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Owen v. Cannon

Court of Chancery of Delaware

June 17, 2015

LYNN CANNON, BRYN OWEN, ENERGY SERVICES GROUP, INC., a Delaware corporation, and ESG ACQUISITION CORP. (n/k/a Energy Services Group, Inc.), a Delaware corporation, Defendants.

Submitted: March 17, 2015

Kenneth J. Nachbar, D. McKinley Measley and Shannon E. German of MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; Attorneys for Plaintiff.

Edward M. McNally, P. Clarkson Collins, Jr., Lewis H. Lazarus, Jason C. Jowers and Patricia A. Winston of MORRIS JAMES LLP, Wilmington, Delaware; Attorneys for Defendants.




In this joint fiduciary duty and appraisal action, Nathan Owen (“Nate-), formerly the largest stockholder of Energy Services Group, Inc. (“ESG- or the “Company"), challenges a conflicted merger (the “Merger") in which he was cashed"out of ESG in May 2013, for the right to receive $19.95 per share, or $26.334 million in total. The Merger was orchestrated by the Company's two other largest stockholders: Lynn Cannon, who replaced Nate as President in August 2009, and Bryn Owen (“Bryn"), Nate's brother. The Merger price was derived from a valuation that ESG's financial advisor performed based on five"year projections (the “2013 Projections") prepared under Cannon's direction, which projections the Company submitted to a nationally reputable lender in order to obtain a $25 million credit facility to buy out Nate.

Nate and his financial expert accept the 2013 Projections that formed the basis for the Merger price, but they argue that the $19.95 per share price is unfair because ESG's financial advisor applied certain incorrect assumptions in its valuation, the most significant of which is the tax rate applicable to ESG as a Subchapter S corporation. Applying what he submits are the correct assumptions to the 2013 Projections, Nate contends that the fair value of his stock was $53.46 million.

Although defendants were content to use the 2013 Projections at the time of the Merger, they now insist that those projections are not sufficiently reliable to value Nate's stock. Instead, they rely on a valuation based on a set of ten"year projections their financial expert created in the midst of this litigation. Based on their expert's valuation, which applies a corporate tax rate for ESG that disregards its status as a Subchapter S corporation at the time of the Merger, defendants contend that the fair value of Nate's stock was no more than $21.502 million.

The two primary areas of disagreement between the parties concern which projections to use for a discounted cash flow (DCF) analysis to value Nate's stock as of the Merger, and whether to tax affect the earnings in that analysis to account for ESG's status as a Subchapter S corporation. In this post"trial opinion, I conclude that it is appropriate to use the 2013 Projections because they reflected management's best estimate of what was known or knowable about ESG's future performance as of the Merger. I also conclude, consistent with this Court's precedents, that it is appropriate to tax affect the earnings in the DCF analysis given ESG's status as a Subchapter S corporation. Based on these two conclusions, and certain other determinations discussed below, I find that the fair value of Nate's shares was $42, 165, 920 as of the Merger.


These are the facts as I find them based on the documentary evidence and testimony of record.[1] I accord the evidence and testimony the weight and credibility that I find it deserves.

A. The Parties

Plaintiff and Petitioner Nathan Owen was the President of ESG until his removal in August 2009, and a director of the Company until the Merger. Before the Merger, Nate held 1, 320, 000 shares of ESG stock, which were cancelled in the Merger in exchange for the right to receive $19.95 per share in cash, or $26.334 million in total. Nate currently resides in Maine.

Defendant Lynn Cannon served as a director of the ESG and as President “pro tem” after Nate's removal as President.[2] Before the Merger, Cannon held 1, 218, 750 shares of ESG stock. In connection with the Merger, Cannon became President of ESG.

Defendant Bryn Owen, Nate's brother, is a Vice President and director of ESG. Before the Merger, Bryn held 1, 098, 750 shares of ESG stock.

