Fair Market Value
Acquirer / Target
Discounted Cash Flow
Overview of the Appraisal Process
In the following chapter, we will spend time discussing the various mechanisms by which a company may undertake to sell itself or the bulk of its operation to another company. This body of law, known as the law of “mergers and acquisitions,” regulates the bulk of the process and methods of engaging in such a transaction and is responsible for many of the effects that these corporate combinations have on the companies involved. The question that we ask now is what happens to the shareholders when the company is sold?
In other words, when a shareholder in A Corp. votes against a sale of A Corp. to B Corp., what are the shareholder's rights? It is clear that, from a legal perspective, the sale of A. Corp. has resulted in a forced taking of the shareholder’s property, and thus compensation would have to be paid to the shareholder for the loss of value of the A Corp. stock that resulted from the dissolution of A Corp. The problem that arises is how to fairly determine the value of the dissolved A Corp. stock.
In a situation as described above, the principal right available to the shareholder is the “appraisal action.” An appraisal action is the business law’s equivalent of a determination of “just compensation” in a property takings case. In the appraisal action, the court will be called on to make a determination of the fair value of an individual share of the company (from above, A Corp.) at the moment prior to the company being sold. In so doing, the court is attempting to determine a value that equates to the “fair market value” (FMV) of the company in the shareholder’s hands prior to the sale of the firm in which he was a shareholder. See
It is also important to note that while appraisal is most typical in merger situations, it may arise in a variety of other contexts as well. When considering this material, keep in mind that what the court is concerned with is that the rights in property that the shareholder had are being harmed by the merger or sale of the company.
The Appraisal Action
The appraisal action itself is solely a court-prescribed means of determining the value of the shares of the company at the moment of the sale. It is important to understand that the courts, as a general matter, are virtually never able to “unwind” or “unmerge” companies once they have already entered into a sale. See
An initial reaction to the “value” problem is to say “let the market handle it.” In other words, a person’s instinct may be to say, “Why not just look at the market price of the company’s securities prior to the sale and use that for the basis of valuation?” While this is a good start to the analysis, it ignores many other issues including the question of how to price a company that is held privately and does not have a “market” value..
Thus, in engaging the appraisal question, courts look at a wide variety of factors. The following list is not exhaustive, and many variations on the tests below have, at times, been implemented by courts. It is also important to note that no court has ever handed down a decision that precisely defines the weight that each of the factors below has in determining the overall “fair value.” This is either because the process itself is too complicated, or, more likely, because each transaction is unique and requires an independent balancing of these facts.
Courts will likely consider the following factors in an appraisal action:
- Public price of the stock (if available) at time of transaction and during period prior to transaction (usually tracked over 5 years at a minimum)
- Price of the stock as paid by the purchasing company in the transaction
- Any competing bids offered in the transaction
- Professional evaluation of the value of the company and its shares (usually done by investment bankers from both the company and the shareholder – typically a discounted cash flow model is made)
- Value of the assets transferred (real property, machinery, goodwill, etc.)
- Value of any shares of the purchasing company transferred (if shares exchanged in the sale)
- Overall economic and legal health of the firm – particularly as concerns the chances that the firm may be forced into bankruptcy.
As the above list should suggest, the variety and extent of the various tests that courts employ in evaluating the FMV of the company prior to sale is huge. Moreover, the relative weight applied to any single factor can rapidly tip the balance from one factor’s view to the other. In the end, courts, while concerned with the above issues, are often just as concerned with the possibility of a fraudulent or otherwise unfair transaction. If the court, when considering the entirety of the transaction as is required in an appraisal, “smells a scoundrel,” it is highly likely that it will favor the opposing party. For the company, this means that the transaction needs to be “entirely fair” – i.e., without the taint of fraud, insider dealings, or any effort to shortchange the small shareholder. See
When Does the Appraisal Right Attach?
It is important to know when the right of appraisal will attach to an act of a company. This is because while certain transactions, such as mergers or sales, certainly trigger appraisal rights for the selling shareholder, certain transactions that are less than full “sales” of the corporation (e.g., transactions that can be described as “fundamental changes”) may likewise trigger appraisal rights. Moreover, the problem is further complicated by the fact that states vary a great deal as to what companies are allowed to do in either extending or limiting appraisal rights.
