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Articles From Brisbane Consulting Group

Court Issues Failed IPO Price to Value Minority Interest

Startup businesses with unproven intangible assets always present valuation challenges, especially when valuing a minority interest in a contentious shareholder dispute. So, courts are likely to give substantial weight to any objective evidence that’s available.

In this case, rather than split the difference between opposing expert opinions or side with one expert, the trial court turned to valuations prepared when the company was contemplating an initial public offering (IPO). The Arizona Court of Appeals upheld that decision. Here are the details. (Kottayil v. Insys Therapeutics, Inc., 2017 Ariz. App. Unpub. No. 1 CA-CV 15-0765, August 29, 2017.)

Facts of the Case

In 2002, two shareholders created a pharmaceutical company called “Insys” to develop innovative treatments for chemotherapy-induced nausea and vomiting, pain management and central nervous system disorders.

The controlling shareholder provided financial support. The minority shareholder, in exchange for providing research and development services, initially received 106,250 shares of the company’s stock, equal to 12.5% of the outstanding shares.

In early 2007, while the products were still in the development phase, Insys began preparing for an IPO. Its registration statement to the Securities and Exchange Commission stated that its success was “highly dependent” on the success of two major R&D projects.

When the recession hit, Insys had trouble financing its ongoing research projects. So, the controlling shareholder agreed to convert into equity a significant portion of roughly $40 million of debt owed to him. An outside valuation firm performed a discounted cash flow analysis and valued the shares at $1.73 each. Using that valuation, Insys issued almost fourteen million additional shares to the controlling shareholder. As a result, the minority shareholder’s interest was diluted to approximately 4.83% of the outstanding shares.

Despite the debt-to-equity conversion, the company’s financial problems continued. In August 2008, amidst increased competition, Insys terminated the minority shareholder, reduced its workforce and abandoned its IPO plan.

In June 2009, the controlling shareholder agreed to provide additional funding for R&D — but only if he could own Insys in its entirety. The company’s board subsequently approved a reverse stock split and announced that the minority shareholder would receive ten cents a share (or $143,858) for his fractional share of common stock. Two months later, the minority shareholder filed a lawsuit, alleging that the board members violated their fiduciary responsibilities to him.

After the lawsuit was filed, the controlling shareholder continued to finance the R&D projects, infusing Insys with another $42 million in cash. After nearly a decade of research, the drugs finally received FDA approval. In March 2013, Insys went public and was estimated to be worth $1.7 billion (roughly $85 per share) as of March 2014.

Valuation Matters

The trial court determined that Insys’s board had breached its fiduciary duties to the minority shareholder in connection with the 2009 reverse stock split. As a result, under relevant state law, the minority shareholder was entitled to receive “fair value” for his shares as of the date of the reverse-stock split transaction.

In other words, he should receive his pro rata share of the company’s entire value, without taking into account any valuation discounts for lack of control or marketability to avoid unfairly enriching the controlling shareholder.

The court noted that valuation experts typically rely on objective data to value a business, such as the company’s history of revenue, the size and performance of the overall market, and relative market share. However, in this case, there was “very limited objective data available for valuation,” causing an expert to rely “almost entirely upon subjective assumptions and predictions, now tainted by hindsight bias.”

The use of subjective data resulted in divergent expert opinions at trial. The plaintiff’s expert applied an adjusted book value method to arrive at a fair market value of $41.46 per share. Using the same information, the defendant’s expert performed a discounted cash flow analysis and arrived at a value of $0.07 a share.

The trial court determined that, under these circumstances, the best approach was to define a range of values. At the low end of the range, the court considered discounted cash flow analyses performed by unrelated third parties between 2004 and 2009 for the company’s internal planning purposes. Those valuations — which ranged from $15 million to $70 million — generated an average value of $53.2 million.

At the high end of the range, the court considered the value estimates made during the company’s aborted IPO attempt in 2007 ($151.5 million). Ultimately, the court went with the high end of the range, awarding the minority shareholder $7,317,450 (plus interest and costs) for his 4.83% interest. Both sides appealed the decision.

Decision Upheld

The Arizona Court of Appeals determined that the trial court “coped admirably with the evidence that was presented” and “reached a reasonable valuation using the analytical tools and evidence that were available.” The appellate court also noted that the trial court focused on the information “known or which could be ascertained” by management on the valuation date. Therefore, the appellate court found no abuse of discretion in the trial court’s valuation of Insys.

Considering all the valuations in evidence, the high end of the range fell squarely in the middle of those proffered. Although the company failed to go public in 2007, the IPO valuation from that time period remains “a valuable data point.” It shows how much management believed other people should be willing to pay for the stock based upon their belief and understanding regarding future revenue.

Consider a Nontraditional Approach

In this case, the courts rejected proven valuation techniques — the adjusted book value and discounted cash flow methods — that were based on subjective assumptions and predictions. Instead, the courts turned to objective market evidence from two years before the valuation date to determine value. When valuing a business for a shareholder dispute, it’s always important to reconcile inconsistent valuation evidence and consider the overriding principle of fairness.



Douglas P. Sosnowski provides business valuation, forensic accounting, and litigation support services for Brisbane Consulting Group. He has extensive valuation experience and has served as an expert witness, testifying in courts of law throughout the state of New York. Doug has experience consulting with publicly traded entities and valuing a variety of closely held companies in connection with mergers, acquisition and divestitures, business combinations, estate and gift tax planning, ESOPs and purchase price allocations. He also has experience in the quantification of lost income in determining business interruption claims for insurance adjusters. Doug is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and the American Society of Appraisers. Doug is a licensed financial advisor holding Series 7 and 66 securities licenses. He graduated with honors from the State University of New York at Buffalo earning his Bachelor of Science degree in business administration with concentrations in accounting and finance.


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