Opinion ID: 2630611
Heading Depth: 2
Heading Rank: 2

Heading: did the district court adequately consider the oakridge energy valuation factors?

Text: ¶ 18 This court noted in Oakridge Energy that the three most recognized and relevant elements of fair value for stock valuation purposes are asset value, market value, and investment value. 937 P.2d at 132. We held that although `[a]ll three components of fair value may not influence the result in every valuation proceeding, yet all three should be considered.' Id. at 135 (quoting Libby, 406 A.2d at 60). ¶ 19 In the instant case, neither party submitted evidence of asset value. Each party's valuation expert submitted estimates of market value and of investment value, referred to by the parties here as income value. [1] However, the court rejected both parties' market valuations and the Minority's investment valuation. Consequently, the court based its entire valuation on Medtronic's determination of investment value. We examine the court's approach for correctness, noting again that choice of valuation methods is a question of law. Swope, 243 F.3d at 491.
¶ 20 The district court had no evidence of asset value before it, and neither party contested the court's disregard of this factor. As justification for ignoring asset value, the district court cited Hansen v. 75 Ranch Co., 288 Mont. 310, 957 P.2d 32, 42 (1998) ([C]ourts have noted that unless the corporation is undergoing an actual liquidation, the liquidation method is not an appropriate method of valuing shares of a dissenting shareholder.). Other courts have also emphasized that in the absence of actual liquidation a corporation must be valued as a going concern. ¶ 21 The Iowa Supreme Court, in Woodward v. Quigley, 257 Iowa 1077, 133 N.W.2d 38 (1965), stated that [i]n this particular case we are not seriously handicapped by the absence of satisfactory evidence of net asset value. Here, as in most instances, investment value is of much greater importance. Id. at 42; see also Cede & Co. v. Technicolor, Inc., 684 A.2d 289, 299 (Del.1996) (stating that an understatement of fair value may result from failure to value company as a going concern); Friedman v. Beway Realty Corp., 87 N.Y.2d 161, 638 N.Y.S.2d 399, 661 N.E.2d 972, 976 (1995) (stating that a determination of fair value of dissenters' shares should be based on their worth in a going concern, not in liquidation); Elk Yarn Mills v. 514 Shares of Common Stock, 742 S.W.2d 638, 642 (Tenn.Ct.App.1987) (noting that the overwhelming weight of authority approves valuation of the assets of the corporation as a going concern). ¶ 22 Minority shareholders owned stock in a going concern, and liquidation was not a prospect. Zinetics was primarily a manufacturing rather than a property-based corporation. Therefore, we conclude that Oakridge Energy did not require the district court to consider asset value where the parties had adduced none.
¶ 23 Zinetics was listed on a non-NASDAQ over-the-counter stock exchange and had experienced some trading prior to the merger. However, Norman attacked the validity of the trades, and Reilly acknowledged that Zinetics was too thinly traded for its own stock price to serve as a reliable indicator of market value. Therefore, the experts attempted to select companies comparable to Zinetics as guidelines. ¶ 24 The district court noted that this is a method which has not been recognized as a valuation tool by our courts. It added, however, that it did not interpret Oakridge Energy to restrict a fair value analysis to the three methodologies approved in [that] decision. We note that the selection of guideline companies was part of the determination of market value, which is one of the three primary valuation models. Oakridge Energy does not exclude reliable and rational methods for determining asset, market, or investment value that were not before the court in that case. ¶ 25 In the instant case, however, the district court observed that [n]either expert could discover even one company which could reasonably be characterized as `comparable' to Zinetics. Medtronic's expert, Norman, chose a mixture of companies in the medical device field, including several extremely large organizations very dissimilar to Zinetics, notably Abbott Laboratories, Baxter International, and United States Surgical. Using standard appraisal techniques, Norman calculated a multiplier based on the ratio of price to earnings for the guideline companies. Under his methodology, such a multiplier applied to actual earnings yields market value. However, Norman then applied a 42.76% downward adjustment in value to compensate for the differences between Zinetics and the guideline companies. ¶ 26 The district court remarked that, [a]s noted by Mr. Reilly, authoritative sources in the field of valuation view adjustments in excess of 50% with considerable suspicion. And for good reason. The necessity of a 50% adjustment suggests that the subjects of the comparison are more different than alike. Evidently concluding that the necessity for a 42.76% discount fell into the same category, the district court rejected Norman's valuation as seriously flawed. We uphold the district court's factual determination. ¶ 27 Reilly, the Minority's expert, identified guideline companies through