First, consider the typical case of a corporate sale. Sales of a company usually come in one of three forms:
- Merger – where A Corp. and B Corp. combine to form C Corp. See
8 Del. C. § 259
- Acquisition – where A Corp. is wholly purchased by B Corp. and only B Corp. survives
- Sale of All Assets – where A Corp. sells all or almost all of its property to B Corp. and then A liquidates
Note that selling a majority of the firm’s assets has also been held to trigger appraisal rights. See
Given these various types of transactions, it may not surprise you that the appraisal rights attach in different ways depending on the form that the transaction takes. For mergers, the shareholders of both A Corp. and B Corp. will be entitled to appraisal as both companies’ shareholders are losing the property with which they started out (the shares of the combining corporations). For an “acquisition” transaction, only the owners of A Corp., the selling company, are entitled to appraisal as they are the only ones giving up their ownership in a company. Finally, in the “sale of all assets” transaction, it is likely that A Corp.’s shareholders will be entitled to appraisal. However, certain methods of selling assets may make that right all but useless if most assets are sold by the time the company is prepared to truly dissolve.
EXAMPLE: Jump Co. and Trampoline Inc. have decided to enter a transaction where they will merge their business operations and management functions. Because the shareholders of both companies will now own shares in the newly formed company – Jump ’O Line – shareholders of both companies will be entitled to vote on whether or not the transaction should proceed.
Finally, the range of changes that states view as so “fundamental” to the corporate form that they trigger appraisal varies a great deal among states. While there are some default changes that will always trigger appraisal, a legal professional would be well advised to review his or her state’s law when working with a company contemplating a major corporate change.
The following is a list of changes that will trigger appraisal:
- Dissolving the company / voluntarily entering bankruptcy proceedings
- Changes to the certificate of incorporation that seriously affect voting or dividend rights
- Changes to a class of stock that seriously affect voting or dividend rights
- Any change that severely alters or removes a previously held shareholder right
Consider the following example:
EXAMPLE: King Co. has several classes of stock outstanding. One such class is a preferred stock that has a cumulative preferred dividend. The dividend is such that whether or not the company’s board chooses to declare and pay a dividend, the stock is entitled to a $.05 per share dividend every year, whether or not it is paid. If the company fails to pay the dividend, the amount simply adds to the value of the stock and must be paid prior to any other dividend being paid. Because King has failed to pay a dividend for the last five years, the amount of accrued and owned dividend to this class of stock has become quite large. Thus, the board attempts to pass a resolution that cancels the accumulated dividend and removes that right from the class. The holders of the preferred class can assert appraisal rights when the resolution is passed at the annual meeting, and can assert to the court that the nature and value of their shares have been fundamentally affected by the board’s action.
Asserting the Appraisal Claim
Any individual who holds at least one share at the time of the transaction is entitled to appraisal of his ownership stake. In order to “perfect” the appraisal claim, the shareholder must generally (though there are some variations in state law) perform the following acts:
- Make notice of intent to seek appraisal prior to the vote
- Either dissent (vote against) or abstain from voting on the sale or transaction
- (A minority of states require a good faith attempt to reach an agreement as to what constitutes “fair value” with the company)
- Filing of the appraisal action
Essentially, the states require the steps above in order to make clear that a shareholder cannot vote for the transaction and then seek appraisal afterwards. The included system of notice also serves to ensure that the company has fair warning that a certain percentage of its shareholders object to the transaction even before a vote is called. This is important because the potential for appraisal litigation that follows can result in extensive costs and lost time for a company.
EXAMPLE: Holiday Inc. recently merged with Traveler’s World. Tommy, an investor in Holiday, felt that the deal was bad for the company. However, rather than sell his shares, Tommy decided to assert his appraisal rights. Thus, he alerted the company’s secretary of his intentions and then voted against the action at the meeting. After the merger passes, Tommy can file his appraisal claim. If Tommy had voted for the merger, he could not then assert his appraisal rights.
Finally, it is important to note that in many transactions, the acquiring company will make, as an element of its offer, a requirement that less than a certain percentage of the target company’s shareholders seek appraisal. In other words, if the threshold percentage – say 5% - is crossed, then the acquiring company will not proceed with the terms of the deal as originally structured. This is because the acquirer does not want to walk into a legal battle with disgruntled shareholders when it proceeds with a transaction.