In the Statutory Fair Value #14 post, we introduced what we called The Benchmark Marketable Minority Level of Value. The marketable minority level of value is an enterprise level of value because it is determined by capitalizing (or discounting) the normalized cash flows to equity of a business enterprise.
In this post, we will introduce the “control” levels of value. In the next two posts, we will talk about the financial control and the strategic control levels of value.
Links to a number of dated citations are not readily available. I have included several traditional footnotes as indented quotations.
Normalizing Adjustments and Control
The concept of normalizing earnings is important in the context of statutory fair value. If enterprise cash flows are not normalized, for example, for excessive owner compensation, capitalizing non-normalized earnings provides an indication of value below that of the value of the enterprise if it were to be sold in the market as a going concern. In New York, for example, case law guidance provides in Beway (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161):
Thus, we apply to stock fair value determinations under section 623 the principle we enunciated for such determinations under section 1118 that, in fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, “’what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business’” (Matter of Pace Photographers [Rosen], 71 NY2d at 748, supra, quoting Matter of Blake v Blake Agency, 107 AD2d at 146, supra [emphasis supplied]).
When companies are sold, it is customary for owner compensation to be normalized to market levels. Selling owners are happy to do this in order to realize the benefit of the capitalized value of above-market salaries. I studied economics as an undergraduate and in graduate school. We often used an expression to prove (or disprove) a point: “If it were not so, …..” That might be a another way economists have of saying, “on the other hand,….”
If it were not so that owner compensation is normalized in fair value determinations, then controlling owners who are squeezing out a minority shareholder (or allegedly oppressing) would both continue to receive the current benefit of above-market compensation and the benefit of a lower value to be paid to the minority shareholder. If this seems too good to be true, then that is likely what the guidance in Beway above is attempting to avoid.
Control Levels of Value
There is a growing consensus that there are at least two conceptual levels of value above the marketable minority level:
- Financial Control. The first level describes what a financial buyer is able (and perhaps willing) to pay for control of a business. Financial buyers acquire companies based on their ability to extract reasonable (to them) rates of return, often on a leveraged basis.
- Strategic Control. The second control level is referred to as the strategic, or synergistic, level of value. Strategic buyers can (and do) pay more for companies than financial buyers because they expect to realize synergies from acquisitions (e.g., perhaps through eliminating duplicate expenses or achieving cross-selling benefits) that increase future cash flows.
Steven D. Garber, “Control vs. Acquisition Premiums: Is There a Difference?” (Presentation at the American Society of Appraisers International Appraisal Conference, Maui, HI, June 23, 1998).
This emerging consensus, supported by evidence from change-of-control transaction data, has led to conceptual levels of value charts with four, rather than three, levels. A general comparison of the two charts is shown in the figure below. We will discuss further refinements to the levels of value chart in the next two posts in this series (on the financial control and strategic control levels of value).
The left side of the figure presents the traditional, three-level chart, including the conceptual premium and discounts that enable appraisers to relate the three levels to each other. The right side of the figure presents an expanded, four-level chart. Note that the “financial control premium” on the right and the “control premium” on the left are the equivalent conceptual premiums.
Z. Christopher Mercer, “A Brief Review of Control Premiums and Minority Interest Discounts,” The Journal of Business Valuation, (Toronto: Carswell Thomas, 1997), pp. 365-387.
As a result, the minority interest discounts shown on the left and right sides of the figure above are the same conceptual discount. We have called the conceptual premium relating the financial control value to the strategic control value the “strategic control premium.”
This flows from the general belief that fair market value is a financial concept based on the hypothetical negotiations of hypothetical willing buyers and sellers, and that the “strategic control premium” reflects the consideration of specific buyers who benefit from particular synergies or strategies. The strategic control level of value might become the appropriate level for fair market value if the typical buyers are strategic buyers. This situation existed during much of the last two decades in the consolidating banking industry (prior to about 2008) and in numerous other consolidating industries.
Note that no name is provided for the conceptual discount that would lower the strategic control to the financial control value. Further, note that this conceptual discount also is not the minority interest discount relating the financial control value with the marketable minority level of value. These are important observations visually. We will investigate the differences more specifically in the coming posts.
As we move up from the marketable minority level to the levels of financial control and strategic control, we see that it is possible that a controlling shareholder may make adjustments to expected cash flows based on the expected ability to run an enterprise better (financial control) or differently (strategic control). Such adjustments would be control adjustments and could have the impact of increasing value if such adjustments would normally be negotiated between hypothetical (or real) buyers and sellers.
In other words, from a conceptual viewpoint, control adjustments are those that, if appropriate, increase enterprise cash flow above that of the (normalized) marketable minority level. As the figure above indicates in a conceptual sense, the value of the expected cash flows of the enterprise from the viewpoint of either a financial control buyer or a strategic control buyer may be greater than the value of the normalized expected cash flow of the enterprise.
Careful review of the control (or acquisition) premium data available to appraisers indicates such premiums generally result from transactions motivated by strategic or synergistic considerations. Consequently, the available control premium data more generally reflects the combination of the financial control premium and the strategic control premium (see figure above).
M. Mark Lee, “Premiums and Discounts for the Valuation of Closely Held Companies: The Need for Specific Economic Analysis,” Shannon Pratt’s Business Valuation Update, August 2001.
This observation suggests the following conclusions:*
- Use of available control premium studies as a basis for inferring minority interest discounts in a fair market value context is conceptually incorrect, except where strategic buyers are the norm. The improper use of such data would tend to overstate the magnitude of minority interest discounts.
- When applied to financial control values, such discounts would not yield marketable minority interest levels of value, but rather something below that level (with no clear conceptual definition).
- And finally, the application of a “standard” marketability discount to that lower (and conceptually undefined) value would tend to understate the value of illiquid interests of private enterprises.
* Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed (New York, NY: McGraw-Hill, 2000). calls the strategic control premium “strategic acquisition premium” in their chart at page 347. They state, regarding the chart:
The diagram presented in Exhibit 15-1 reflects the value influence of the ownership characteristics of control versus the noncontrolling stockholder’s situation as discussed in Chapter 16. This schematic usually would represent the fair market value standard of value on a going-concern basis premise of value. In some cases, there may be yet another layer of value, which may reflect synergies with certain third-party buyers (as examples of: (1) reducing combined overhead by the consolidation of operations or (2) raising prices by reducing competition). There is not yet a widely used term for this additional layer of price premium over fair market, going-concern value. However, this price premium — when combined with the ownership control premium — is sometimes called an acquisition premium. The standard of value reflecting these synergies usually would be considered investment value. This is because it reflects the value to a particular buyer, generally referred to as the synergistic buyer, rather than value to the hypothetical willing buyer. This “hypothetical” typical willing buyer acquires the subject company strictly because of its financial merits, and is generally referred to as a financial buyer. (emphasis in original)
Z. Christopher Mercer, “Understanding and Quantifying Control Premiums: The Value of Control vs. Synergies or Strategic Advantages,” The Journal of Business Valuation, (Toronto: Carswell Thomas, 1999), pp. 31-54.
And in the Context of Statutory Fair Value
It should be clear that thinking about the levels of value has been evolving for some time. In the next two posts in this statutory fair value series, we will discuss the further evolution in the context of the integrated theory of business valuation.
These concepts are critical to business appraisers in statutory fair value determinations. They are also critical to the judiciaries of the various states as they grapple with judicial determinations of fair value.