a computer search screening for catheter manufacturers similar to Zinetics in size and revenues that had brought a product to the production stage. Eleven companies met the criteria. None of these companies, however, had ever shown a net profit. Therefore, Reilly could not use the usual per share price over earnings ratio as the multiplier applied to earnings. Instead he resorted to market value of invested capital (MVIC) divided by revenues of each of the guideline companies (MVIC/revenue). [2] Medtronic assailed this method and demonstrated to the district court's satisfaction that the MVIC/revenue approach yielded values which fluctuated inexplicably over time in a manner unrelated to the fundamental financial performance of the companies. ¶ 28 The Minority failed to rebut Medtronic's evidence, although provided an opportunity to do so by the district court. Moreover, the Minority has failed to marshal the evidence in favor of the district court's finding and show the evidence to be insufficient. This omission augments our deference to the factual findings of the court below. See In re Estate of Bartell, 776 P.2d at 886. ¶ 29 The Minority attacks the district court's finding that the values fluctuated over time as violating the section 16-10a-1301(4) requirement that stocks be valued immediately before the contested corporate action. This argument fails, however, because the district court did not consider the results from diverse dates to actually arrive at a value for Zinetics, but instead to test the consistency and reliability of the valuation method. ¶ 30 For example, Medtronic demonstrated that using the median MVIC/revenue ratio for the guideline companies for 1994 and applying it to Zinetics' revenues for that same year yields a market value for Zinetics of $6.1 million in 1994 (based on Zinetics' revenue of $1.5 million), while the same exercise yields a market value of nearly $36 million in 1995 when Zinetics revenue was just over $2 million. Nothing in the record supports a 600% increase in market value based on a 33% increase in revenue. The apparent increase is an artifact resulting from the fluctuation of the MVIC/revenue per share of the guideline companies, which was approximately four in 1993-1994 and close to eighteen in 1994-1995. Furthermore, the MVIC/revenue value varies inversely with revenue. ¶ 31 In the face of such evidence, the district court stated that it [did] not believe that Mr. Reilly's methodology produces values for Zinetics . . . which would correspond to historical trends in the company's performance measured by revenue or net income. The court therefore concluded that Mr. Reilly's market approach, like Mr. Norman's, should be substantially disregarded as unreliable. We agree.
¶ 32 Having rejected both experts' market valuation models, the district court was left with only the investment value model upon which to rely. In Oakridge Energy, although neither party had submitted evidence of investment value, we noted that courts have traditionally favored investment value ... as the most important of the three elements. 937 P.2d at 133 (citing Dudley v. Mealey, 147 F.2d 268, 270 (2d Cir.1945), superseded on other grounds by statute as stated in In re B & W Enterprises, Inc., 713 F.2d 534 (9th Cir.1983); Woodward, 133 N.W.2d at 41). The Libby court found investment value to be a central component of fair value. 406 A.2d at 66. We cited Libby in Oakridge Energy for the proposition that `[t]he assets of a company are of value chiefly because of their earning capacity.' Oakridge Energy, 937 P.2d at 133 (quoting Libby, 406 A.2d at 66). ¶ 33 The income approach to value applies the discounting and capitalization methods to cash flows and net earnings, making a total of four components. Discounted cash flow calculations involve projections for a determined number of yearly or other future period cash flows and a terminal value of the company's cash flow. These are discounted using a discount rate describing the required return on equity capital. Generally, higher risk dictates a higher required rate of return. Discounted earnings calculations apply the same method to earnings. In capitalized cash flow calculations, a capitalization rate that assumes certain growth and quantifies risk is applied to a past year's average or a current year's actual cash flow. The same method using earnings yields capitalized earnings. ¶ 34 Employing only the discounted cash flow method, Reilly arrived at a per share value of 13.4 cents. Norman arrived at a value of 1.97 cents per share using a weighted average value of discounted cash flow, capitalized cash flow, discounted earnings and capitalized earnings methods and applying a marketability discount of 31.9%. Norman explicitly valued Zinetics as part of Synectics. ¶ 35 The district court selected Norman's investment method valuation model, observing that investment model valuation as a subsidiary of Synectics is the most reliable approach for valuing Zinetics. It found the data, projections, and analyses in the various schedules of Norman's report to be consistent with these criteria. The district court disregarded Reilly's valuation, noting only that Mr. Reilly limited his investment analysis to discounted cash flow. This unexplained rejection