In the last two posts, we introduced the Control Levels of Value (Statutory Fair Value #15) and the Financial Control Level of Value (Statutory Fair Value #16). The discussion of the financial control value suggested that differences between this conceptual level of value and the marketable minority level of value would occur only if there were differences in expected cash flow, risk and/or growth between the two levels.
At this point, the control premium relating the price a financial control buyer might pay to the marketable minority value can be specified in terms of differences (from the marketable minority level) in expected cash flow, risk and/or growth.
This equation defines the financial control premium as the difference in value between the financial control and the marketable minority levels.
Several observations on the relationship between value at the marketable minority and financial control levels of value follow.
Application of financial control premiums should be limited to situations in which the hypothetical willing buyer reasonably expects to:
- Increase cash flows relative to normalized cash flows of the enterprise; and/or,
- Increase expected growth of cash flows of the enterprise; and/or,
- Decrease the discount rate relative to Rmm; and, importantly,
- Be willing to share all or a portion of the expected benefits enumerated above with seller.
In the absence of any of the preceding conditions, the financial control value will be the same as the freely traded, marketable minority value. Why? Because nothing would have changed to create a delta between the two conceptual levels of value.
A further implication of this logic is that values derived by applying guideline public company multiples to normalized earnings of privately owned enterprises will approximate financial control values. This assumes, of course, that the public multiples are properly adjusted for fundamental differences in expectations (primarily for risk and growth) between the guideline public companies and the subject private enterprises. The concept of the fundamental adjustment and its role in the Integrated Theory will be discussed in a future post.
The financial control premium is clearly a range concept. The financial control premium that might be paid for a particular enterprise will vary with potential buyers based on their unique circumstances and the degree of competitive bidding.
Insight. Financial control value is not a concept that relates to a particular financial buyer, or the buyer who could pay the highest price based on his own expectations related to a particular enterprise. That kind of value is known as investment value, or value to a particular buyer. This concept of investment value, in the context of financial control, allows for, relative to the marketable minority concept, either a higher or lower value. It also allows for a range of expected values from a range of potential buyers (like observed in the real world).
We have come a long way catching up to Eric Nath’s startling suggestion in 1990 that the public market multiples of guideline companies yielded controlling interest values. Suffice it to say that many appraisers thought this observation was nothing short of heresy. I was in that group! The Integrated Theory reconciles Nath’s position of control multiples coming from the public markets if the financial control premium is zero.
 Z. Christopher Mercer, “Do Public Company (Minority) Transactions Yield Controlling Interest or Minority Interest Pricing Data?,” Business Valuation Review, Vol. 9, No. 4 (1990): pp. 123-126. In this article, I charged to the defense of public multiples providing marketable minority value indications. Nath’s view is reconciled with the Integrated Theory under the assumption that no value-enhancing factors are available to the financial control buyer, and the financial control premium is therefore zero. I did not recognize this potential for reconciliation in 1990.
We have defined Ve(c,f) from the viewpoint of financial control buyers. Ve(c,f) sets the upper boundary for negotiation of price with sellers (unless a particular buyer is willing to reduce R(f). The greater the positive differences between Ve(c,f) and Ve(mm), the greater the potential for the consummation of transactions. Nath’s observation was that, given the relatively low number of acquisitions in any year relative to total number of public companies, the difference, in most instances, must be zero (or not large enough to warrant the interest of financial buyers). This suggests that public market pricing could reflect both marketable minority and financial control pricing. There is a growing consensus among appraisers that there is a difference between financial and strategic control values, and a growing recognition that, to the extent they exist, financial control premiums are likely small.
If financial control premiums, to the extent that they exist, are quite small, then there are important implications for the minority interest discount.
Insight. Yogi Berra is said to have said, “You can observe a lot just by seeing.” It wasn’t until the mid-1990s that I (and a number of other appraisers, of course) began to “see” that market data for control premiums pertained to something other than financial control. I recall giving a speech in which I analyzed control premium data for a couple of recent years. There were perhaps 400 transactions in each of the years, and about half of the totals for each year were acquisitions of financial institutions by other financial institutions. I recall saying that I couldn’t attest that every one of the transactions analyzed were strategic in nature, but that it was clear to me (having just written my first book, Valuing Financial Institutions, that virtually every bank acquisition was strategic. And it was apparent from just “seeing” the non-bank acquisitions, that they were strategic in nature, as well. The point I made then was that if my observations were correct, then that control premium data should not be used to develop measures of the Minority Interest Discount, and that doing so would substantially overstate any applicable minority interest discounts.
The Financial Control Premium and Statutory Fair Value
The idea that financial control premiums might be small or non-existent is, despite its logic and grounding in valuation theory, still considered to be somewhat controversial. The corollary, which is that implied minority interest discounts might be small or non-existent, is even more controversial within pockets of the valuation profession.
In statutory fair value determinations, where not proscribed by law or case guidance, some appraisers still apply substantial minority interest discounts to minority interests based on (strategic) control premium data.
In other situations, some appraisers still develop strategic indications of statutory fair value by considering (strategic) control premium data when, in many, if not most jurisdictions, this would not be appropriate.
This discussion of the financial control premium, then, leads directly to an investigation of the so-called “prerogatives of control” and the Minority Interest Discount, to which we will proceed in the next post in this series on statutory fair value.