November 1, 2017 Update: The Supreme Court upheld the Chancery Court’s decision - unfortunately no insight is provided in the one page order.
The Delaware Supreme Court heard oral arguments yesterday in the ISN Software appraisal matter. I didn’t realize this case was even under appeal but the argument covered some interesting ground. The stream of the argument is available on the Court’s web page and imbedded below:
Raymond DiCamillo from Richards Layton & Finger argued on behalf of Appellant, ISN Software Corporation, Jon E. Abramczyk argued on behalf of Appellee, Ad-Venture Capital, and Tony Fiotto from Goodwin Proctor argued on behalf of Appellee, Polaris Venture Partners.
The three justice panel hearing the argument included Justice Collins J. Seitz, Jr., Justice James T. Vaughn, Jr., and Justice Gary F. Traynor.
Mr. DiCamillo took issue with four aspects of the Chancery Court’s opinion:
(1) The Court’s working capital adjustment failed to value the company as a going concern based on the company’s operative reality as of the valuation date;
(2) The Court incorrectly relied on the CAPM model for calculating the discount rate and based its size premium determination on the wrong size decile;
(3) The Court failed to consider all relevant factors by refusing to give any weight to a contemporaneous transaction involving the target company stock; and
(4) The Court erred in awarding interest to Ad-Venture starting on the date of the appraisal demand rather than the date of judgement.
Mr. Abramczyk devoted most of his time to refuting Appellant’s characterization of the working capital adjustment, quickly responded to the remaining claims, then identified two issues on cross-appeal:
(1) The Court abused its discretion by relying on an expert’s projections that were based, in part, on assumptions that have no support in the record; and
(2) The Court erred in awarding the appraised value to options and restricted shares.
Mr. Fiotto solely addressed the decision of the Court to not award attorneys fees to Polaris Venture Partners.
For the sake of brevity, among other things, I am going to focus solely on the working capital dispute. The working capital adjustment was, by far, the most material of the decisions appealed by either party, it is easily the most interesting, and it strikes me as the most binary of the arguments presented.
ISN Software Corporation employs what is known as a software as a service ('SaaS') delivery model in which software is licensed on a subscription basis and is centrally hosted by the company. Because the software is hosted rather than packaged and distributed, there is no inventory. Further, the upfront subscription fees, create large amounts of deferred revenue that can be used by the company to fund its operations. For these reasons, most SaaS companies have significantly negative working capital that becomes more negative as the company grows.
The Viz below plots net working capital from 2012 to 2016 for a group of publicly-traded SaaS companies (the smaller inner panel shows the deferred revenue annually for the company selected):
As these companies are paid subscription fees upfront, the portion of the fee paid but not yet earned is booked as a liability on the balance sheet in an account typically titled "deferred revenue" or "unearned revenue." It is booked as liability because, under accrual accounting, it has not yet been earned and is therefore not yet true revenue.
For example, lets assume we own a web hosting company and charge $1,000 annually for our hosting services. When a customer signs up (day 1) they pay us $1,000 for the year. At this point, we have not yet earned the $1,000 so it is booked as a liability with an offsetting entry to cash:
After three months, we have now earned 1/4th of the $1,000 so we debit the unearned revenue account by $250 with an offsetting entry to earned revenue:
This is why you see such large negative working capital balances for SaaS companies, particularly during their growth phase. As the company adds more and more customers/subscribers, they book increasing amounts of deferred revenue which drives the level of current liabilities well in excess of current assets. Keep in mind, although cash is, in fact, a current asset, it is not considered in the calculation when estimating working capital investment for a discounted cash flow analysis.
This is one of the reasons why investors, particularly PE investors, like SaaS companies. The subscription-based model not only creates more stable revenue streams, it is also self-funding from a working capital investment perspective.
Returning to the ISN Software arguments, Appellant argues that the court erred by effectively allowing this self-funding dynamic to persist indefinitely in its DCF analysis. Furthermore, Appellant takes the position that this ability to self-fund working capital was not the company’s operative reality as of the valuation date. Appellee argues that it was in fact the company’s operative reality as of the valuation date and the only way Appellant can claim otherwise is by relying on an alternate set of projections that were allegedly prepared after the fact and on a cash rather than accrual basis. Note that under the cash basis of accounting, accruals go away as the revenue is recognized when the cash is received (Day 1 in our example above) rather than when it is earned.
Putting aside the second set of projections, from a valuation perspective, Appellees seem to have the stronger argument. Particularly given the fact that the Court’s working capital assumption was that ISN would require a very small amount of working capital rather than zero or negative (as it had been prior to the valuation date). I searched SEC.gov for recent transactions involving SaaS companies or other companies with a subscription- like model and looked at the working capital assumptions made in the DCF analyses of the financial advisors.
The first deck I found was prepared by Qatalyst Partners for the Transaction Committee of the Board of Directors of NetSuite Inc. in connection with the sale of NetSuite to Oracle for $9.3 billion in July 2016:
The management projections relied on by Qatalyst for its DCF analysis assume increasingly negative working capital investment amounts (i.e., cash inflows) in every year of the forecast. Furthermore, Qatalyst estimated the value of NetSuite beyond the forecast period (aka terminal value) by applying a multiple to the $480 million unlevered free cash flow figure (in 2021) - a figure that assumes negative working capital investment of $196 million. In other words, Qatalyst assumed that NetSuite would self-fund working capital forever.
Lazard relied on a similar working capital investment assumption in its DCF analysis when valuing Xueda Education Corp., an educational resource company that collects tuition and fees upfront for its tutoring services:
It all comes down to what the operative reality is for the company as of the valuation date. In ISN Software’s case, absent any evidence to the contrary, there is no reason to assume that the company cannot continue to fund its future growth in the exact manner that it funded its growth historically. In fact, there doesn’t appear to be any justification at all for the Chancery Court to have assumed that the company would have a "small (although not nonexistent)" need for additional working capital investment in the future.