Gearreald v. Just Care, Inc.: In Appraisal Proceeding, Court of Chancery Determines Fair Value of Company to Be $34 Million-$6 Million Less than Acquisition Price
June 5, 2012
In Gearreald v. Just Care, Inc., C.A. No. 5233-VCP (Del. Ch. Apr. 30, 2012), the Court of Chancery found in an appraisal proceeding that the fair value of Just Care, Inc. (“Just Care”) was $34,244,570, approximately $6 million less than the acquisition price.
Just Care—a privately held company that operates a private healthcare detention facility in South Carolina—was acquired in a strategic transaction for $40 million. The appraisal petitioners included Just Care’s founder and former CEO, who voted in favor of the merger as a director before voting against it as a stockholder, and Just Care’s CFO. The petitioners claimed that the fair value of Just Care as of the merger was $55.2 million; Just Care contended $33.6 million.
The Court relied upon a discounted cash flow analysis in determining fair value. Initially, the Court considered the credibility of Just Care’s management projections, which were prepared outside of the ordinary course and at a time when the CEO and CFO risked losing their positions if the acquisition bid succeeded and were trying to convince Just Care’s board to pursue different alternatives. Accordingly, the Court found that the projections were not entitled to the same deference usually afforded to contemporaneously prepared management projections. Additionally, the Court determined that an out-of-state expansion scenario included in the projections was too speculative to be included in the valuation of Just Care, which had operated only one facility in 11 years of existence.
In determining a discount rate for the DCF analysis, the Court stated that the correct capital structure for an appraisal of Just Care is the theoretical capital structure it would have maintained as a going concern. Specifically, changes to Just Care’s capital structure made in relation to the merger—in this case, Just Care’s paying off all debt as a condition of the merger—should not be considered in determining appraised value. Accordingly, the Court explained that it was inappropriate to apply Just Care’s actual capital structure as of the merger’s closing in the appraisal analysis.
The Court also applied an equity size premium to account for the higher rate of return demanded by investors to compensate for the greater risk associated with smaller companies. Both experts agreed that, by size alone, Just Care falls within Ibbotson decile 10b, which includes companies with market capitalizations of $1.6 million–$136 million, but the petitioners argued for the application of an equity size premium implied for larger decile 10a companies. Since one of the reasons investors demand higher returns from smaller companies is because smaller companies tend to be less liquid, the petitioners advocated applying a lower equity size premium to eliminate the “liquidity effect” contained within the size premium. While the Court agreed that a liquidity discount related to transactions between a company’s shareholders and other market participants is prohibited in an appraisal proceeding, the liquidity effect the petitioners advocated eliminating in this case arose in relation to transactions between Just Care and its providers of capital and, as such, was part of Just Care’s value as a going concern.