3.3.6.1.1 Delaware block method:• weighted average method

The Delaware "weighted average" approach, not binding in nature,1 is widely recognized by courts in different states when valuing dissenters' shares. In applying this method, courts first determine a corporation's market value, net assets value, and earnings value and then assign a reasonable weight to each element based on individual circumstances.2

The market price is of little use for a closely held corporation since shares are not publicly traded in such companies. Even for a public company, the market price alone is not sufficient to decide the value of a company because market value may be affected by the adverse impact resulting from the board or the controlling shareholders. For example, as we all know, market prices can fluctuate dramatically, and not surprisingly, a transaction may well be timed by the controller, or the value of the shares may be purposely decreased before the transaction. One example is the insiders paying themselves $200,000 in bonuses in the financial reporting period prior to the proposed cash-out merger. These bonuses lowered the corporation's reported earnings and kept its stock price from rising.3

Net assets value is the "current fair market value of the corporation's assets on a going concern basis",4 which means fair value should not be based on liquidation value, at least if the corporation has no plan to liquidate at the time of the transaction which give rise to appraisal rights.5 Any cost-based accounting method, like the book value method,6 in which assets are recorded at their cost or at a lower amount if the assets have decreased,7 leads to a gross undervaluation of shares because neither appreciation nor value of intangible assets is recorded in the balance sheet.

The corporation's earnings value is determined by dividing the corporation's earnings per share by an appropriately chosen capitalization rate.8 There are two components in this method: (1) net earnings per share, and (2) a proper capitalization rate.

Eamings per share can be the averaged eaming over the past three years, the last 5 years or any other time period which is considered proper.9 "Past earnings are relevant only to the extent that they serve as a reliable proxy for future eamings."10 The proper capitalization rate is the reciprocal of a properly decided multiplier which can be based on the price/eamings (P/E) ratio.11 For example, corporation A's averaged net eamings in the last three years were $5 per share. If the P/E ratio of Corporation A is 25, the proper capitalization rate is 1/25, which is 0.04. The stock price in corporation A is $125 per share ($5/0.04). However, since the price of the stock is unknown in the valuation stage, and therefore the P in the P/E ratio is unknown, a proper capitalization rate is usually decided by referring to comparable corporations with known P/E ratios.12

Courts first find several industry peers of the target corporation with reviewable financial information, calculate their ratios, and subsequently make adjustments to the derived ratio to reflect differences between the comparable corporations and the target corporation.13 In particular, if a ratio is derived by comparison to public companies in the same industry, to arrive at a fair value for a private company, an upward multiplier (or a downward ratio) adjustment is needed because the price for shares trading on the market reflects the fact of a small quantity of stock, i.e. minority shares, not the pro rata value of the corporation as a whole; and thus, the price bears an implied discount.14

A famous case to illustrate how the Delaware block method works is Piemonte v. New Boston Garden Corp.15 Plaintiffs in this case were stockholders in Boston Garden Arena Corporation. A Massachusetts corporation wanted to merge with the defendant corporation. The plaintiffs invoked the appraisal remedy for a fair value of their shares. Garden Arena had a wholly owned subsidiary which owned a franchise called Boston Bruins and a corporation known as Boston Braves. Garden Arena also operated Boston Garden and a corporation operating a food and beverage concession at the Boston Garden. The judge determined (1) the market value of Garden Arena stock at $ 26.50 per share, with 10% weight, because the shares were thinly traded on Boston Stock Exchange; (2) net assets value as $103.16 per share, weighted 50%; and (3) the eamings value as $52.60. The judge first determined that the average eamings per share for the last five fiscal years was $5.26, and then he applied a capitalized ratio of 1/10, in other words, a multiplier of 10. He gave this category 40% weight. An appraiser's choice of a multiplier is largely discretionary and will be upheld if it is within the range of reason.16 Finally, the court set the fair value of each share at $75.27.

The appellate court concluded that "the judge's method of valuing the Garden Arena stock was essentially correct",17 and "the judge followed acceptable procedures in valuing the Garden Arena stock; his determinations were generally within the range of discretion accorded a fact finder."18 But the case was remanded for further consideration of the valuation of Boston Garden, the Bruins franchise, and the concession operation, because the statements made by the judge showed that he had failed to make his own judgment on the price of these three entities.19 The appellate court required a determination of the value made by the judge himself.20 The judge might arrive at the same price as either party's expert, but he was not obliged to accept their appraised price.

This weighted average method has been in use for decades. It is, however, substantially different from the methods of valuation used in the real world.21 This mechanical approach to appraisals is more often than not unfavourable to the interests of dissenting shareholders, and it is not in accordance with current financial methods of valuation which are more forward looking.22 Bainbridge criticizes the block method in his book: "The three factors have very linie to do with each other, are based on radically different assumptions and methodologies and thus can lead to widely divergent results."23 In fact, there is nothing wrong with the averaged method itself, but the problem is that the court should not routinely assume three fixed methods for every case. In different situations, different valuation methods are needed, subject to the attributes of the company. In consequence, the court in Weinberger opened up possibilities to all methods of valuation "generally considered acceptable in the financial community."24