A warning to potential acquirors of distressed targets appears at the end of the Delaware Court of Chancery’s recent opinion in In re Tesla Motors, Inc. Stockholder Litigation.
The suit challenges the Tesla board’s decision to acquire SolarCity as an alleged bailout of a floundering company in which Tesla’s Elon Musk had a substantial economic interest. One of the claims on which the Court refused to grant the Tesla defendants’ motion for summary judgment, after reviewing the pre-trial evidence, was that the Tesla board’s decision to engage in the acquisition constituted “corporate waste.”
While Vice Chancellor Slights acknowledged that corporate waste claims have historically been difficult to establish, he concluded that proving waste “is not impossible” and then permitted the claim to survive the motion for summary judgement, reasoning:
“Plaintiffs claim they will show at trial that SolarCity was worth almost nothing when the Merger was consummated. If SolarCity was, in fact, insolvent when Tesla acquired it, that proof may well sustain a waste claim.”
A claim for corporate waste requires, as the opinion notes, the transaction in question to be “so one sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.” Furthermore, as the Court acknowledges, the rare waste claims on which plaintiffs have prevailed have been limited to “unconscionable cases where directors irrationally squander or give away corporate assets.”
But Vice Chancellor Slights’ holding nonetheless seems to imply that paying a premium for a company that is “worth almost nothing” on a stand-alone basis “may well” fall into the category of corporate waste and that the Court of Chancery is prepared to permit waste claims against fiduciaries of buyers of deeply distressed targets to survive pre-trial motions.
Significant purchase prices are regularly paid for targets (including unicorns and other start-ups) despite the fact that they are in “stealth mode” or otherwise “pre-revenue,” burning cash at a pace that has put them on the road to eventual insolvency or has left them without a foreseeable path to profitability. Moreover, a significant portion of new M&A activity in our current economic environment post-COVID-19 will likely consist of cash-rich companies competing to buy targets facing extreme liquidity crises.
Acquirors have their reasons for these acquisitions—for instance, they regularly attribute significant value to the brand, technology or other intellectual property, market position, founders, or key employees of these targets. What should boards and managements of purchasers do in response to Vice Chancellor Slights’ warning that paying a premium price for a target, which is arguably insolvent or otherwise worthless on a stand-alone basis, may be enough to sustain a waste claim against the fiduciaries of the acquiror (at least during pre-trial motions)?
- Management and corporate development teams for purchasers need to build records to support the substantive valuations used in these transactions.
- The record need not be based upon traditional discounted cash flow analyses or even a set of forecasts for the target on a stand-alone basis. The buyer need not obtain a fairness opinion either. Indeed, the record should be transparent about the challenges that the target faces to justify a stand-alone valuation of any significance.
- Most importantly though, the analysis should demonstrate how the acquisition will generate value for the acquiror and tie the acquisition’s rationale back to the buyer’s business lines and initiatives that are part of the board’s previously approved strategic plan.
- For acqui-hires, the analysis should detail the distinct skills and benefits that the target’s employee team brings to the acquiror, the business lines that these skills and benefits will support and the manner in which they will do so, as well as the broader financial and strategic justifications.
- For intellectual property and technology-focused acquisitions, the analysis should similarly detail the value proposition presented by these items: which business lines and initiatives will benefit and how, and the broader financial and strategic justifications.
- For acquisitions that will give the buyer a special market position, the analysis should explain the value of this position and tie that value back to the buyer’s strategic plan.
- Procedurally, the applicable officers and management overseeing the acquisition and, if the acquisition rises to the level that requires board approval per the board-adopted “sign and spend” policy, the directors need to review and hold meetings to receive and deliberate on the materials and analyses described above.
Vice Chancellor Slights’ warning was timely given the current downturn. Now the burden is on directors and officers to be sure they are taking the right affirmative steps when buying distressed targets so that these fiduciaries are positioned to defeat waste claims before having to endure a trial on these claims, as will be happening in the Tesla case.