|
|
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
|
Control Premiums And Minority Discounts *by All shares are equal, but some are more equal than others, to
borrow from George Orwell. The value of the company can be estimated, as described in
Chapters 10 and 11, but do stockholders share equally in that value? Are the shares of
controlling stockholders worth more per share than the shares of the minority? The answer,
as will be seen below, is, it all depends. Reasons for control premium Control confers value. Stockholders holding a controlling
interest in a company can determine the nature of the business; select management; enter
into contracts; buy, sell, and pledge assets; borrow money; issue and repurchase stock;
register stock for public offering; and liquidate, sell, or merge the company. The
controlling party can also set management compensation and perquisites, declare (or not
declare) dividends, make capital distributions, and control contracts and payments to
third parties. In privately held companies the ability to set compensation is critical,
for owner/managers frequently distribute proceeds as compensation rather than dividends in
order to avoid double taxation. Minority stockholders often have minimal influence on
these important activities. Amount of control premium Whether anyone will pay a premium for a controlling interest (a control premium) depends largely upon whether the potential buyer believes he or she can enhance the value of the company. If the company is being run satisfactorily by current management and new ownership could neither do better nor create synergies to increase value, what extra value could be created through acquisition? It is the potential for a new owner to increase value that makes buyers willing to pay a premium for control. Obviously, the size of the premium will depend upon how much incremental value buyers believe can be created. Following the above reasoning, one would expect variation in the sizes of control premiums, depending upon the particular circumstances of the target companies. That is what one finds in practice. A study of 1997 acquisitions reported 487 purchases of major blocks of stocks in publicly traded companies for which a premium was paid. The premiums ranged from zero to 733% with a median of 27.5% and mean of 35.7%. In addition, premiums were not paid in all cases. Another 49 acquisitions were made at a discount from market. The discounts ranged from zero to 67% and had a median of 6.8% and mean of 12.2%. Of course, acquisition premiums are not only affected by the potential for increasing the value of the acquisition target. A premium may simply reflect a more sanguine view by the buyer of the prospects of the company than the current owners hold. In addition, depending upon the depth of the market for a particular stock, competition from other potential buyers, and the views and financial needs of the existing stockholders, a buyer may not have to pay as much as he or she estimates the company is worth in order to acquire it. Similarly, low or negative acquisition premiums may be the result of specific needs of the seller. In short, the mere fact of control does not lead to any specific premium. In fact, it does not necessarily lead to any premium at all. Logic and the data support the courts in their position that the existence and size of a control premium depends upon the facts of the specific case. If a control premium is to be added in the valuation of a company, the basis for adding it must lie in some identified potential for increasing value in the company, and the size of the premium depends on how much the value can be increased. There are several ways that a new owner might enhance value. There may be potential synergies between the company and the buyer's other activities, although these synergies are often overestimated (see Chapter 12 herein). Perhaps the company is mismanaged, and profitability could be increased by new management. If current management is overcompensated, stockholder value can be enhanced by reducing compensation costs. Another possibility is that the sum of the company's parts is worth more than the whole, and the company can be liquidated at a profit. In valuing a company, care must be taken to avoid double
counting premiums. In the case of publicly traded companies the market frequently
anticipates changes which will enhance value, either because the market expects current
management to make the changes or because it expects new management following a buyout.
Similarly, in the valuation of private companies, financial statements are routinely
adjusted to eliminate revenues or expenses that relate to current ownership but would not
exist for a new owner. For example, reported earnings of a company might be $500,000, but
the analyst might conclude that the CEO/owner is overpaid and that adjusting the CEO's
salary to market would add $100,000 to earnings. The valuation would then be done based
upon $600,000 of earnings. Suppose the valuation was being done on the basis of a
price/earnings ratio of 5X. The company would be worth $2,500,000 based upon unadjusted
earnings but $3,000,000 based on adjusted earnings. The extra $500,000 would be the value
of a control premium but would only be a premium over the $2,500,000. Adding it to the
$3,000,000 would be double counting. Any control premium should only reflect those
enhancements not already taken into account. Minority discount While a premium may be appropriate in acquiring a controlling
block of shares in either a public or private company, a minority discount will only be
relevant when valuing shares in a closely held company. Publicly traded shares are already
priced as minority holdings, requiring no discount from the quoted value of the stock.
