An Empirical Walk Down Valuation Way: Are the Valuation Methods of Closely Held Companies Chosen by the Courts a Function of the Type of Case and Level of Court?
DiGabriele, James A., Journal of Legal Economics
This study investigates whether the valuation methods of closely held companies chosen by courts are a function of type of case and level of court. The results of the current study indicate there appear to be systematic trends in court preferences for various valuation methods and approaches. While there is a high degree of variability even among cases with very similar characteristics, the systematic trends presented in the current study provide an empirical basis for making decisions regarding which valuation method or methods to proposed to the court. In addition, these findings further indicate that individuals involved in selecting the valuation method or methods to be proposed to the court need to attend to macro-economic factors in addition to the specifics of the individual case.
Judges are routinely faced with assessing the equity value of a company in bankruptcy, merger and acquisitions, securities, tax, and other litigation. In the United States, an appraisal (valuation) right is a common law remedy to compensate minority shareholders for the weakening of their control rights over the years. Throughout much of the 19th century, shareholders of corporations were viewed as having a binding contract that ensured their firm would continue its operations as it had in the past. This meant minority stockholders had the right to veto fundamental corporate changes; if the majority wanted change despite their veto, the majority would have to buy out dissenters at a negotiated price (Weiss 1981; Thompson 1995; Wertheimer 1998).
In the era of the 1930s Great Depression, Delaware case law developed a valuation method that, by the late 1970's became known as the Delaware Block Method. By 1983, virtually all American courts of corporate law used a version of the Delaware Block Method for the valuation of stock. The Block Method estimates fair value as a weighted average of pre-merger market price, net asset value, and capitalized earnings value. As explained by a Delaware judge, the purpose of staying within a weighting framework is to render the valuation process a little less arbitrary (Yee 2002).
The underlying reasons for this type of judicial valuation are based on two prevailing assumptions. First, it is assumed that market price does not necessarily reflect fair value. Second, it is assumed that valuation is an art rather than a science. Considering this position, the Delaware Supreme Court also agreed with the weighing of valuation evidence in the appraisal process, highlighting the broad valuation preference of the Court of Chancery. The general rule is that in determining the actual value of stock, consideration should be given to the other relevant factors of value including earnings, dividends, market price, assets, and any other pertinent factors. Obviously, the Block Method is subject to tremendous subjectivity in application, allowing Judges great latitude in how they fix the weighing factors (Yee 2002).
This subjectivity surrounds a fundamental premise of judicial valuation in corporate law: markets are subject to inefficiencies and, correspondingly, judges are justified if they choose to ignore market prices. Again, this traces back to an influential Delaware Court of Chancery opinion during the Great Depression. The Chancellor stated that markets are known to gyrate in a single day. The court should not review the numerous causes that contribute to their nervous leaps from gloom to zeal and then back again from bliss to sorrow. It would be unfortunate either for the consolidated corporation or for the dissenting stockholder if, on the particular date that is designated by statute for the valuation of the dissenter's stock, the date of the consolidation, the market should be in one of its extreme moods and the stock had to be paid for at the price fixed by the quotations of that day (Yee 2002).
Judges usually are not experts in financial theory or valuation, and as a result, courts have frequently struck a compromise between values in an effort to streamline efficiency. …