of Reilly's discounted cash flow valuation makes it difficult, if not impossible, for the Minority to marshal the evidence in favor of the court's decision and argue that it was insufficient. The Minority is left in the untenable position of having to guess at the basis of the court's decisionas indeed are we. The court has pointed to no specific flaw in Reilly's income valuation model, and none is obvious to us. ¶ 36 The court acknowledged a measure of merit in the Minority's criticisms that Norman had inexplicably reduced Zinetics projected earnings in 1998 from its actual 1997 earnings, considered only expected unit price increases for the catheters while disregarding inflation, and increased investor rate of return expectations using both a small cap company and a micro cap company adjustment. It identified no corresponding strengths in Norman's analysis. Therefore, the district court recalculated the investment value and reported that [w]hen the numbers proposed by [the Minority] for revenue, discount rate and capitalization rate are used to recalculat[e] Mr. Norman's investment valuations, the results do not exceed the $ .04528 per share offered by Medtronics for the respondent's common stock. ¶ 37 We note first that the district court was correct in recognizing the merit of Reilly's projections. Zinetics had enjoyed a history of robust growth and, furthermore, post merger events vindicated the Minority's optimistic income and cash flow projections. Former Zinetics President Davis testified that just before he left the company in April of 1999, gross sales had reached $600,000 per month. Reilly's initial revenue projections correspond closely to Davis' undisputed testimony that Zinetics' 1998-1999 revenues were between $4 million and $4.5 million. Norman's projections significantly underestimated reality, beginning at $2,846,854 for 1998. ¶ 38 The governing statute defines fair value as the value on the date of the merger, excluding changes in anticipation of the merger. Utah Code Ann. § 16-10a-1301(4) (1995). However, the statute contains no prohibition against employing hindsight to verify the value on the date of the merger, as long as the merger occasioned no change in that value. Oakridge Energy did not address this issue in the context before us here. ¶ 39 The trial transcript provides several salient observations from the district court regarding the distinction between a squeeze out merger and a typical dissenters' rights action. The district court remarked that in a dissenters' rights action, dissenters have at least the option to participate in the corporate action. However, a squeeze out merger amounts to a forced sale, with dissenters having no control over the decision to sell, the price, or the timing. We note that while it would be impermissible to consider post-merger increases above and beyond the pre-merger projections, post-merger information may be used to verify the projections. See Gonsalves v. Straight Arrow Publishers, Inc., 701 A.2d 357, 362 (Del.1997) (supporting consideration of post-merger evidence to support projections). ¶ 40 If, as the district court held, Medtronic did not suppress the value of Zinetics in anticipation of the merger, then there is no presumption that short-term post-merger gains were the result of the merger. Therefore, we hold that in the instant case checking projections against subsequent actuality does not conflict with the requirements of section 16-10a-1301(4). ¶ 41 We also agree with the court's approval of Reilly's discount and capitalization rate. However, the court's failure to show its calculations leaves us with a number of questions. First, discounted cash flow was the only analysis that Reilly performed. This appears to be adequate, since in Norman's analysis that result was close to the average of the results from the four methods. However, the court's memorandum decision refers to inserting the Minority's projections for revenue rather than cash flow into Norman's model. Furthermore, Reilly's exhibit XI (Discounted Cash Flow Synthesis) sets forth three scenarios valuing Zinetics, respectively, at $11,263,000, $3,811,000, and $12,096,000. Each is based on a separate set of five yearly projections and a terminal value. The court did not indicate which of these sets, or what combination, it inserted into Norman's model. Finally, the court did not indicate whether it restricted its calculations to substituting Reilly's numbers in Norman's discounted cash flow model only, or whether it included other models. ¶ 42 These omissions are troubling because when the direct capitalization multiple and the projected cash flows set forth in Reilly's exhibit XI for years one through five and the terminal values for each of the three scenarios are inserted into Norman's Schedule J (Zinetics Medical Inc. Discounted Cash Flows as Part of Synectics) and the final results are averaged and then divided by the number of shares outstanding, the result is substantially more than 4.528 cents per share. This is also the case using the values from either scenario one or three. Only scenario two yields a value per share of less than the amount offered. The choice among the three options, or the average of all three or any two, is a factual determination within the discretion