Chancery Finds Deal Price is the “Least Bad” Methodology to Appraise Fair Value of an Early-Stage Company—FairXchange

In Hyde Park v. FairXchange (July 30, 2024), the petitioner sought appraisal by the Court of Chancery of its shares of FairXchange, LLC ("FairX"), a nascent securities exchange that was acquired by Coinbase Global, Inc. Although neither party argued for reliance on the deal price to determine appraised fair value, and the court viewed the sale process as seriously flawed, the court held that reliance on the deal price was the "least bad" methodology to determine appraised fair value of an early-stage company with a plan to disrupt the market and no track record. Vice Chancellor Laster determined fair value to be equal to the deal price-$330 million (equating to $10.42 per share). The petitioner had proposed a valuation of $573 million, based on a DCF analysis; and the respondent had proposed a valuation of not more than $150 million, based on certain market-based factors.

Key Points

• The decision highlights the difficulty in determining appraised fair value for this type of early-stage company. The court stressed that, with respect to early-stage companies with plans to disrupt the market and no track record, it is particularly difficult to determine appraised fair value (that is, going concern value of the company on the merger closing date, without taking the merger into consideration). The court concluded there was no "persuasive methodology" to determine fair value in this context, where a company in just a few years easily could be either a unicorn worth billions or a company worth zero. The court relied on the deal price, finding it to be the "least bad" methodology under these circumstances.
  
  
• The court rejected reliance on a DCF analysis. For a DCF analysis to be reliable, the company's projections must be reliable. In the context of this type of early-stage company, FairX's projections-although they had been prepared in the ordinary course and used to support bank and equity financings-were "too speculative" to be reliable, the court held. Notably, the court gave "some weight" to the fact that FairX's stockholders, who were sophisticated investors, approved the merger-meaning, the court stated, that they did not credit the projections. We note that the court's analysis would not apply to other types of early-stage companies-such as, say, pharmaceutical companies that develop new drugs, which also face risks and uncertainty, but operate within an established industry with parallel established markets that demonstrate how drugs are commercialized.
  
  
• The court largely rejected reliance on the past valuations that supported FairX's financing rounds. The most recent round had failed due to, allegedly, manipulation of the process by a third party; and the prior, completed round was based on information that was already stale. Beyond these particular issues, the court stated more generally that reliance on financing rounds would provide only weak evidence of fair value, given that the negotiations on price and terms are so intertwined that the value of a round only reflects the value of the company "for purposes of investors who are investing under a specific set of terms."
  
  
• The court relied on the deal price, notwithstanding that the sale process was seriously flawed. The court compared FairX to an ancient coin, rare baseball card, or piece of art-stating that such non-cash generating assets are worth whatever someone is willing pay for them. We would note that, for an early-stage company with a disruptive plan and no track record, the deal price reflects, almost entirely, not going concern value as a stand-alone enterprise, but the target's option value-that is, what the buyer was willing to pay for the chance that a company with no cash generation and no track record may be worth billions in its near-term future. Moreover, in FairX, the deal price also was unreliable because the sale process was seriously flawed, with value clearly "left on the table." The court viewed the deal price as the "least bad" methodology for determining fair value in this context, however.
  
  
• The court may rely on appraisal methodologies other than those advocated by the parties. The court emphasized that, notwithstanding the Delaware Supreme Court's decision in Aruba (2019), the Delaware appraisal statute and case law make clear that the Court of Chancery has the power to make its own valuation determinations and can rely on methodologies even if not proposed by the parties.

Background. FairX catered to retail investors who wanted to trade commodity futures. It had built "a world-class trading platform," with "fast, reliable and adaptable technology" that could also be used for retail trading in cryptocurrency futures. The company "sought to achieve great things." Like the Robinhood trading platform that had used a disruptive market-maker-pays business model to bring low-cost trading in equity securities to retail users, FairX sought to do the same for futures. From September 2021 to February 2022, large cryptocurrency players sought to become vertically integrated by acquiring early-stage companies that ran exchanges. Although all the targets were in the early stages of development with uncertain futures, the amounts the acquirors were willing to pay for them soared.

During this time, a bidding contest for one of FairX's peers-ErisX-resulted in a $550 million purchase price. After the ErisX sale, the FairX CEO then "desperately wanted a near-term exit of his own." (FairX's CEO had founded ErisX, but left after disputes with the firm's lead investor and so had obtained no benefit from ErisX's sale.) Without board approval, the CEO initiated discussions with Coinbase about its acquiring FairX. Despite having no experience in M&A matters, he then led the process, rejected advice to institute a banker-led process, and discouraged competition in the process.

On January 11, 2022, the parties executed the Merger Agreement, pursuant to which Coinbase agreed to acquire FairX for $330 million ($265 million in Coinbase stock and $65 million in cash). In the Merger Agreement, FairX's CEO and the other selling stockholders (the "Selling Stockholders") agreed to indemnify Coinbase for any post-closing appraisal award that exceeded the merger consideration. The merger closed on February 1, 2022. Between signing and closing, Coinbase's stock price declined, reducing the value of the consideration to $310.4 million. After the closing, two venture capital funds managed by Hyde Park Venture Partners sought appraisal. Pre-merger, Hyde Park owned about 15% of FairX's equity. Hyde Park's partner who served on FairX's board had been removed when he criticized the sale process.

