In mid-2013, Vice Chancellor Donald F. Parsons issued an opinion regarding the fair value of Cogent, which was acquired by 3M in December of 2010. Stockholders of Cogent filed suit against the board of the newly formed 3M Cogent, claiming that the merger price of $10.50 per share was unfair and that the more appropriate valuation was $16.26 per share, quite a bit higher than the $10.12 per share calculated by 3M Cogent’s valuation experts. Utilizing a discounted cash flow (“DCF”) analysis, 3M Cogent’s experts factored in the notion that Cogent utilizes stock-based compensation. Vice Chancellor Parsons concluded that stock-based compensation was not to be treated as a cash expense in this case, and therefore it was inappropriate to use it in determining the lower fair value estimate.
Vice Chancellor Parsons pointed to research that illustrated how stock-based compensation affects a company’s cash flow. Vice Chancellor Parsons’s research stated that since stock-based compensation is not a direct cash expense, it is not apparent how it factors into the DCF analysis. The research he cited illustrates two points regarding stock-based compensation: (1) it can have a positive tax treatment for the company; and (2) it can have the effect of diluting value from the company. These two effects can potentially have an effect on the cash flow of the company as well.
While issuing stock is not a cash expense, it does cause the cash flow of the company to fluctuate. One of these fluctuations is caused by the tax treatment, or lack thereof, that the issuance of stock options receives. By not paying employees in taxable cash, companies are effectively saving money by not having to pay employment taxes on cash salaries. These tax savings are reflected in a company’s operating cash flow, and the impact of the savings varies from company to company. If it can be shown that the tax savings significantly affected a company’s operating cash flow, then it would be beneficial to figure this benefit gained from stock-based compensation into the DCF analysis.
The second way in which stock-based compensation affects a company’s cash flow is through dilution of outstanding shares. Issuing outstanding shares to employees as compensation will decrease the value of the current outstanding shares, thus causing dilution. To make up for this dilution, a company will need to conduct buybacks of shares to offset the new issuances, or the shares will trade at a lower price, which ultimately reduces the value of shares for each shareholder. Therefore, stock-based compensation can be an operating expense when done in excess.
Ultimately, Vice Chancellor Parsons ruled that stock-based compensation was not a relevant factor to be taken into account in a valuation analysis. 3M Cogent did not make a showing that the stock-based compensation would have an impact on the company’s cash flow, and therefore it was not an appropriate factor to be considered. According to Vice Chancellor Parsons, an expert would have to illustrate how stock-based compensation affects the operating cash flow of the company. If the expert was unable to opine on the correlation, then the evidence cannot be used in a DCF analysis.
Vice Chancellor Parsons ruled correctly in this case. The party seeking to have stock-based compensation used in the DCF analysis must provide evidence that illustrates the way in which stock-based compensation offsets the DCF analysis. Absent any kind of record evidence, it is impossible for the Court to make a ruling in favor of adjusting the price per share according to the impact of stock based. In another recent appraisal opinion, In re Appraisal of Ancestry.com, Inc., Vice Chancellor Glasscock ruled that stock based compensation should be factored into the discounted cash flow analysis. Respondent’s financial experts presented evidence that showed the importance of accounting for stock-based compensation when evaluating the value of a company, and Vice Chancellor Glasscock agreed. That being said, it is crucial that lawyers check on their financial experts to ensure they are presenting evidence to support their conclusion regarding the inclusion of stock based compensation in the discounted cash flow analysis. Otherwise, a court will have no way to give effect to such compensation.
Alexander Faris is a second year law student at Delaware Law School. Alex is currently a staff member on the Delaware Journal of Corporate Law, and looks forward to stepping into his new role as Internal Managing Editor of the Journal this spring. In addition to serving on the Journal, Alex is also a member of the Transactional Law Honor Society and is pursuing the Business Organizations Law Certificate.
Suggested Citation: Alexander Faris, 3M Cogent Appraisal Litigation—Stock Based Compensation as a Factor in the Discounted Cash Flow Analysis—Parsons’s Side of the Table, Del. J. Corp. L. (Apr. 2, 2015), www.djcl.org/blog.