This is not so for minority shares in a private company. Reasons for minority discount For all the reasons that a controlling stockholder may enjoy power and economic benefit, the minority stockholder may not. This is not to say that the minority stockholder cannot benefit from the actions of the majority. If the majority sells out at a control premium to a new owner who buys all the stock or succeeds in enhancing the value of the company, the minority owner will share in the gain. However, the minority shareholder in a private company is not generally able to control his or her own destiny, and the value of the minority shareholding is discounted. The depth of the discount will depend on the circumstances. There are two reasons that the discount can vary. First, there are differences in the ability of minority stockholders to fend off majority oppression or exert influence on the company. In some cases, government regulations, indenture restrictions, contractual obligations, the financial condition of the company, and the realities of the competitive marketplace can restrict the freedom of action of those in nominal control. Moreover, the minority may have more power than the size of their holdings would indicate. Statutes, articles of incorporation, or bylaws may require consent of more than the usual 51% to approve certain actions. A minority shareholding may be enough to constitute a majority when combined with blocks of other shares; having the swing vote can confer power. Cumulative voting for directors can enhance minority power. The second cause of variation in minority discounts is differences in the extent to which the minority stockholders are economically disadvantaged. In circumstances where a company is well run (i.e., management is fairly compensated, financial information is provided, all stockholders receive the same pro rata returns to capital, and in general the minority stockholder enjoys the same benefits as the stockholder in a public company) the minority discount will be less. At the other end of the spectrum, when the minority stockholder has been frozen out, a substantial discount is required. Minority interests of private companies typically lack
marketability. A publicly traded share is in the minority, but it has liquidity. A share
in a private company is both in the minority and lacks a market. Conceptually, lack of
marketability is a separate attribute from merely being in the minority. However, the data
frequently do not allow us to distinguish between minority and lack-of-marketability
discounts; the two often become rolled together in analyses and by the courts. Amount of discount Usable statistics on the size of minority discounts are scarce. A variety of types of data have been put forward as measuring minority discounts. Some are more credible than others. The difficulty with much of the data is that it is not clear whether they measure minority discounts, or at least minority/lack-of-marketability discounts, as opposed to something else. Studies which clearly measure minority or minority/lack-of-marketability discounts are of private sales of minority interests in real estate and in private companies. Although not a perfect fit, minority interests in real estate are comparable to minority interests in corporations in the sense that they share similar problems of lack of control and illiquidity. Two studies of sales of fractional interests in real estate indicate a wide range of minority discounts (zero to over 80% at the extremes), with the bulk of the discounts clustering in the 25% to 40% range. The other data come from a study of 49 sales of minority
stockholdings in private corporations. Unfortunately, the minority discounts reported were
from adjusted book values, not from estimates of market values. Although book value is
frequently unrelated to market value, the author of the study reported that all the
companies in the study had substantial tangible assets, in which case book value was
probably close to being a floor for market value. The study showed discounts ranging
between zero and 78%, with a median of 39% and a mean of 40%; approximately half were
clustered in the 20% to 50% range. Minority discounts and case law A minority discount will be relevant in estate and gift tax cases but usually not in minority buyout cases. In tax cases the objective is to establish fair market value, and the courts have long recognized that "minority stock interests in a 'closed' corporation are usually worth much less than the proportionate share of the assets...." Tax courts have allowed discounts for minority interests, but it has frequently been difficult or impossible to determine whether the discount was being allowed because the shares represented a minority interest, were unmarketable, or both. A survey of selected decisions shows discounts of one kind or another ranging from 10% to 65%. The range for minority discounts, in those few cases in which it was clear what the award was for, was 20% to 35%. In minority buyout cases the courts have not tried to determine "market value" or "fair market value" of a minority interest but rather "fair value," which is usually only broadly defined in the statutes. Not surprisingly, there has been substantial variation among courts as to the determination of fair value. In general, the concept of fair value incorporates the notion that the minority shareholder should receive his or her pro rata share of the value of the company. The rationale is that the need for judicially ordered buyout
is usually triggered by a situation that cannot otherwise be resolved without dissolution
of the corporation or by oppressive behavior on the part of those in control. In the first
