GLASSCOCK, Vice Chancellor.
This case presents what has become a common scenario in this Court: a robust marketing effort for a corporate entity results in an arm's length sale where the stockholders are cashed out, which sale is recommended by an independent board of directors and adopted by a substantial majority of the stockholders themselves. On the heels of the sale, dissenters (here, actually, arbitrageurs who bought, not into an ongoing concern, but instead into this lawsuit) seek statutory appraisal of their shares. A trial follows, at which the dissenters/petitioners present expert testimony opining that the stock was wildly undervalued in the merger, while the company/respondent presents an expert, just as distinguished and learned, to tell me that the merger price substantially exceeds fair value. Because of the peculiarities of the allocation of the burden of proof in appraisal actions— essentially, residing with the judge—it becomes my task in such a case to consider "all relevant factors" and determine the fair value of the petitioners' shares.
Here, my focus is the fair value of shares of common stock in BMC Software, Inc. ("BMC" or the "Company") circa September 2013, when BMC was taken private by a consortium of investment firms (the "Merger"), including Bain Capital, LLC, Golden Gate Private Equity, Inc., and Insight Venture Management, LLC (together, the "Buyer Group"). Our Supreme Court has clarified that, in appraisal actions, this Court must not begin its analysis with a presumption that a particular valuation method is appropriate, but must instead examine all relevant methodologies and factors, consistent with the appraisal statute.
BMC is a software company—one of the largest in the world at the time of the Merger—specializing in software for information technology ("IT") management.
The Company is organized into two primary business units: Mainframe Service Management ("MSM") and Enterprise Service Management ("ESM").
Beauchamp and BMC's CFO Stephen Solcher both testified that, at the time of the Merger, BMC's business faced significant challenges to growth due to shifting technologies. Foremost, MSM was in a state of stagnation, as hardly any businesses were buying into the outdated, so-called "legacy" technology at the heart of MSM products and services—the IBM mainframe computer—and indeed some of BMC's MSM customers were moving away from mainframe technology altogether.
As a result of the decline in mainframe computing, BMC had become entirely dependent on its ESM business for growth.
Notwithstanding these challenges to its growth, BMC's business remained relatively stable leading up to the Merger, aided in part by BMC's role as an industry leader in several categories of products, in part by the overall diversity and "stickiness" of its products, and in part by its multiyear, subscription-based business model, which spreads its customer-retention risk over several years.
The primary way that BMC has historically dealt with the high rate of innovation and competition in the IT management software industry is to lean heavily on mergers and acquisitions ("M&A") to grow and compete.
At trial, Beauchamp and Solcher both conceptually clustered the Company's M&A activity into two general categories, what they referred to as "strategic" transactions and "tuck-in" transactions.
As explained by Beauchamp and Solcher, it was these latter, smaller acquisitions that formed the basis of BMC's inorganic growth strategy.
Like many technology companies, in order to attract and maintain talented employees, BMC compensated a significant portion of their employees using stock-based compensation ("SBC").
Because the Company believed SBC was vital to maintaining the strength of its employee base, management had no plans to stop issuing SBC had it remained a public company.
BMC in the ordinary course of business created financial projections— which it called its "annual plan"
The annual plan was limited to internal use and represented optimistic goals that set a high bar for future performance.
Also in October of each year, BMC would begin to prepare high-level three-year projections that were not as detailed as the one-year annual plan.
Although management's projections required many forecasts and assumptions, BMC benefited from the predictability of their subscription-based business model. A significant amount of the Company's revenue derived from multiyear contracts that typically spanned a period of five to seven years.
BMC created multiple sets of financial projections leading up to the Merger. In July 2012, BMC began preparing detailed multiyear projections as the Company began exploring various strategic alternatives, including a potential sale of the Company.
As discussed in more detail below, the Company quickly abandoned their initial efforts to sell the company. In January 2013, however, following poor financial results in the third quarter, BMC again decided to explore strategic alternatives, requiring management to update the October Projections.