of the district court. Yet the court has not explicitly made this determination. ¶ 43 Although the district court specifically approved Norman's investment valuation model, its later statement at least implies that if forced to choose between Norman's and Reilly's performance projections and discount/capitalization rates, it might choose Reilly's. The court interpreted the results of its calculations as eliminating the need for a choice. However, if Reilly's estimates operating in Norman's model yield a fair value of more than 4.528 cents per share, then a choice is necessary. Therefore, we approve the court's recognition of the factual validity of Reilly's estimates, as discussed above, and remand this case for recalculation. For each of Reilly's three scenarios, or whatever combination of the three the court chooses, it should (1) insert the cash flow projections for years one through five and the terminal values from Reilly's exhibit XI into the calculations shown in Norman's Schedule J; [3] (2) calculate the present value amount for each year's cash flow, using Norman's multiples for present value factor; (3) calculate the terminal value for each, using Norman's 0.17 present value factor but replacing Norman's 16.45% capitalization rate with Reilly's direct capitalization multiple of 6.67; and (4) add the yearly and terminal present values to obtain the cumulative present value. If the court has found that the value is best represented by a combination of Reilly's scenarios, the court should then average the cumulative present values obtained for the combination of scenarios the court has chosen, to obtain the total value of Zinetics. Finally, the court should divide the cumulative present value derived from the court's choice of one or a combination of scenarios by 128,806,800, the number of shares outstanding, to obtain the fair value per share.
¶ 44 Given the strong probability that the per share fair value derived by the method outlined above will be greater than 4.528 cents, we next address the issue of discounts. Norman's report states: All other things being equal, an interest in a business is worth more if it is readily marketable or, conversely, worth less if it is not.... There is not a ready market for [Zinetics'] stock. In our opinion, the fair value of Zinetics' stock would include a marketability discount. In the values that reflect the non-marketable nature of Zinetics' stock, we have applied a 31.93% discount. Norman further stated that [t]he market value of a security is impacted by the elements of control o[r] lack of control inherent in the block of stock being valued. Noting that [i]n this valuation, the 18.56% block of stock is clearly a minority position, Norman confirmed that [w]e have applied a 36.81% control premium when the value is identified to reflect a control position value. ¶ 45 Minority shares and shares considered non-marketable are subject in some contexts to discounts that place their value below a simple percentage of the total value of the corporation. Likewise, majority shares sometimes benefit from a control premium. However, a majority of courts that have addressed the issue of minority discounts has held that discounts at the shareholder level are inherently unfair to the minority shareholder who did not pick the timing of the transaction and is not in the position of a willing seller. Hansen, 957 P.2d at 41. Moreover, some courts have reasoned that valuing the shares at less than their proportionate share of the corporation's fair value produces a transfer of wealth from the minority shareholder to the shareholders in control. Id. As the Woodward court observed, contrasting dissenters' valuation with tax valuation, the statute is designed to protect the minority from the very considerations which resulted in a discounted value in the tax cases. By statute the minority is guaranteed the `real' value of its stock. 133 N.W.2d at 44. The Eighth Circuit Court of Appeals observed in Swope that [t]he American Law Institute explicitly confirms the interpretation of fair value as the proportionate share of the value of 100% of the equity, by entitling a dissenting shareholder to a `proportionate interest in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability.' 243 F.3d at 492 (quoting American Law Institute, Standards for Determining Fair Value, Principles of Corporate Governance: Analysis and Recommendations (ALI) § 7.22(a) (1994)); see also Utah Code Ann. § 16-10a-301(4). The Swope court explained that `fair value' in minority stock appraisal cases is not equivalent to `fair market value.' Dissenting shareholders, by nature, do not replicate the willing and ready buyers of the open market. Rather, they are unwilling sellers with no bargaining power. 243 F.3d at 492. ¶ 46 We agree and note that this is especially true of dissenting shareholders in a squeeze out merger. See Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1145 (Del.1989); Security State Bank v. Ziegeldorf, 554 N.W.2d 884, 890 (Iowa 1996); In re Valuation of Common Stock of McLoon Oil Co., 565 A.2d 997, 1002-05 (Me.1989); Rigel Corp. v. Cutchall, 245 Neb. 118, 511 N.W.2d 519, 525-26 (1994). Therefore, the court should not employ discounts in its valuation of the Minority's shares of Zinetics.