Discussion

As a particular type of early-stage company, FairX was particularly hard to value. The court noted that FairX (i) was "privatelyheld, so it lack[ed] a public market for its shares"-which "eliminate[d] a potentiallyreliable valuation indicator while also making it difficult to construct valuation ratiosto use in a comparable companies or comparable transactions analysis"; (ii) "was still at an early stage in its growth," so it did not yet generate free cash flow; and (iii) "was pursuing a disruptive business model that would likely generate binary results"-that is, "either the Company would succeed brilliantly, or it would go to zero." The court concluded that there was "not a persuasive methodology for arriving at fair value" under these circumstances, but that, "[on] this record, the least bad methodology [was] the deal price."

The court rejected Hyde Park's DCF-based valuation, as the company's projections were "too speculative." The court noted that, as a DCF analysis values a company based on the "expected value of [its] future cash flows, discounted to present value in a mannerthat accounts for risk," withoutreliable projections any values generated by the analysis are meaningless. The court wrote: "The difficulty lies in FairX's disruptive business model. No one had ever tried to do what FairX hoped to accomplish for retail futures trading…. Management's projections reflected how FairX would perform if everything went according to plan. Projecting results for a new business is inherently speculative…. The projections that FairX management created are too speculative to use. They represent FairX's hoped-for reality, not its operative reality." Further, the court noted, although the Hyde Park partner on FairX's board had sent a letter to FairX's stockholders urging them not to support the merger because FairX "could be worth at least $1 billion by the end of 2022," the stockholders, who were sophisticated investors, supported the merger "rather than banking on FairX's success." And even the Hyde Park partner "thought it was a coin flip, 50/50, as to whether FairX would make the…projections."

The court largely rejected the Selling Stockholders' proposed methodologies.

• Financing rounds.The court acknowledged that financing rounds have the advantage of being negotiated transactions. However, the court stated, financing rounds do not begin with negotiation over price and then shift to bargaining over terms. Instead, they involve both at once, "result[ing] in tradeoffs between the price term and non-price terms." Therefore, the value of a financing round is "squishy," as it "reflects the value of the company for purposes of investors who are investing under a specific set of terms." Further, the court found that the evidentiary value of FairX's last financing round (reflecting a pre-money valuation of $150 million) was "weak," as it had been abandoned after, allegedly, the round was manipulated by a third party, causing a potential lead investor to delay its response to the company. The prior financing round, which was completed (reflecting a pre-money valuation of $100 million), was based on information that had become stale, as thereafter FairX "hit multiple milestones," including successful demonstration of its technology, additional broker and market-maker partners, and increased trading volume.
  
  
• Other proposed methodologies. The court rejected the Selling Stockholders' proposed reliance on: (i) a comparable transaction analysis-finding that the $64 million transaction was not comparable, as the company was not a competitor of FairX, had pursued a non-disruptive business model, used antiquated technology, and had no path to offering crypto products; (ii) Hyde Park's internal valuation of its investment in FairX-$100 million, which represented book value, as was "permitted under accounting rules" but not reflective of going concern value; and (iii) a Rule 409A valuation-$0.59 per share, which was stale and also unreliable because it was obtained for the purpose of valuing options for employees (creating an incentive for a low valuation).
  
  
• Other factors undercutting the Selling Stockholders' arguments.(i) The court viewed the Selling Stockholders as having "constructed a litigation narrative" after signing the Merger Agreement, when it learned about appraisal proceedings for the first time at a meeting with Delaware counsel. After the meeting, management revised its earlier, optimistic projections; and created an "Outline of [FairX's] Operative Reality Today," laying out "a narrative…to portray the sale to Coinbase as the only option for a company with zero prospects and virtually no chance of success." (ii) The Selling Stockholders did not offer "a specific assessment of fair value," but offered only that fair value was "no more than ~$150 million." (iii) The Selling Stockholders' position on valuation "evolved over the course of the case"-with an expert's opinion at the outset that fair value was lower than the value of the merger consideration on the merger closing date ($310.4 million); a pre-trial brief argument that fair value was "about $154 million"; and a post-trial brief argument that fair value was "no more than ~$150 million."

The court viewed the sale process as seriously flawed. The court stressed that deal price was a "not perfect" methodology under these circumstances, including because the sale process was seriously flawed. The court referred to the sale process as involving "a thirsty and inexperienced CEO negotiating hurriedly from a position of weakness" against Coinbase. FairX's CEO had approached Coinbase about a potential acquisition without board approval; ignored advice from many quarters that the sale process should be led by bankers; committed himself to a deal with Coinbase and discouraged competitive bids (and told Coinbase as much); did not keep the board informed; repeatedly made "rookie mistakes" and "blunders"; and made "soft" requests for a higher bid from Coinbase while focusing on negotiations to "optimize his personal payout." The sale process flaws "all fell on FairX's side of the ledger," the court stated. The CEO "left value on the table," resulting in "the deal price in this case operat[ing] as a probable floor, not a ceiling." Nonetheless, given the unreliability of the alternative methodologies, the court found the deal price was the least bad option.