As I have described above, SBC was an integral part of BMC's business before the Merger and management had no reason to believe that SBC would decrease if the Company had remained public. Additionally, because BMC had a regular practice of buying shares to offset dilution, management believed SBC was a true cost and, therefore, included SBC expense in their detailed projections.
Management believed tuck-in M&A was integral to the Company's revenue growth and, therefore, its projected revenues took into account continued growth from tuck-in M&A transactions.
In May 2012, in response to "sluggish growth" and "underperformance," activist investors Elliott Associates, L.P. and Elliott International, L.P. (together, "Elliot") disclosed that Elliot had increased its equity stake in BMC to 5.5% with the intent to urge the Company to pursue a sale.
On July 2, 2012, after discussions with other large stockholders, BMC agreed to a settlement with Elliott that ended its proxy contest.
In July 2012, in conjunction with its settlement with Elliott, BMC's board formed a committee (the "Strategic Review Committee") to explore all potential strategic options that could create shareholder value, including a sale.
On August 28, 2012, the board instructed Beauchamp to begin contacting potential strategic buyers and instructed the team of financial advisors to begin contacting potential financial buyers to gage their interest in an acquisition.
The Strategic Review Committee evaluated the indications of interest and, encouraged by BMC's improved financial results in the second quarter of fiscal year 2013,
Despite the Company's renewed confidence following improved quarterly results, in December 2012 Elliott sent a letter to the board that expressed continued skepticism of management's plans and reiterated its belief that additional drastic measures, like a sale, were required to maximize stockholder value.
The board called a special meeting on January 14, 2013 to reevaluate their options, which included three strategic opportunities: (1) a strategic acquisition of Company A, another large software company; (2) a modified execution plan that included less implied growth and deep budget cuts; and (3) a renewed sales process targeted at the previously interested financial buyers.
In March 2013, after contacting potential financial buyers,
On April 24, 2013, the Buyer Group submitted a bid of $45.25.
Starting on April 27, 2013 and continuing over the next few days, the board met with the financial advisors to discuss the details of the Buyer Group's final offer, which included: a 30-day go-shop period that started upon signing the Merger agreement; a two-tiered termination fee of a 2% and 3%; and a 6% reverse termination fee.
The go-shop period lasted from May 6, 2013 through June 5, 2013.
On May 10, 2013, a group of stockholders brought a breach of fiduciary duty action to challenge the sales process.
The Petitioners' expert witness, Borris J. Steffen, exclusively relied on the discounted cash flow ("DCF") method and determined that the fair value of BMC was $67.08 per share;
The Respondent's expert witness, Richard S. Ruback, similarly relied on the DCF method to conclude that the fair value of BMC was $37.88 per share,
Although the difference between the experts' estimates is large, the contrasting prices are the result of a few different assumptions, which I now describe below.
Steffen based his calculation of free cash flow on management's projections for 2014 through 2018 that BMC reported in its proxy statement dated June 25, 2013.
Ruback, however, concluded that management's projections were biased by "overoptimism" and, therefore, reduced management's revenue projections used in his calculation of free cash flow by 5%.
Steffen used a discount rate of 10.5% while Ruback used a discount rate of 11.1%. The difference in discount rates is almost entirely explained by the experts' contrasting views of the equity risk premium ("ERP"). Steffen calculated his discount rate using a supply-side ERP of 6.11%, which he believed was preferable since valuation calculations are forward-looking.
Steffen selected a long-term growth rate of 3.75%.
Steffen used an excess cash value of $1.42 billion, which he calculated by reducing cash and cash equivalents as of September 10, 2013 by the minimum cash required for BMC to operate of $350 million.
Ruback started with cash and cash equivalents as of June 30, 2013
Steffen's analysis did not account for SBC in his free cash flow projections.
Conversely, Ruback included SBC as a cash expense that directly reduced his free cash flow projections.
Steffen did not deduct M&A expenditures from free cash flow. He believed that management's projections were not dependent on M&A activity since he did not find that management deducted M&A expenditures in their own analysis.