Non"party Felimon Gurule is the Vice President of Information Technology at ESG. Before the Merger, Gurule held 112, 500 shares of ESG stock.

Respondent Energy Services Group, Inc., a Delaware corporation based in Norwell, Massachusetts, provided services to the retail energy industry. At all relevant times before the Merger, Nate, Cannon, and Bryn were the three members of the Company's board of directors, and Nate, Cannon, Bryn, and Gurule were stockholders of the Company. In connection with the Merger, Cannon, Bryn, and Gurule transferred their ESG stock to Defendant ESG Acquisition Corp. (―Acquisition Corp."), a Delaware corporation, in exchange for an equal amount of Acquisition Corp. stock. In the Merger, ESG merged with and into Acquisition Corp., which is now known as Energy Services Group, Inc.[3] Unless noted otherwise, I refer to Energy Services Group, Inc. and Acquisition Corp. interchangeably as ―ESG" or the ―Company, " and I refer to Cannon, Bryn, and Acquisition Corp. as “Defendants."

B. The Formation of ESG

In the mid"1990s, Nate started a website" and intranet"development company called IC Solutions, which was the predecessor to ESG.[4] Bryn joined IC Solutions and reported to Nate.[5] In the late 1990s, one of the country's first retail energy providers, which are known as ―REPs, " engaged IC Solutions to create a software solution to manage its electronic data interchange, or EDI, in order to participate in the retail electricity market. Other REPs also approached IC Solutions for a similar service.[6]

EDI is the data interchange system that REPs use to schedule and deliver electricity.[7] REPs operate in states that have deregulated retail electricity that permit competition with the incumbent utility. REPs arbitrage what they term “headroom": the difference in price between the electricity that they can buy at wholesale prices through short"term contracts and the electricity bought by incumbent utilities through long"term contracts.[8] Historically, the price of natural gas, a primary source to generate electricity, has been highly volatile, which creates opportunities for headroom.[9] For example, when natural gas prices drop, REPs can buy electricity at lower wholesale prices than incumbent utilities that are locked into long"term contracts and thereby sell electricity at lower retail prices than incumbent utilities.[10]

Lynn Cannon was introduced to Nate through his wife, Leslie Cannon, who had been doing marketing and business planning work for Nate to explore business opportunities for IC Solutions.[11] Nate and Lynn Cannon began discussing working together to create EDI solutions for the then"nascent retail electricity industry.[12]

Nate, Cannon, and Bryn agreed to work together at what became ESG. Each would receive stock in exchange for their contributions to the Company. In general terms, Cannon would invest capital; Bryn would work in client services; and Nate would lead the company.[13] They also decided to hire Gurule, a software developer at IC Solutions.[14]

On September 20, 2000, Nate, Cannon, Bryn, and Gurule entered into a Stockholders' Agreement, which specified their stock ownership of ESG as follows:[15]


Number of Shares

Percentage Ownership


1, 320, 000


1, 218, 750
1, 098, 750


112, 500


As required by Section 9 of the Stockholders' Agreement, ESG made the appropriate elections to be taxed as a Subchapter S corporation.[16] Thus, ESG does not pay federal tax on its income. Rather, the stockholders of ESG pay federal income tax on their respective shares of the Company's profits.

C. ESG's Lines of Business and Growth

Before the Merger, ESG offered three services: (i) Transaction Management Services (TMS), which is an EDI solution; (ii) Prospect"to"Cash (P2C), which is largely a billing management service; and (iii) Wholesale Energy Services (WES), which is a data management and reporting service. TMS has accounted for the majority of the Company's revenue, as demonstrated by ESG's revenues in 2012, the last full year before the Merger: approximately $18.8 million from TMS, approximately $10.8 million from P2C, and approximately $1.8 million from WES.[17] Given its recurring revenue business model, an average contract length of around three years, and high customer retention rates, [18] ESG's revenues have generally been “predictable, " as Cannon acknowledged at trial.[19]

