All’s Fair: The Board’s Role in Fairness Opinions (article)
Boards of Directors play a vital role in transactions. As management teams evaluate the big picture in a merger, acquisition, or divestiture, Boards have a fiduciary responsibility to follow the “Business Judgment Rule” in protecting the interests of the shareholders.
According to the Business Judgment Rule, a court will uphold the decisions of a Board or its individual Directors as long as they are made (1) in good faith, (2) with the care that a reasonably prudent person would use, and (3) with the reasonable belief that the Board and its Directors are acting in the best interests of the corporation.
Transaction prices for complex arrangements can affect a company’s overall value, which in turn affects a shareholder’s return on investment. From the buyer’s perspective, a decline in the value of a company post-transaction would negatively affect a shareholder’s return, and could open the door for a lawsuit from shareholders to potentially sue a company and even the individual Directors for executing a transaction that allegedly damaged the company’s value. A seller faces the same issues, or in the case of a sale of the entire company, the issue becomes whether the agreed-upon price is fair to the shareholders.
One of the ways Boards can protect shareholders’ interests is by verifying that the terms of the transaction are fair to the company’s shareholders from a financial point of view. They can accomplish this by obtaining a fairness opinion. Boards that understand the importance of fairness opinions can both meet their fiduciary duties to shareholders by meeting the “Business Judgment Rule,” as well as proactively help management teams in evaluating and addressing potential financial risks in a complex transaction.
What Is a Fairness Opinion?
A fairness opinion is a written opinion as to whether the price to be paid or received for a company or assets in a transaction is fair to the subject company’s shareholders from a financial point of view. A fairness opinion provider—which could be a valuation firm or an investment bank—evaluates cash flow projections, comparable company multiples and/or comparable transaction multiples to estimate what a reasonable range of values would be for the company or assets to be sold or received by the subject company in the transaction. It is important to note that a fairness opinion does not address the question of whether a transaction garnered the best price; it solely states that the transaction generates fair consideration for the party to whom the opinion is addressed.
When Is a Fairness Opinion Needed?
In many cases, a company’s legal team will recommend that the company seek a fairness opinion for a transaction. Boards should be aware of the situations that may trigger the need for a fairness opinion as well, though, in the event the legal team does not flag a transaction that may need more support.
Fairness opinions are frequently provided to both public and private companies when a transaction takes place, and are often utilized by public companies where more information on a transaction is disclosed. A public company typically has a larger number of shareholders than a private company, which potentially presents a higher risk for a lawsuit if a shareholder believes that the transaction price is not reasonable.
Other situations may indicate the need for a fairness opinion as well. These include transactions that were not shopped to multiple sources in the investment community, such as management buyouts or other related party transactions. Private equity firms engage a firm to provide fairness opinions because they sometimes encounter related party transactions when transferring companies or assets between funds.
What Is the Board’s Role in Fairness Opinions?
The Board has the responsibility to select a reputable firm to provide the fairness opinion, which is based on many factors, including price, industry expertise and the opinion provider’s reputation, among other factors. Investment banks often offer to provide a fairness opinion in conjunction with serving as a financial advisor on a transaction. However, the independence of the investment bank’s fairness opinion should be carefully evaluated, as they frequently stand to receive a large success fee upon consummation of the transaction, which might potentially be seen as a conflict of interests.
The Board also has the responsibility to evaluate that the fairness opinion the company receives is reliable. The Board will want to see evidence that the opinion provider had adequate time to complete a thorough analysis, and that it was performed based on reasonable data. Board members should consider the inputs the opinion provider used, such as whether the provider analyzed the appropriate ranges of value for the transactions, and if the fairness opinion accurately considers the structure of the transaction. Cash flow projections that are dissimilar from past results or management projections—without adequate justification—are a big indicator that the fairness opinion may not be sound. The Board should also make sure that appropriate comparable public companies are selected for multiple analyses, and look at the appropriateness and time frame for any comparable transactions; outdated comparable transactions could skew the fairness opinion results.
For public companies, the Board will want to ensure the fairness opinion can withstand scrutiny. Public company fairness opinions are often, but not always publicly disclosed, and so they generally require more detailed review and disclosure with significant input from the company’s legal counsel.
Lastly, the Board should have clear understanding of any differences between the ranges of value indicated by the valuation methodologies and the transaction price proposed by the company’s management team. These will be questions that shareholders will want answered, and the Board can help identify and address any concerns with the fairness opinion provider and the management team before the transaction is completed.
When Boards get a fairness opinion to help them review and understand transaction prices, they can significantly reduce the risks involved for a complex transaction. They may be able to protect the company’s overall value and reduce the risk of potential litigation.
For more information about fairness opinions, please contact Greg Watts, Senior Managing Director of the CBIZ Valuation Group.
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