On September 13, 2013, Petitioners Merion Capital LP and Merion Capital II LP commenced this action by filing a Verified Petition for Appraisal of Stock pursuant to 8 Del. C. § 262. Immediately prior to the Merger, Petitioners owned 7,629,100 shares of BMC common stock. On July 28 2014, Respondent BMC filed a Motion for Summary Judgment, arguing that Petitioners lacked standing to pursue appraisal because they could not show that each of their shares was not voted in favor of the Merger. I denied the Motion in a Memorandum Opinion dated January 5, 2015.
I presided over a four-day trial in this matter from March 16 to March 19, 2015. The parties submitted post-trial briefing and I heard post-trial oral argument on June 23, 2015. Finally, in July the parties submitted supplemental post-trial briefing regarding the treatment of synergies. This is my Post-Trial Opinion.
The appraisal statute, 8 Del. C. § 262, is deceptively simple; it provides stockholders who choose not to participate in certain merger transactions an opportunity to seek appraisal in this Court. When a stockholder has chosen to pursue its appraisal rights, Section 262 provides that:
Section 262 vests the Court with significant discretion to consider the data and use the valuation methodologies it deems appropriate. For example, this Court has the latitude to select one of the parties' valuation models as its general framework, or fashion its own, to determine fair value. The principal constraint on my analysis is that I must limit my valuation to the firm's value as a going concern and exclude "the speculative elements of value that may arise from the accomplishment or expectation of the merger."
Ultimately, both parties bear the burden of establishing fair value by a preponderance of the evidence. In assessing the evidence presented at trial, I may consider proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court. Among the techniques that Delaware courts have relied on to determine the fair value of shares are the discounted cash flow approach, the comparable transactions approach, and comparable companies approach. This Court has also relied on the merger price itself as evidence of fair value, so long as the process leading to the transaction is a reliable indicator of value and any merger-specific value in that price is excluded.
Here, the experts offered by both parties agreed that the DCF approach, and not the comparable transactions or comparable companies approach, is the appropriate method by which to determine the fair value of BMC. Thus, I will start my analysis there.
In post-trial briefing and at closing argument, the parties helpfully laid out the limited areas of disagreement between their two experts as to DCF inputs. I will briefly explain my findings with respect to those areas in contention, but I note at the outset that, while I have some disagreements with the Respondent's expert, Ruback, I generally found him better able to explain—and defend—his positions than the Petitioners' expert, Steffen. Since I generally find Ruback more credible, I start with his analysis as a framework, departing from it as noted below.
The parties' experts both relied on the same management projections. Ruback, however, made a 5% reduction to projected revenue based on his analysis that the Company had historically fallen short of its projected revenues. Although it is apparent to me that the management projections, while reasonable, harbored something of a bias towards optimism, I ultimately find Ruback's approach too speculative to accurately account for that bias. Thus, in conducting my own DCF valuation of the Company, I use the management projections as is, without a 5% deduction.
The parties contend that the key difference in their experts' respective discount rates is that the Petitioners' expert used a supply side ERP, while the Respondent's expert used a historical ERP. This calculation is forward-looking, and this Court has recently tended to employ the supply side ERP approach. In then-Chancellor Strine's decision in Global GT LP v. Golden Telecom, Inc.,
While it may well be the case that there is an argument in favor of using the historical ERP, nothing in Ruback's testimony convinces me to depart from this Court's practice of the recent past. I note, however, that the testimony at trial showed this to be a vigorously debated topic, not just between these two experts, but in the financial community at large; scholarship may dictate other approaches in the future. Here, though, I ultimately find the most appropriate discount rate, using the supply side ERP, to be 10.5%.
The Respondent's expert adopted the inflation rate as the Company's growth rate, but I did not find sufficient evidence in the record to support the application of a growth rate limited to inflation. In Golden Telecom, and again in Towerview LLC v. Cox Radio, Inc.,
The Petitioners' expert purported to use this methodology, but arbitrarily opted to add 50 basis points to the midpoint of inflation and GDP, an approach I do not find supported in the record. Therefore, though I find the midpoint approach to be sound, I reject Steffen's addition of 50 basis points and use 3.25% as my growth rate.