instance, liquidation and distribution of the proceeds would lead to each stockholder
receiving a pro rata share, without any discount; when mandating a buyout the court
attempts to leave the minority stockholder in no worse position than he would have been
had the corporation been dissolved. In the second instance, the oppression of the majority
would be rewarded if the minority stockholder did not receive a pro rata share but was
subjected to a minority discount instead. Although the courts are not unanimous, minority
discounts have not generally been taken in minority stockholder buyout cases. Bottom-up method In valuing minority interests we have, up to this point, discussed valuing the company first, then calculating the minority discount. An alternative approach is to value the minority interest directly, sometimes referred to as the bottom-up method. In direct estimation the analyst looks at the stock simply as another investment. The stock pays a dividend, or not, with some degree of regularity. Capital distributions may or may not be expected in the future. The company is in an industry and has a history, financial condition, assets, management, and other attributes that make one confident, or not, that the dividends and the distributions will be paid. The cash from future dividends and distributions can be estimated, and there is some degree of risk that the estimate may be wrong. The projected cash flow can be discounted back to a present value. The discount rate should reflect the degree of risk associated with the projections, as well as the facts that the instrument is unmarketable, lacks control, and is issued by a private company. In this manner the minority, non-marketable share is valued
by the discounted cash flow method directly as a financial instrument without the need to
value the company as a whole or estimate discounts. While the method sounds neat and
clean, it relies upon the correct choice of a discount rate, which can be subjective,
since, by definition, there is not a market of non-marketable securities from which to
derive the relevant discount rate. Nevertheless, the bottom-up method has considerable
appeal, especially when the minority gets very little benefit from its shareholdings or is
far removed from corporate control. EXAMPLE A simplified example to illustrate the application of control premiums and minority discounts may be instructive. Fred Founder owns 60% of Intergalactic Enterprises, Inc. Cousins Larry and Liz own 20% each but don't work for the company. The company pays dividends. When Larry dies, Intergalactic is valued at $10,000,000 for estate tax purposes.
Note: The discount is relatively modest because the company is paying dividends, giving the minority stock an investment value based on yield. The company stops paying dividends, and soon thereafter Liz dies of unrelated causes.
Note: The discount is greater because the minority holding has lost its investment value derived from the dividends. Heirs Larry II and Liz II and Fred Founder are now stockholders. Fred sells his 60% to AcquisitionCo. AcquisitionCo is an independent third party, the price is set in arms length negotiation, and Fred gets no consideration other than payment for the shares. AcquisitionCo pays a premium because it can enhance value 20% by making operations more efficient. AcquisitionCo anticipates only arms length intercorporate transactions and, thus, has no means of capturing the entire increase in value for AcquisitionCo; the gain in value will be shared with Intergalactic minority stockholders. Consequently, AcquisitionCo only pays a premium based upon Founder's shares (i.e., the shares it will actually own), not on the whole company.
Note: The minority shareholder values increase with the value of the company and thus benefit from the acquisition, even though they do not share directly in the control premium and still suffer the same percentage minority discount. Had AcquisitionCo been able to siphon off all the gain in value for itself, there would have been no gain for Larry II and Liz II, and AcquisitionCo could have paid a higher premium for Fred's controlling block. On this different set of facts, however, AcquisitionCo and Fred Founder might have been open to charges of looting, and Larry II and Liz II might have had grounds for suit. AcquisitionCo brings in Larry II and Liz II to manage the company, which they do for several years, but then Larry II and AcquisitionCo have a falling out, and AcquisitionCo fires Larry II, whereupon Larry II sues. The court finds AcquisitionCo breached its fiduciary duty to a minority stockholder and orders AcquisitionCo to buy Larry II's stock with no discount.
AcquisitionCo decides it can further enhance value by achieving synergies with its own operations. To that end it wants to own 100% of Intergalactic. Liz II doesn't want to sell. AcquisitionCo pays a premium for her minority shares just to buy her out.
If it wasn't obvious before the example, it should be now: control premiums and minority discounts depend upon the purpose for which the premium or discount is being calculated and the facts of the specific situation. As with so many things in life and the law, God and the devil are in the details. * First published in Robert B. Dickie, Financial Statement Analysis and Business Valuation for the Practical Lawyer (Section of Business Law, American Bar Association, 1998). If you wish to receive future publications as they are released, sign up for our Newsletter. |
||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
The Firm |
Business Valuation |
Litigation Support | Clients
information@philipsaunders.com |
