.
The Company retained Rothschild, Inc. to advise the Company on the Business Combination and value its equity in a fairness opinion. In February 2017, Rothschild performed a discounted cash flow (“DCF”) analysis that yielded a Company “equity value” of $931 million. Rothschild did not present another valuation to the Company prior to the Business Combination closing in July 2017.
On September 21, 2017, Petitioners filed their Section 262 petition for appraisal of their 10,304 shares of Company common stock converted to Ex-Sigma membership units as part of the Business Combination. Four months later (and six months after the closing of the Business Combination), the Company asked Rothschild to revise its valuation as of July 2017 (the “Backdated Valuation”). The Backdated Valuation used lower revenue growth projections and calculated the Company’s equity value at $675 million.
As part of the appraisal proceeding, Petitioners’ expert witness, produced an analysis valuing the Company’s equity as of the closing of the Business Combination at $798.711 million, or $5,079 per share. Petitioners’ expert used a DCF-type analysis to arrive at his equity valuation, while primarily relying on the Company’s own “Lender Model” (which Petitioner’s expert found to contain the most updated Company projections) to derive financial projections.
By contrast, the Company’s expert concluded that the Company’s equity value was $286.4 million (or $1,723 per share), later revised to $468.1 million (or $2,817 per share). The Company’s expert relied on a DCF-type analysis similar to that applied by Petitioners’ expert, and he used the Company’s “Equity Case” for financial projection, which contained a similar 5% annual revenue growth rate. However when determining the appropriate discount rate to apply to those projections, Company’s expert used a new and relatively untested theorem positing that a company’s equity risk must always be greater than its debt risk (which in the case of the debt-laden Company was already high). This led to the application of a higher discount rate resulting in a significantly lower equity value.
The Court reviewed both expert valuations, as well as a competing lower valuation prepared by the Company resulting in an equity valuation of $271.4 million, or $1,633 per share. The Court first highlighted its equitable powers in a Section 262 appraisal proceeding to determine the “fair value” of shares in question after considering “all relevant factors”. The Court noted that statutory appraisal is a “flexible process” vesting the Court with “significant discretion” to determine fair value, which includes, after undertaking a review of valuations put forward by each party and their experts, the power to “select one of the parties’ valuation models as a general framework, or fashion its own”. Specifically, the Court noted that its role does not require a judicial determination completely separate and apart from the valuations provided by the parties’ expert witnesses.
Based on this standard of review, the Court determined that Petitioners’ expert had presented a credible valuation, subject to certain modifications. The Court agreed with both parties that a DCF-based valuation was appropriate, given the lack of reliable market evidence or sufficiently comparable companies. The Court then determined that the Company’s valuation lacked credibility for several reasons. First, the Court pointed to the Company’s disagreement with its own expert over its valuation, finding the Company’s use of the “Bank Case” was unjustified given the opinions of both parties’ experts and the Company’s strong growth in the years leading up to the Business Combination. Second, the circumstances surrounding the Backdated Valuation, including its creation and delay in disclosure to Petitioners, damaged the Company’s credibility. Finally, the Court found the untested discount method put forward by the Company’s expert to be lacking in support from other experts in the field.
By contrast, the Court found the valuation put forward by Petitioners’ expert to be credible and reasonable, noting that it relied on financial projections and other metrics that the Company itself had often used and viewed as most credible prior to the Business Combination. The only input from Petitioners’ expert that the Court took issue with was the size premium used in calculating the discount rate, which was in turn based on the Company’s market capitalization following the Business Combination. The Court noted that Petitioners’ expert did not take into account the decrease in Exela’s stock price following the Business Combination, which led the Court to apply a higher size premium to the valuation calculated by Petitioners’ expert. Consequently, the Court concluded that that the Company’s fair value as of the Business Combination was $4,591 per share.