The court rejected making any adjustment to the deal price. The court rejected any deduction of merger synergies from the deal price because, although the Selling Stockholders argued that Coinbase "must have" expected substantial synergies, "no one attempted to quantify them." The court rejected any adjustment to the deal price for a change in value between signing and closing because, although there was a decline in Coinbase's stock price that caused the value of the merger consideration to decrease, "a decline in an acquirer's stock price does not necessarily correspond to a change in the target's value, particularly when the acquirer is comparatively large and the target comparatively small."

The court can make its own appraisal determination if it finds the parties' methodologies unpersuasive. The Delaware Supreme Court had reversed Vice Chancellor Laster's appraisal decision in Aruba on the basis that in that case the Vice Chancellor relied on unaffected trading price when both parties had argued only for reliance on the DCF methodology. The Supreme Court stressed in its Aruba opinion that, because the unaffected market price methodology had not been proposed by the parties, it had not been "subjected to the crucible of pretrial discovery, expert depositions, cross-expert rebuttal, expert testimony at trial, and cross examination at trial." In FairX, Vice Chancellor Laster rejected FairX's argument that the lesson from Aruba is that the court cannot rely on any valuation methodology that the parties themselves did not advance. The Vice Chancellor stated that Aruba "feels like a decision censuring the trial judge for acting improperly in that specific case," and that there was no indication of any intention by the Supreme Court "to set out a new framework for appraisal cases in which the trial court lacks the power to make its own valuation determination." The Vice Chancellor stressed that Delaware's appraisal statute and case law are clear that the trial court has the burden of determining fair value in appraisal cases-and, "when neither party establishes a value that is persuasive, the court itself must make [the] determination based upon its own analysis."

Practice Points

• Early-stage companies, with disruptive plans and no track record, should keep in mind the characteristics the court found rendered certain methodologies unreliable as indicators of fair value in that context.

• DCF and projections. If proposing reliance on a DCF analysis, a party should address why the projections are not too speculative to be reliable, notwithstanding the company's lack of a track record and uncertain future. In other words, the party should point to firm anchors to assumptions in the projections. For example, if the company's plans call for creating a new market that does not yet exist, there may be an existing, parallel market that would provide a sufficient underpinning for the projections.

• Financing rounds. Failure of a financing round may indicate that the company was not worth the pre-money valuation on which the round was conducted. Where a party argues that a financing round is a reliable indicator of fair value, the party should explain the extent to which negotiations on price took precedence over negotiations on terms; and why the information is not stale (taking into account any milestones achieved after the round).

• A company-respondent should avoid the actions the court viewed as undercutting the Selling Stockholders' appraisal arguments.

• Documents should not be created that appear to be made-for-litigation in anticipation of a potential appraisal proceeding-such as revising earlier, optimistic projections without explaining a clear business basis for doing so, and creating documents that lay out a favorable narrative seemingly unsupported by the facts.Use of highly legal terms (for example, "operative reality") should be avoided in business documents, as they may create the impression that the documents were prepared in anticipation of litigation.
  
  
• The court is likely to prefer a "specific assessment" of fair value as compared to a proposed range, floor, or ceiling.
  
  
• A party's proposed fair value determination should not "evolve" over the course of the proceeding, or at least, an explanation of any changes over time should be provided.
  
  
• A party seeking adjustment of the merger price to exclude synergies arising from the merger (which can be positive or negative), should provide evidence of the expected synergies so that, if the court relies on deal price, it will adjust the deal price accordingly.
  
  
• We would note, although the court did not address this, that careful consider consideration should be given to the benefits and disadvantages of removing a director who has criticized the sale process.

• Care must be taken not only with formal corporate communications but also informal communications. In FairX, the CEO's emails and oral communications provided evidence that he was "apoplectic" after the ErisX sale and "desperate" to benefit from a similar sale of FairX. Also of note, the court noted five separate times in the opinion that, while the CEO did not transmit a key email to the board, he had transmitted it to his spouse. These emails included the CEO's initial indication of price to Coinbase; Coinbase's initial letter of intent; and an exchange with a Coinbase deal team member emphasizing his commitment to a deal with Coinbase. The court also noted that the CEO's spouse drafted a conciliatory email for the CEO to send to one of the other FairX directors who had expressed concerns about the process.
  
  
• The court often exposes sale process flaws in detail-even when not directly relevant to the court's analysis or holdings. We have noted in other Briefings the court's trend in recent years to call out sale process flaws and name names. In FairX, the sale process flaws were not central to the court's analysis or result (indeed, they cut against reliance on the sale process). Nonetheless, over 32 pages of the 62-page opinion, the court described the sale process flaws in detail.
  
  
• Merger agreement provisions. A buyer may wish to consider negotiating to obtain (as Coinbase did in FairX) a right to be indemnified in the event an appraisal award exceeds the deal price (possibly subject to a cap). Similarly, a seller might wish to seek entitlement to indemnification if an appraisal award is less than the deal price. Such provisions can offer an alternative to an appraisal condition in allocating appraisal risk.

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