Is the price right?
Cover all the bases with a fairness opinion

When a company is about to embark on a major transaction — such as a merger or acquisition — having an objective outsider review the numbers to ensure management has covered all of the bases is key. Fairness opinions do exactly that. They state whether the price offered in a transaction falls within a range of fairness — from a financial point of view.

A fairness opinion doesn’t endorse a proposed transaction or substitute for internal due diligence, nor is it required by law or statutory authority. But it does assure managers, minority shareholders, lenders and other stakeholders that a transaction appears fair from an objective point of view.

Embraced by private companies - Although the landmark Delaware Supreme Court case Smith v. Van Gorkom didn’t mandate fairness opinions for major transactions, it did validate them as a way for boards of directors to demonstrate reasonable business judgment. Many public companies subsequently have used fairness opinions to defend themselves against possible lawsuits and investor criticism.

Of course, fairness opinions don’t provide absolute guarantees against legal challenges, particularly if management engages in fraud or other unethical behavior. But they do help demonstrate that directors acted on an informed basis, in good faith, in a manner they reasonably believed to be in the best interests of the company and its shareholders, and without fraud or self-dealing.

Customarily, a board of directors obtains a fairness opinion, but anyone — including buyers, managers, lenders, trustees and minority shareholders — may find it useful to obtain one. Private companies can also reap benefits from fairness opinions.

Fairness is frequently relevant - Although most often used in mergers and acquisitions, fairness opinions may also prove beneficial in other situations, including:

• Divestitures and spin-offs,
• Leveraged buyouts,
• Treasury stock purchases,
• Corporate restructurings or refinancing,
• Going-public (or private) transactions,
• Employee stock ownership plans, and
• Bankruptcy reorganizations.

A fairness opinion is especially important when a transaction is complex or likely to receive opposition from disgruntled minority shareholders or creditors. Further, a fairness opinion provides added protection when related parties — such as corporate affiliates or top executives — have financial incentives that conflict with other stakeholders’ priorities. For example, a fairness opinion makes sense if the company is undergoing a management buyout or if the CFO’s employment contract includes a substantial change-in-control bonus clause.

Some loan covenants specifically require fairness opinions if the borrower engages in a transaction with an affiliate above a prescribed dollar amount. These covenants protect lenders from fraudulent conveyances that may compromise the lender’s position in default or bankruptcy.

The means to an end - In many ways, the processes underlying fairness opinions are similar to those used in traditional business valuations. Fairness opinion providers review many of the same documents, including historic financial statements, shareholder agreements, management forecasts and business plans. They also conduct site visits and management interviews.

In addition, fairness opinion experts employ the same three valuation techniques — the cost, market and income approaches — to estimate a range of reasonable values for the company (or other asset involved in the transaction). But valuation may be just the tip of the iceberg. Experts also may consider the transaction’s financial structure, the consideration’s type and timing, future accounting implications, and the deal’s tax consequences.

For example, the consideration exchanged in an acquisition might include cash and convertible preferred stock in the combined entity. Evaluating the fairness of this hypothetical deal would require an additional investigation into the buyer’s financial position.

It’s also possible that compliance with an accounting standard — such as FASB Statement No. 141, Business Combinations — might unexpectedly reduce a merged company’s future earnings per share. By anticipating these unintended consequences, fairness opinions can help reduce forthcoming opposition.

What to expect:

• There is no standardized format for fairness opinions, but most contain:
• A description of the transaction, including the parties, date, consideration and terms,
• A summary of the expert’s procedures and analyses,
• A list of sources used to evaluate the transaction,
• A statement of assumptions and limiting conditions, and
• A conclusion statement (“fair” or “unfair”).

If an expert dubs a proposed transaction “unfair,” it’s likely that management will think twice before moving forward. In most cases, the parties renegotiate the terms — or walk away from the deal — if the price falls outside the expert’s range of reasonable values.

Sidebar: Independence is key for fairness opinions

Public companies traditionally turn to their investment bankers for fairness opinions. But investment bankers’ independence has come under attack in recent years.

Some analysts and stakeholders believe that financial incentives — such as “success fees” and ongoing financial relationships — could cloud investment bankers’ objectivity when issuing fairness opinions.

The National Association of Securities Dealers (NASD) responded to these allegations with a probe into the fees, methods and independence issues related to fairness opinions. The pending changes call for enhanced fairness opinion disclosures to help stakeholders identify potential conflicts of interest.

Proactive stakeholders needn’t wait for SEC approval. Many companies are choosing independent valuators for their fairness opinions. You should ask the following questions to determine whether any potential weaknesses might compromise a fairness opinion’s reliability:

• Was the fairness opinion provider a financial advisor in the proposed transaction?
• Does the fairness opinion provider have a prospective financial interest in any of the parties to the transaction, such as contingent fees, ongoing service contracts or postdeal financing arrangements?
• Will top executives receive any bonus payments on closing?
• Was the fairness opinion provider given adequate time and access to information to perform a comprehensive analysis?
• Did management dictate methods or unreasonably limit the fairness opinion provider’s procedures?
• If the fairness opinion provider relied on management’s assumptions and financial projections, do the contents appear reasonable? Did the expert independently verify internally generated financial information?

Selecting an experienced, objective fairness opinion provider — one without a stake in the deal — can dramatically improve the perceived reliability of fairness opinions.