Much of the Company's success can be traced to several apparent advantages it holds over its competitors. As touted on the Company's website, ESG's three products offer an “end-to-end business process solution” for REPs, [20] which can reduce their costs and the risk of data translation errors.[21] Cannon and ESG's senior management testified uniformly that they believe ESG's products and services are higher quality than those of its competitors.[22]

Consistent with its strong position in the market, the Company experienced significant revenue and cash flow growth in the years leading up to the Merger despite facing competition since its founding.[23] In the five-year period before the Merger, ESG's revenues and earnings before interest and taxes (EBIT) demonstrated strong growth, which ESG's financial expert, E. Allen Jacobs, calculated as follows (in millions):[24]


















According to Nate's expert, Yvette Austin Smith, over the seven years from 2005 to 2012, ESG's revenue grew at a compound annual rate of 23.4%.[25]

ESG made pro-rata distributions of a majority, but not all, of its income to its stockholders. Historically, Nate, Bryn, Cannon, and Gurule received a combination of (i) below-market salaries (i.e., $80, 000 per year for Nate, Bryn and Cannon and more for Gurule); (ii) monthly “draws" that were in effect interest-free loans against their distributions; and (iii) distributions, a portion of which covered the stockholders' tax liabilities for their pro rata shares of the Company's profits.[26] Because the amounts paid to Nate, Bryn, Cannon, and Gurule as salary were below-market, the distributions they received did not accurately reflect the return on their equity investments in the Company. To accurately reflect their equity returns, the distributions must be “normalized" to account for the difference between market-rate salaries and the salary payments they actually received.[27] Table 1 below reflects the normalized distributions from ESG to Nate, Bryn, Cannon, and Gurule for the years 2009-2012 as calculated by Jacobs, Defendants' expert.

Table 1 ESG Normalized Distributions[28]

$1, 148, 389
$966, 212
$1, 115, 315
$3, 229, 916
$1, 864, 181
$1, 537, 720
$1, 794, 635
$5, 196, 535
$1, 937, 022
$1, 606, 018
$1, 799, 602
$2, 334
$5, 344, 976
$1, 740, 546
$1, 487, 198
$1, 596, 909
$4, 825, 330
$3, 385, 556
$3, 004, 595
$3, 503, 761
$237, 228
$10, 131, 140
$4, 226, 053
$4, 008, 597
$4, 437, 621
$277, 020
$12, 949, 291
$14, 301, 747
$12, 610, 340
$14, 247, 842
$517, 259
$41, 677, 188

Using the normalized distributions in Table 1, Jacobs calculated the median percentage of pre-tax income that ESG distributed for the years 2007-2012 as 76.7%.[29] The Company retained most of its undistributed income as cash on its balance sheet. At the time of the Merger, ESG had $17.4 million in cash and equivalents on its balance sheet.[30]

D. Nate's Removal as President of ESG

During the late 2000s, a significant disagreement arose among Nate, Cannon, and Bryn concerning what to do with the Company's growing pile of cash. Nate wanted to reinvest in the business. Cannon and Bryn were more interested in “being paid” through profit distributions.[31] There also was day-to-day friction in managing the Company. In July 2009, for example, Cannon postponed a new WES project after repeated operational delays.[32] Nate responded by directing ESG's controller to not “pay any bonuses without my explicit approval."[33] A colorful email exchange ensued, with Nate and Cannon each stating that the other would have been fired if he was not a stockholder of ESG.[34]

Nate, Cannon, and Bryn sought to work out their differences. On August 11, 2009, they engaged in mediation conducted by Bryn's father-in-law.[35] They left the one-day mediation with “assignments" to work on in anticipation of a second meeting.[36]

