The decision concerned an online music retailer in the matter In re: Appraisal of The Orchard Enterprises, Inc. While Chancellor Strine’s decision includes multiple noteworthy elements (including the use of hindsight to support projections, and the continued support of discounted cash flow analyses and capital asset pricing model), the most significant element in the decision may be how Chancellor Strine decided that the liquidation preference should not be applied. Despite the existence of preferred stock with claims on the enterprise value of the subject company ahead of common shareholders, Chancellor Strine concluded that the preferred stock in this case should be valued on an as-converted basis (i.e., ignoring liquidation preference), resulting in a significantly higher value for common stock than otherwise would have been calculated had the liquidation preference been recognized as a valid claim on the assets of the business.
The Orchard Enterprises, Inc. (“Orchard”) primarily sells licensed music, though online retailers such as iTunes and Amazon, for a variety of artists. The company traded on NASDAQ (NasdaqGM: ORCD) until 2009 when an existing shareholder, Dimensional Associates, LLC (“Dimensional”), acquired the remaining common stock that it did not already hold. Prior to the merger, Orchard’s capital structure consisted of 6.4 million shares of common stock and 449 thousand shares of preferred stock (convertible at any time at the option of the holder into 3.33 shares of common stock). Preferred stock also received a liquidation preference of $55.70 per share under certain events, including a transaction that resulted in a change in control. Based on the number of shares of preferred stock, the total liquidation preference was $25 million. Generally, liquidation preference confers a right to preferred shareholders to receive payment on their shares before common shareholders receive any payment. For example, in a typical change in control transaction, where preferred shareholders have an option to convert into common stock, preferred shareholders will elect to receive their liquidation preference unless converting into common stock would entitle them to a larger payout.
Dimensional, a private equity firm, owned 42.5 percent of the common stock and essentially all of the preferred stock, giving Dimensional 53 percent of the voting power. While the preferred stock did not have a preferred dividend, it was entitled to dividends on Orchard’s common stock on an as-converted basis.
In 2009, after seeking buyers for the company with no success, Dimensional decided to buy out the common shareholders and take Orchard private. Dimensional made an offer for the outstanding common shares, and Orchard’s board of directors formed a special committee to evaluate the offer, hiring a financial advisor. In March 2010, the financial advisor delivered a fairness opinion that the price of $2.05 per share was fair, and the Going Private Merger was approved. The common shareholders, including Dimensional, also approved an amendment to the Certificate of Designations (“COD”) allowing the transaction to occur, keeping in place the preferred stock. Under the existing terms of the COD the transaction could not have occurred as offered by Dimensional.
The holders of common stock, the Petitioners, sought an appraisal, arguing that each common share was worth $5.42, not the $2.05 that was offered. Respondent Orchard countered that the merger price was generous and that the shares were worth $1.53 as of the merger date. The main difference between the two parties’ values was the treatment of the $25 million liquidation preference. The Court evaluated projections, tax adjustments and cost of capital assumptions, to arrive at a value per share of $4.67. The common stock of Orchard was trading at $1.34 per share when the transaction was first announced, less than 30 percent of the value determined by Chancellor Strine
As mentioned, the largest difference in approach between the two experts at trial was the treatment of the $25 million liquidation preference for the preferred shareholders. The petitioners’ expert excluded the liquidation preference altogether, arguing that it “was speculative at best” and instead allocated value to the preferred stockholders on an as-converted basis. Orchard’s expert, on the other hand, argued that the company’s preferred stockholders were entitled to the first $25 million of the company’s equity value, and deducted the $25 from the equity value before allocating the remainder to the common shares outstanding.
The Court rejected Orchard’s approach, noting that the liquidation preference had not been triggered as of the merger date, and argued that “the possibility that any of the triggering events would have occurred at all, much less in what specific time frame, was entirely a matter of speculation.” The Court claimed that the triggering events “involve the end of Orchard’s existence as a going concern” and that one would have to “speculate that transactions will occur that are not supposed to be the basis for appraisal” in order to incorporate the liquidation preference. Supported by a 1989 decision from Cavalier Oil Corporation v. Harnett1, the Court asserted that the appraisal value of a company should not be determined on a liquidated basis.
The Court did not address, however, how common shareholders would receive any value in Orchard as a going-concern absent the merger. That is, Orchard had not paid any dividends in the recent past, nor did Orchard intend on paying dividends in the foreseeable future based on disclosures in their SEC 10-K filings. Therefore, the only way in which common shareholders would likely have received any return on their investment (other than selling their shares on NASDAQ) would have been in a transaction of the company. However, the current approach in a Delaware appraisal action is to determine value without regard to any transaction—resulting in an internal inconsistency where value might only be generated as a result of a transaction, yet a transaction cannot be considered in the valuation.
Liquidation preference is not a new concept, nor is it unique to Orchard. Companies backed by private equity or venture capital often used preferred stock with liquidation preference as a means of raising capital. It offers investors the chance to be first in line to receive a return on their investment in a subsequent transaction, ahead of common stock for example. As a result, all shares are not created equal, and as might be expected, the value of a share at the front of the line is typically worth more than a share at the back of the line, all other things being equal. The public price of Orchard’s common stock appeared to recognize this – trading at $1.34 per share when the transaction was announced. Assuming the overall enterprise value as estimated by Chancellor Strine is correct, the traded value of $1.34 is significantly closer to the value offered in the merger ($2.05) than the value determined by Chancellor Strine ignoring liquidation preference ($4.67).
While Chancellor Strine was presented with only 2 options: (1) ignore liquidation preference entirely, or (2) incorporate it entirely, there are other approaches that could have been offered. For example, valuation practitioners have used a probability-weighted method as well as an option pricing method to value common shares in a complex capital structure (e.g., when there is preferred stock with liquidation preference). A probability weighted method would entail projecting different future scenarios, assigning a probability to each scenario, and discounting the value of common stock in each of those scenarios back to the valuation date. Probability-weighted methods are also often used in bankruptcy proceedings as a method of valuing contingent liabilities. An option pricing method, on the other hand, considers all possible outcomes along a log-normal distribution, and is often favored by the Big 4 accounting firms when valuing common stock in a complex capital structure. A detailed discussion of the probability-weighted method and the option pricing method are beyond this article, but the AICPA’s Practice Aid on “Valuation of Privately Held Company Equity Securities Issued as Compensation” addresses these methods in a more comprehensive manner.
The common shareholders who elected their appraisal rights in the Going Private Merger of Orchard should be pleased with Chancellor Strine’s decision. While any market-based transaction for the common stock in Orchard would have likely taken into account the preferred stock that sat atop the capital structure, for purposes of appraisal rights in this matter Chancellor Strine excluded the liquidation preference and treated the preferred stock the same as the common stock. The result was a value of common stock that was significantly higher than was offered to common shareholders in the Going Private Merger. What is not clear from Chancellor Strine’s decision is how the decision might have been different under a different set of facts. It remains to be seen, for example, how liquidation preference might be treated in an appraisal action for a merger where liquidation preference is triggered, when a preferred dividend exists, or when dividends have never been paid and are not expected to be paid in the foreseeable future.
1.Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1144 (Del. 1989)