One of the most contentious issues when valuing businesses is how to factor elements of control into the equation. Users of valuation reports often assume a controlling interest is entitled to a control premium. Conversely, they assume noncontrolling interests should be discounted.
It’s not quite that simple, though. For one thing, whether a control premium or a discount for lack of control (DLOC) is appropriate depends on the valuation methodology. Additionally, quantifying and supporting these premiums and discounts can be challenging. Here are some answers to common questions to help clarify how valuation professionals handle these matters.
What is control?
For starters, a valuator examines whether the buyer of a business interest would acquire certain prerogatives of control. These are rights typically associated with a controlling interest, such as the right to execute or block the following actions:
- Electing directors and appointing or changing management,
- Setting compensation and benefits,
- Setting policy and changing the course of the business,
- Selecting suppliers, vendors and subcontractors and awarding contracts,
- Acquiring or liquidating property, equipment and other assets,
- Acquiring or merging with other companies,
- Liquidating, dissolving, selling or recapitalizing the company,
- Registering the company’s stock for a public offering,
- Declaring and paying dividends, and
- Amending the company’s articles of incorporation or bylaws.
Whether a buyer would acquire some or all of these prerogatives depends on the size of the interest being acquired and the company’s governing documents. For example, if a buyer acquires a 60% voting interest in a company, but a two-thirds “supermajority” is required to effect a merger or liquidation, then the buyer wouldn’t acquire that particular prerogative of control.
What “basis of value” does the valuation methodology generate?
Next, it’s critical to establish whether the preliminary methodology generates a controlling or noncontrolling basis of value. Consider the following:
Asset-based (cost) approach. A valuation based on the combined fair market value of the company’s assets and liabilities is likely a controlling basis of value. Why? Because shareholders owning a minority interest in the company lack the control needed to sell assets or pay off debts.
Market approach. Under the guideline merger and acquisition (M&A) method, the expert estimates value from transactions involving entire companies or substantial interests in them. Because M&As typically involve transfers of controlling interests, valuations using this method generally produce a controlling basis of value.
Conversely, the guideline public company method, another technique under the market approach, derives value from publicly traded stock prices of comparable companies. By definition, these prices reflect transactions involving noncontrolling interests.
Income approach. When applying the income approach, a business interest is valued based on the present value of projected future cash flows. The valuator’s assumptions in projecting those cash flows dictate whether the resulting value represents a controlling or noncontrolling basis of value.
For example, suppose cash flow projections are based on the assumption that specific changes will be made (such as eliminating excessive owner salaries and benefits or adjusting depreciation expense from a tax-based method to a method more clearly reflecting economic reality). In that case, the valuator adjusts projected cash flow, and the result is likely a controlling basis of value. Why? Only a controlling shareholder would have the power to make such changes. Under those circumstances, the value of control is reflected in the projected cash flows. Conversely, the value derived using the discounted cash flow method is likely a noncontrolling basis of value if the expert didn’t adjust the company’s income stream for discretionary items, such as related-party transactions and above-market owners’ compensation.
What are control premiums and DLOCs?
Regardless of the valuation approach, whenever possible, valuators address a business interest’s degree of control by adjusting the projected income stream or returns. But, in some cases, an expert may need to apply a discrete control premium or DLOC to arrive at the appropriate basis of value.
Valuators can use control premium studies to help determine appropriate premiums. These studies measure the premiums buyers have paid for controlling interests in public companies (on a pro rata basis) over the stock’s price per share on the public markets.
There are no empirical studies that directly measure DLOCs. Instead, experts use the mathematical inverse of control premiums observed from public stock transactions.
When might premiums or discounts be appropriate?
Various situations call for experts to apply control premiums or DLOCs, rather than (or in addition to) incorporating an implicit adjustment through their valuation methodology. To illustrate, suppose a valuator identifies several comparable M&A transactions and wants to use them to value a noncontrolling interest. Is this acceptable? Yes. However, a DLOC might be necessary to convert the basis of value generated from the guideline M&A method from controlling to noncontrolling.
In this situation, the expert could apply a pricing multiple to the subject company’s unadjusted earnings before interest, taxes, depreciation and amortization (EBITDA) to reflect the expected income stream for a noncontrolling owner. Without adjustments for discretionary items, the resulting value would account for some of the business interest’s lack of control. However, this methodology doesn’t consider the risk that the controlling owner(s) could alter the subject company’s EBITDA in the future. So, a DLOC might be warranted.
Alternatively, what if other pricing multiples that can’t be adjusted for elements of control — such as price-to-revenue or price-to-book value — are more reliable valuation metrics? The use of those pricing multiples would also likely warrant a DLOC.
No cookie-cutter formulas
Evaluating control requires an analysis of several factors, including the subject company’s characteristics, its ownership structure, the potential buyers, the buyers’ opportunities to exercise control and the valuation’s purpose. We’ve only scratched the surface of this complex topic. Contact us to learn more and understand how the concepts apply to your circumstances.
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