I note that the Respondent's expert did an analysis of implied EBITDA growth rates for comparable companies, which he found to be an average of -1.7%. I do not find there to be sufficient evidence of the true comparability of those companies such that the approach I am adopting, just discussed, is unreasonable.
The Petitioners' expert used an excess cash figure as of the Merger date, while the Respondent's expert used a figure from the last quarterly report prior to the Merger. I found credible the testimony at trial that the Company was preserving its cash balance in contemplation of closing the Merger and that, but for the transaction, the Company would not have conserved an extra $127 million in cash.
The Respondent's expert also made an adjustment to excess cash for the expense associated with repatriating cash held abroad. The Petitioners argued that this was inappropriate because the Company's 10-K stated its intent to maintain cash balances overseas indefinitely. These funds, however, represent opportunity for the Company either in terms of investment or in repatriating those funds for use in the United States, which would likely trigger a taxable event. Accordingly, I find it appropriate to include a reasonable offset for the tax associated with repatriating those funds.
It is abundantly clear to me that, as a technology company, BMC's practice of paying stock-based compensation is an important consideration in this DCF valuation. Both experts accounted for stock-based compensation, but only the Respondent's expert did so in a way that accounted for future stock-based compensation, which I find to be the reasonable approach. His approach was to treat estimated stock-based compensation as an expense, which I find reasonable in light of the Company's history of buying back stock awarded to employees to prevent dilution; in that sense, it is clearly in line with a cash expense. The Petitioners have argued strenuously that this overstates the cost, but they presented only the methodology of Steffen—which fails to account for future SBC—as an alternative. Accordingly, I adopt Ruback's calculation as it relates to stock-based compensation.
The parties also disagreed as to whether so-called "tuck-in" M&A expenses should be deducted in calculating free cash flows. I find that the projections prepared by management and used throughout the sales process, including those projections that formed the basis for the fairness opinion, incorporated the Company's reliance on tuck-in M&A activity in their estimation of future growth and revenues. Those projections expressly provided a line-item explaining the Company's expected tuck-in M&A expenses in each year of the projections, and the Company's CFO, Solcher, credibly testified that, because the Company planned to continue with its inorganic growth strategy had it remained a public company, he prepared the management projections with growth from tuck-in M&A in mind.
Taking all of these inputs and assumptions together, I conducted a DCF analysis that resulted in a per share price for BMC of $48.00.
Having found a DCF valuation of $48.00, I turn to other "relevant factors" I must consider in determining the value of BMC. Neither expert presents a value based on comparables, although Ruback did such an analysis as a check on his DCF. Thus, I turn to consideration of the merger price as indication of fair value. As our Supreme Court recently affirmed in Huff Fund Investment Partnership v. CKx, Inc.,
The record here demonstrates that the Company conducted a robust, arm's-length sales process, during which the Company conducted two auctions over a period of several months. In the first sales process, the Company engaged at least five financial sponsors and eight strategic entities in discussing a transaction from late August 2012 through October 2012. As a result, the Company received non-binding indications of interest from two groups of financial sponsors: one for $48 per share and another, from a group led by Bain, for $45-$47 per share. Ultimately the Company decided at the end of October to discontinue the sales process based on management's confidence in the Company's stand-alone business plan, which was temporarily bolstered by positive second quarter financial results.
However, when the Company returned to underperforming in the third quarter, it decided to reinitiate the sales process. In the second sales process, which was covered in the media, the Company reengaged potential suitors that had shown interest in acquiring the Company in the previous sales process, from late January 2013 through March 2013. As a result, the Company received non-binding indications of interest from three different groups of financial sponsors in mid-March, one for $42-$44 per share, one from the Buyer Group, led by Bain, for $46-47 per share, and one from the Alternate Sponsor Group for $48 per share. Negotiations with the low bidder quickly ended after it refused to raise its bid. The Company, therefore, proceeded with due diligence with the two high bidders through April 2013, distributing a draft merger agreement to them, and setting the deadline for the auction process at April 22, 2013.