Rather than continue with the mediation, Cannon decided that it was time to end Nate's employment relationship with ESG. On August 11, the same day of the mediation, Cannon drafted a notice for a special meeting of the ESG board of directors to remove Nate as President. Cannon understood that he could not eliminate Nate's ownership interest “without going through some type of negotiated purchase, " but that, with Bryn's cooperation, there would be sufficient votes on the three-person board to end Nate's day-to-day relationship with the Company.[37]

On Thursday, August 13, 2009 at 1:49 p.m., Cannon and Bryn sent Nate a notice of a special board meeting to occur on Friday, August 14 at 11:00 a.m., in Boston.[38] This was the first formal board meeting in the history of the Company.[39] The notice identified the purpose of the meeting as “considering, and upon such a determination by the Board of Directors, approving the immediate termination [of] the employment of Nate Owen as President of the [Company], and the election of Lynn Cannon as President pro tem.” Further, the board would “consider the employment of Nate Owen as Vice President, Special Projects, pursuant to terms and conditions attached” to the notice.[40] Those terms and conditions contemplated a six-month leave of absence and a demotion for Nate, who would report to Cannon if he returned after six months.[41] Cannon knew that Nate would find this condition unacceptable.[42]

Nate, who was in Pennsylvania attending to a medical issue for his wife, was “shocked" by the proposal and felt “incredibly betrayed" by his brother.[43] He called the lawyer whose name appeared in the special meeting notice (Barry C. Klickstein, Esquire at Duane Morris LLP)[44] and asked for a delay of the meeting to make it easier for him to travel to Boston and attend the meeting in person. Cannon and Bryn refused.[45]

After making arrangements for his family, Nate traveled overnight to attend the meeting. Once there, he was not allowed to say anything. Cannon and Bryn promptly voted, over Nate's objection, to remove him as President. After the meeting, Nate's keycard access was deactivated, his email access was terminated, and all of his work and personal emails were deleted from the system. That same day, $35, 000 was removed from his personal bank account, likely because Cannon and/or Bryn cancelled a recent direct deposit from the Company.[46]

After the six-month leave of absence, Nate did not return to ESG, nor did he contact Cannon or Bryn about returning to work.[47] Under the terms imposed by Cannon, Nate continued to receive a base salary and benefits as well as stockholder distributions.[48]

According to Nate, the Company became “extremely obstinate" in providing Nate access to information about ESG once he was terminated.[49] In October 2009, Nate made a formal demand under 8 Del. C. § 220 to obtain books and records from the Company.[50]ESG thereafter provided certain financial information, including its 1999-2008 tax returns, its 2007-2008 audited financial statements, and a copy of its QuickBooks files.[51]

E. Cannon Prepares Multi-Year Projections and Offers to Buy Out Nate

Before 2010, ESG had not prepared multi-year projections for the Company or its individual lines of business.[52] Instead, at the beginning of each calendar year, Cannon would prepare an annual budget. ESG management participated in Cannon's budgeting process “in terms of providing the inputs for what [the Company] can expect for the upcoming year."[53] Bryn also typically reviewed the budget with Cannon.[54]

Cannon's understanding of ESG's future prospects stems in large part from weekly, two-hour meetings held on Monday mornings, during which he and the department heads discuss sale opportunities and operations.[55] Drew Fenton, Vice

President of Business Development at ESG, described the two-hour meetings as “exhausting."[56] Once a month, ESG management also compares realized revenue to the annual budget.[57] Based on these meetings with management, Cannon admitted that he knows what the department heads know, meaning that he is “very familiar" with the Company's business and has a “good handle" on specific customer relationships.[58]

In February 2010, Cannon extrapolated the Company's 2010 annual budget into a set of multi-year projections for years 2010-2015 to see what ESG's future performance might “look like from a P&L perspective."[59] I refer to these projections as the “2010 Projections."[60] To create the 2010 Projections, Cannon took the Company's 2010 annual budget and then applied an assumed growth rate to each line of the budget for each year. Some line items had higher growth rates in later years, and others had lower growth rates. Cannon projected revenue growing from approximately $15.27 million in 2009 to $39.5 million in 2015.[61]

