A fairness opinion is a written determination that a proposed transaction is “substantially fair from a financial point of view.” A typical fairness opinion addresses whether the sale of a company is fair to the selling shareholders or whether a “down round” financing is fair to the non-participating shareholders. But there are other forms of opinions: for example, when a company is selling a division or making an acquisition.
Fairness opinions are not required in every transaction, however corporate directors, especially independent directors, often want such an opinion before proceeding with a merger or other transaction. This is especially true when for publicly traded companies, for venture-backed companies which are selling for an amount near the value of the liquidation preferences, or for companies going through a recapitalization and dilutive financing.
Growing Pressure for Independent Fairness Opinions
Historically, directors looked to the investment bank advising on the transaction to provide an opinion. However, rulings from the Delaware Chancery Court question the wisdom of this.
For example, in a 2005 decision about the acquisition of TCI by AT&T, the court criticized the decision of the Special Committee of TCI to use the same financial advisor as the company, especially since that investment bank stood to earn a contingent fee only if the deal closed. (In re Tele-Communications, Inc. Shareholders Litigation, No. 16470.)
There was hope that the SEC would address this issue – and it went part way in 2007 with FINRA Rule 2290, requiring than an investment bank disclose the conflict of interest when it both earns a transaction fee and provides both a fairness opinion. But, for a Board of Directors or Special Committee that wants to go a step further and obtain a truly independent fairness opinion, Teknos can offer expert advice and sound counsel for a reasonable fee.
Fiduciary Risk to Venture Capital Directors in Financings and Sales
Two recent decisions from the Delaware Chancery Court have highlighted the potential risks to venture capital directors of companies in financings and sales.
In one case, a venture-backed software company, Trados, sold for slightly less than the amount of the liquidation preferences, which meant that all of the proceeds went to the preferred stockholders and management, leaving nothing for common stockholders. In a final judgement, the court found that venture capital directors, management directors, and even an outside director were not independent and, for that reason, the sale of the company needed to meet the test of “entire fairness.” Entire fairness is a two pronged test—fair process and fair price—and the directors failed the first part of the test because of the manner in which the sale process was handled, the creation of a management carve-out, the failure to consider forming a special committee or obtaining a fairness opinion, and the failure to obtain vote of the majority of the disinterested shareholders. (In Re Trados Shareholder Litigation, No 1512.)
In the other case, another venture-backed software company, Bloodhound Technologies, was put through a series of down round financings by a syndicate of venture capital firms, effectively washing out the founders, before the company eventually was sold for five times what had been invested. In a summary judgment, the court found that the venture capital directors and management directors were not independent (and even that creation of a management carve-out for 19% of the proceeds of the sale supported a “reasonable inference that the merger was unfair”) and allowed the plaintiffs to proceed toward trial. The case was subsequently settled, but the danger for venture directors in down round financings is clear. (Carsanaro v. Bloodhound Technologies, Inc., No. 7301.)
See our white paper on Fiduciary Risks for Venture Directors in Financings and Sales.
Current Thinking About “Fairness”
At present, there is no basis against which to judge whether a transaction is substantively fair. This can lead to different interpretations of the proper standard to use. At a minimum, the consideration received in a sale or paid in a purchase must be no less than the value of what is tendered.
Beyond that, some believe that fairness must be considered relative to what other shareholders or parties receive (e.g. examine different treatment for control shareholders or generous consulting and non-compete payments for managers). Fairness also must consider other factors: comparing cash versus non-cash or contingent consideration, coordinating and evaluating competing offers, and judging the likelihood of completion of any offer. Finally, fairness must not utilize overly broad ranges or assumptions biased only in one direction – it must be meaningfully fair.
Elements of a Good Fairness Opinion
A good fairness opinion follows strong procedural guidelines and also scrutinizes the economic substance of the proposed transaction. The professionals at Teknos understand valuation techniques and the special requirements of technology companies. We utilize a variety of different valuation approaches, examining everything from historical trading in the company’s stock (if the company is public) to current acquisition premiums being paid to the discounted value of projected earnings.
In addition to providing the traditional opinion letter which forms the core of a fairness opinion, Teknos completes an extensive written analysis and explains that to the Board of Directors or Special Committee, both before execution of the transaction documents and again just prior to the closing. We have performed fairness evaluations in connection with purchases, sales, inside financings and other transactions and opinions by our team members have been included in SEC filings.
Teknos would be pleased to provide a proposal for a fairness opinion in connection with a transaction. We can complete our work rapidly, if necessary, and our fees are reasonable, varying with the size and complexity of the proposed transaction. For more information please contact us: firstname.lastname@example.org
Disclaimer: Teknos Associates provided expert witness testimony in connection with the Trados case. However, our comments on the case are based only on information which is in the public record and the opinions in the whitepaper are those only of Teknos Associates and may not be taken to represent the position of any of the litigants or law firms involved in the case.