Appraisal rights litigation has been steadily rising in both the number of petitions filed and the dollar amounts at stake. Historically, appraisal rights litigation has been considered risky due to the wide discretion the court has under statute to determine fair value. This type of litigation is seen as costly, as a trial usually involves extensive expert testimony regarding the different methods on which the court can call to determine fair value.
Appraisal rights litigation is popular in Delaware for a multitude of reasons. Delaware courts have awarded a higher determination of fair value than the merger price in seven of the nine cases from June 2010 to June 2014. Although pending legislative proposals may permit corporations to avoid this, Delaware also has awarded statutorily-prescribed interest well above market rates—5 percent above the Federal discount rate, compounded quarterly and accruing from the closing date of the transaction to the date the appraisal award is actually paid. Another key factor appears to be the rise in shareholder activism and hedge funds looking to maximize profits on mergers and acquisitions.
A point for debate in the arena of appraisal rights litigation involves the treatment of stock compensation as an expense when determining fair value. Most investment firms recognize that expense when determining fair value of a company’s shares. However, a 2013 opinion by the Delaware Court of Chancery in Merion Capital, L.P. v. 3M Cogent, Inc. excluded stock compensation as an expense when determining fair value.
Starting in 2006, the Financial Accounting Standards Board required all firms to recognize stock-based compensation as a cash expense. Essentially, even though the stock-based compensation is non-cash in nature when distributed, there will be a dilutive impact when the options are exercised. As a result, many firms in the investment world treat stock-based compensation as a cash expense because there will be a dilutive impact in the future. By treating it as a cash expense when determining fair value, a more accurate assessment of fair value is achieved.
In Merion Capital, L.P. v. 3M Cogent, Inc., Vice Chancellor Donald F. Parsons declined to count stock-based compensation in a discounted cash flow analysis because there was no showing it would have any effect on the actual cash flows of 3M Cogent. In a more recent case, In re Appraisal of Ancestry.com, Inc., the respondent, Ancestry.com, argued that a failure to account for stock-based compensation expenses with a discounted cash flow analysis might result in overvaluation. Vice Chancellor Sam Glasscock III agreed, reasoning that stock-based compensation must be accounted for somehow once it reaches a “material level.”
Stock-based compensation must be measured, either by counting it as a cash expense or measuring its dilutive effect. Stock-based compensation is viewed by the financial industry as a cash expense since stock acts as a quasi-currency because the stockholder or employee accepts stock in lieu of actual cash. Due to this view, the financial industry’s practices are at odds with the decision in Merion Capital, L.P. v. 3M Cogent, Inc. to leave out stock-based compensation.
The financial industry includes stock based compensation as a cash expense because there will be a dilutive impact on the company’s shareholders in the future. Because fair value should take into account all material costs, accounting for stock based compensation as a cash expense will most accurately reflect the value of the company being appraised. In the interest of achieving the most appropriate estimate of fair value, the Court of Chancery, when faced with appraisal litigation, should account for stock based compensation as a cash expense.
John Gentile is a Volume 40 Articles Editor of the Delaware Journal of Corporate Law. John serves as a Judicial Extern to the Honorable Karen L. Valihura of the Supreme Court of Delaware, and he is currently in the process of completing the Business Organizations Law Certificate Program.
Suggested Citation: John Gentile, Stock-Based Compensation as a Cash Expense in Appraisal Rights Litigation, Del. J. Corp. L (Mar. 21, 2015), www.djcl.org/blog.