On April 18, 2013, just days before the impending deadline, one of the sponsors in the Alternate Sponsor Group backed out of the auction and the remaining financial sponsor explained that it could no longer support its prior indication of interest but was considering how to proceed in the auction at a valuation closer to the stock's then-current trading price of $43.75. The Company agreed to extend the auction deadline at the request of the Alternate Sponsor Group in an attempt to maintain multiple bidders. On April 24, the Buyer Group submitted an offer of $45.25 per share. The remaining financial sponsor told the Company that it was still interested in the auction, but that it would need an additional month to finalize a bid and reiterated that if it did ultimately make a bid, it would be below the initial indication of interest from the Alternative Sponsor Group. On April 26, the Company successfully negotiated with the Buyer Group to raise its offer to $45.75 per share, and then to raise its offer again, on April 27, to $46.25 per share.
On May 6, 2013 the Company announced the Merger agreement, which included a bargained-for 30-day market check or "Go Shop," running through June 5. As part of the Go Shop process, the Company contacted sixteen potential bidders—seven financial sponsors and nine strategic entities—but received no alternative offers.
The sales process was subsequently challenged, reviewed, and found free of fiduciary and process irregularities in a class action litigation for breach of fiduciary duty. At the settlement hearing, plaintiffs' counsel noted that the activist investor, Elliot, had pressured the Company for a sale, but agreed that the auction itself was "a fair process."
I note that the Petitioners, in their post-trial briefing, attempt to impugn the effectiveness of the Company's sales process on three grounds. First, the Petitioners argue that Elliot pressured the Company into a rushed and ineffective sales process that ultimately undervalued the Company. However, the record reflects that, while Elliot was clearly agitating for a sale, that agitation did not compromise the effectiveness of the sales process. The Company conducted two auctions over roughly the course of a year, actively marketed itself for several months in each, as well as vigorously marketed itself in the 30-day Go Shop period. The record does not show that the pre-agreement marketing period or the Go Shop period, if these time periods can be said to be abbreviated, had any adverse effect on the number or substance of offers received by the Company. In fact, the record demonstrates that the Company was able to and did engage multiple potential buyers during these periods and pursue all indications of interest to a reasonable conclusion. The Petitioners' argument that Elliot could force the Company to carry out an undervalued sale is further undermined by the fact that the Company chose not to pursue the offers it received in the first sales process, despite similar agitations from Elliot, because management was then confident in the Company's recovery. In sum, no credible evidence in the record refutes the testimony offered by the Company's chairman and CEO, which testimony I find to be credible, that the Company ultimately sold itself because it was underperforming, not because of pressure from Elliot. The pressure from Elliot, while real, does not make the sales price unreliable as an indication of value.
Second, the Petitioners argue that the Company's financial advisors were leaking confidential information about the sales process to the Buyer Group, allowing it to minimize its offer price. For this contention the Petitioners rely solely on a series of emails and handwritten notes prepared by individuals within the Buyer Group, which purport to show that the Buyer Group was getting information about the Alternate Sponsor Group from a source inside Bank of America, one of the Company's financial advisors.
Finally, the Petitioners argue that the same set of emails and notes from within the Buyer Group show that the Company made a secret "handshake agreement" or "gentleman's agreement" with the Buyer Group after receiving its final offer of $46.25 per share that the Company would not pursue any other potential bidders, including the Alternate Sponsor Group. The Petitioners allege that this handshake agreement prevented the Company from further extending the auction deadline to accommodate the additional month requested by the Alternate Sponsor Group and thus precluded a second bidder that would have maximized value in the sales process. Again, I note as a preliminary matter that I do not find that the Petitioners have sufficiently proven the existence of such a so-called handshake agreement. But in any case, even if the Company had made such an agreement, the record shows that by the time such an agreement would have been made the Alternate Sponsor Group had already notified the Company that one of its members had dropped out, that it could no longer support the figure in its prior indication of interest, and that if it was going to make a bid, that bid would come in closer to $43.75. I also note that by this time the Company had already extended its initial auction deadline by several days to accommodate the Alternate Sponsor Group. Finally, the Alternate Sponsor Group could have pursued a bid during the ensuing go-shop period, but did not do so. In light of these facts, the Company's decision not to wait the additional month requested by the Alternate Sponsor Group before moving forward with the only binding offer it had received was reasonable and does not to me indicate a flawed sales process.
