All's Not Fair in Love and Mergers.

A fairness opinion affirming that a merger or sale transaction is financially fair to a company's shareholders is an important but frequently overlooked risk management technique. Such opinions are required in deals involving public companies. Yet there are often compelling reasons for privately held businesses to obtain them, too. Armed with a fairness opinion, a company's senior management and board of directors can make better-informed decisions about a change-of-control transaction and avoid possible turmoil down the road.

The fiduciary duties of the board of directors have come under increasing scrutiny in the last 20 years as M&A activity has exploded. SEC regulations and key court decisions, especially in the 1980s, established a clear standard for boards of public companies (including, but not limited to, those being acquired) to make "informed decisions" using the Business Judgment Rule. Essentially, boards considering change of control transactions are required to exercise due care, act in good faith and in a disinterested manner and not abuse their discretionary position.

These requirements have led boards to hire financial advisors as independent third parties, providing evidence that a board has complied with the Business Judgment Rule and to assist directors in decision-making. The fairness opinion has become the universally accepted tool to prove such compliance.

Why Private Companies?

The boards of private companies are increasingly following their public counterparts and obtaining fairness opinions in change-of-control transactions for many reasons. On the simplest level, private companies are also subject to the risk that complex capital structures and different classes of ownership will uncover differing interests among shareholders -- and the likelihood that a group of disgruntled shareholders will challenge a transaction.

In addition, the very nature of privately held companies poses particular risks in mergers and sales. For example, many privately held businesses are family-owned, which introduces uniquely complex relationships and potential conflicts. Disputes between family members -- especially those in management vs. those outside the company -- are common.

Similarly, private family-owned businesses often lack outside board members, so many don't have the expertise or independence to fully evaluate a transaction's fairness. Alternatively, the management of a private company may already hold an interest in the company that's acquiring the business. These related party transactions typically incur additional scrutiny from shareholders and their legal advisors.

The bottom line? Any or all of these factors up the risk that disaffected shareholders will mount a challenge. Without a fairness opinion, the consequences of a challenge can be severe, especially during the sensitive pre-closing phase. The attack may be frivolous, malicious or poorly reasoned, but it can postpone or derail the deal. Documented by solid, thorough analysis, an independent fairness opinion effectively discourages such a challenge and keeps the deal on track. Investing in a fairness opinion can also help to avoid multimillion-dollar litigation.

Consider the case of a fairness opinion prepared for a private real estate investment trust, or REIT, that was merging with a public REIT. Prior to closing, one of the private REIT's shareholders, a family member uninvolved in management, threatened to sue, believing that the merger price was too low. Since the public REIT had many deals on its agenda, a nuisance like this lawsuit could easily have killed the deal. The company's financial advisor assisted the CEO, CFO and company counsel in explaining to this shareholder in detail why the deal was fair, The challenge soon buckled under the weight of the analysis, and the deal was completed.

The CFO's Role

The nature of the specific requirements of the fairness opinion and its underlying analysis suggest that the senior financial executive best serves the company and its board by being knowledgeable about the value of the opinion as a preventive measure, by playing a key part in selecting the financial advisor and by providing timely, accurate financial and operating information to that advisor.

An experienced advisor knows how to make the process successful. He or she will work with senior management, corporate financial executives (who often are the primary liaisons to the financial advisor) and legal and accounting representatives, thus minimizing disruptions as everyone strives to close the deal. Such an advisor can work quickly, as these transactions often demand. An opinion usually takes at least 10 days to two weeks; anything less is generally insufficient for proper analysis and could undermine the due care and procedural fairness requirements. And the advisor's opinions include presenting a thorough supporting analysis, reassuring the board about its decision and providing protection if litigation develops later, as it often does.

The simple language of the fairness opinion -- to affirm that the transaction is fair to the company's shareholders from a financial perspective -- belies the potential complexity of the proposed transaction and the accompanying analysis. On completion of a fairness opinion, a CFO should be able to answer all of the following questions positively and without hesitation:

* Has the advisor performed the proper procedures?

* Did he or she apply generally accepted valuation techniques in valuing the target company?

* Did he or she appropriately consider the benefits of control ownership?

* In a stock merger, has the acquiring company -- whose equity the selling shareholders will receive in exchange for theirs -- been properly valued?

In addition, a CEO should expect the fairness opinion advisor to inform him or her as early as possible of any issues regarding the evenhandedness of the transaction, preventing a deepening disaster later on. A case in point is the advisor hired by a special committee of the board of directors of an asset management company that was acquiring its advisory company. The latter was owned by the acquiring company's senior management. When the advisor scrutinized the transaction, it was clear that the financial terms favored the sellers at the expense of the acquirer's shareholders, After some negotiation, the terms were modified and the transaction was completed.

Later, when some unhappy shareholders sued, the company's unambiguously positive track record of hiring an experienced third party, the existence of the fairness opinion and the supporting analysis allowed management and the board to successfully defend the transaction in court. Company counsel said the fairness opinion and its documentation were vital to both the completion of the deal and the company's successful defense of the board's actions.

Throughout the process, the company's CFO played a key role, both in recommending potential fairness opinion advisors to a special board committee and in serving as an important source of financial and other information. Without that cooperation, it would have been difficult to get the job done on a timely, informed basis.

A fairness opinion is an essential component of many, if not most, private company sale or merger transactions. Financial executives of privately held companies can help ensure that a transaction of vital importance to the company and its shareholders is completed, with minimum risk, by being able to determine when it makes sense to get a fairness opinion -- and how to identify qualified, experienced providers.

In so doing, the financial executive provides an important value-added service.

Jeffrey M. Gordon, CFA, is a managing director at Duff & Phelps, LLC, specializing in fairness and solvency opinions and valuations for corporate and estate planning. He can be reached at [phone].