Cannon claims he created the 2010 Projections, and every future set of multi-year projections for ESG, without seeking input from anyone else at the Company. Although ESG's employees confirmed that Cannon did not seek their input into the preparation of projections per se, [62] the weight of the evidence reflects that, even if Cannon did not explicitly ask for their input, he obtained functionally equivalent knowledge based on the extensive discussions of ESG's future prospects he had with members of management on a regular basis.[63] Indeed, Cannon's familiarity with the Company's business prospects grew over time after he had arranged to remove Nate from management and assumed firm control over the day-to-day operations of ESG.

According to Nate, Cannon and Bryn (through ESG) offered to repurchase his stock for $8 million in 2010. Nate rejected this offer, which Cannon denied making, [64] as “ridiculously low."[65] Although no documentary evidence supports the existence of this offer, I find Nate's testimony to be credible on this point.[66] The making of such an offer also is consistent with the fact that Cannon contemporaneously created a set of multi-year projections for the first time in the Company's history in 2010; and that the parties had retained, at ESG's expense, valuation experts during this period.[67]

In 2011, Cannon engaged Duff & Phelps to provide a valuation of the Company for the purpose of repurchasing Nate's shares.[68] Duff & Phelps performed a discounted cash flow analysis based on projections extrapolated from Cannon's 2011 annual budget, as well as an analysis of five, comparable publicly traded companies.[69] On May 12, 2011, Duff & Phelps provided a midpoint valuation of ESG (including cash and equivalents) of approximately $64.8 million, or approximately $17 per share.[70] At that price, Nate's 1, 320, 000 shares would have been worth $22.44 million.[71]

According to Nate, ESG made a second offer to repurchase his shares in mid-2011, this time for $12 million. He rejected the offer as “entirely insufficient."[72] No documents in the record reflect such an offer and Cannon again disclaimed ever making such an offer, but I find Nate's testimony more credible.[73]

In early 2012, Cannon prepared a revised version of the 2010 Projections, which I refer to as the “2012 Projections."[74] The 2012 Projections use the same growth assumptions as the 2010 Projections but project higher future revenues. This is because the 2012 Projections were derived from the Company's actual results for 2010, which were higher than the 2010 annual budget used to create the 2010 Projections.[75] For example, projected revenue of $39.5 million for the year 2015 in the 2010 Projections increased to projected revenue of $44.34 million in the 2012 Projections.[76]

In an April 2012 planning conference, Cannon presented the 2012 Projections to senior management as a “bogie" for ESG's potential future performance.[77] The presentation described the projections for the years 2013-2015 as “Revenue Targets."[78]The same presentation noted that while falling natural gas prices were good for ESG customers, there was a market expectation that natural gas prices would level off eventually.[79]

F. ESG Engages Grant Thornton to Perform a Series of Valuations

In June 2012, Cannon engaged Grant Thornton to assist ESG in obtaining financing to buy back Nate's shares.[80] Cannon directed the Company's controller, Lisa Swift, to send the 2012 Projections to Grant Thornton.[81] When ESG shared the 2012 Projections with Grant Thornton in June 2012, it had exceeded the monthly projections in them.[82]

ESG's main contact at Grant Thornton was Len Batsevitsky, although a colleague, Peter Resnick, would perform the indication of value of the Company in connection with the Merger.[83] In June 2012, Grant Thornton used the 2012 Projections to analyze a proposed financing structure from Wells Fargo.[84]

In early July 2012, Cannon spoke with Batsevitsky about making certain adjustments to the 2012 Projections, including decreasing revenue growth and increasing operating costs.[85] In an email, Cannon stated that these revisions were necessary due to “future competitive forces in the market.” Batsevitsky responded that the revisions would “make the projections more conservative which may be better as Wells [Fargo] will most[] likely use ...

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