For the reasons stated above, I find that the sales process was sufficiently structured to develop fair value of the Company, and thus, under Huff, the Merger price is a relevant factor I may consider in appraising the Company.
The appraisal statute specifically directs me to determine fair value "exclusive of any element of value arising from the accomplishment or expectation of the merger. . . ."
Here, the acquisition of BMC by the Buyer Group is not strategic, but financial. Nonetheless, the Respondent alleges that synergistic value resulted from the acquisition, and that if the Court relies on the purchase price to determine fair value, those synergies must be deducted. They point to tax savings and other cost savings that the acquirer professed it would realize once BMC is a private entity. If I assume that inherent in a public company is value, achievable via tax savings or otherwise, that can be realized by an acquirer—any acquirer—taking the company private, such a savings is logically a component of the intrinsic value owned by the stockholder that exists regardless of the merger. Therefore, to the extent some portion of that value flows to the sellers, it is not value "arising from . . . the merger," and thus excludable under the explicit terms of the statute; but is likely properly excluded from the going-concern value, which our case law has explained is part of the definition of fair value as I must apply it here.
During trial and in post-trial briefing, Respondent offered the testimony of a Bain principal to show that the Buyer Group would have been unwilling to pay the Merger price had they not intended to receive the tax benefits and cost reductions associated with taking the Company private. In fact, had these savings not existed, the Buyer Group would have been willing to pay only $36 per share, an amount that resembles the going-concern value posited by Respondent's expert. However, demonstrating the acquirer's internal valuation is insufficient to demonstrate that such savings formed a part of the purchase price. Here, the Respondent's expert did not opine on the fair value of the Company using a deal-price-less-synergies approach. Instead, the Respondent offered only the testimony of the buyer and its internal documents to show that the purported synergies were included in their analysis. While it may be true that the Buyer Group considered the synergies in determining their offer price, it is also true that they required a 23% internal rate of return in their business model to justify the acquisition,
When considering deal price as a factor—in part or in toto—for computing fair value, this Court must determine that the price was generated by a process that likely provided market value, and thus is a useful factor to consider in arriving at fair value. Once the Court has made such a determination, the burden is on any party suggesting a deviation from that price to point to evidence in the record showing that the price must be adjusted from market value to "fair" value.
I undertook my own DCF analysis that resulted in a valuation of BMC at $48.00 per share. This is compared to, on the one end, a value of $37.88 per share offered by the Respondent, and on the other, a value of $67.08 per share offered by the Petitioners. Although I believe my DCF analysis to rely on the most appropriate inputs, and thus to provide the best DCF valuation based on the information available to me, I nevertheless am reluctant to defer to that valuation in this appraisal. My DCF valuation is a product of a set of management projections, projections that in one sense may be particularly reliable due to BMC's subscription-based business. Nevertheless, the Respondent's expert, pertinently, demonstrated that the projections were historically problematic, in a way that could distort value. The record does not suggest a reliable method to adjust these projections. I am also concerned about the discount rate in light of a meaningful debate on the issue of using a supply side versus historical equity risk premium.
Taking these uncertainties in the DCF analysis—in light of the wildly-divergent DCF valuation of the experts—together with my review of the record as it pertains to the sales process that generated the Merger, I find the Merger price of $46.25 per share to be the best indicator of fair value of BMC as of the Merger date.
As is the case in any appraisal action, I am charged with considering all relevant factors bearing on fair value. A merger price that is the result of an arm's-length transaction negotiated over multiple rounds of bidding among interested buyers is one such factor. A DCF valuation model built upon management's projections and expert analysis is another such factor. In this case, for the reasons above, I find the merger price to be the most persuasive indication of fair value available. The parties should confer and submit an appropriate form of order consistent with this opinion.