We now turn to corollary implications of the analysis of the financial control premium. The minority interest discount necessary to adjust a financial control value to a marketable minority value in an operating company may be zero, or quite small. This conclusion follows from the discussion of the conceptual elements of the financial control premium.
Developing and articulating reasonable financial control premiums and minority interest discounts is difficult outside the conceptual framework of the Integrated Theory. Consider the discussion of the value of control in the most recent edition of Pratt/Reilly/Schweihs. Many appraisers cite the list of prerogatives of control found in each of the Pratt/Reilly/Schweihs books (and other books) as support for the application of a substantial minority interest discount. The prerogatives of control include the ability to unilaterally: [Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business, 4th ed (New York: McGraw-Hill, 2000), pp. 347-348. The list is growing with succeeding editions.]
- Appoint or change operational management
- Appoint or change members of the board of directors
- Determine management compensation and perquisites
- Set operational and strategic policy and change the course of the business
- Acquire, lease, or liquidate business assets, including plant, property, and equipment
- Select suppliers, vendors, and subcontractors with whom to do business and award contracts
- Negotiate and consummate mergers and acquisitions
- Liquidate, dissolve, sell out, or recapitalize the company
- Sell or acquire treasury share
- Register the company’s equity securities for an initial or secondary public offering
- Register the company’s debt securities for an initial or secondary public offering
- Declare and pay cash and/or stock dividends
- Change the articles of incorporation or bylaws
- Set one’s own compensation (and perquisites) and the compensation (and perquisites) of related-party employees
- Select joint venturers and enter into joint venture and partnership agreements
- Decide what products and/or services to offer and how to price those products or services
- Decide what markets and locations to serve, to enter into, and to discontinue serving
- Decide which customer categories to market to and which not to market to
- Enter into inbound and outbound license or sharing agreements regarding intellectual properties
- Block any or all of the above actions
In short, the controlling shareholder is empowered with the rights to manage a business enterprise for the benefit of the controlling shareholder. Appraisers (and courts) have long thought that control buyers pay control premiums for the prerogatives of control listed above. The Pratt/Reilly/Schweihs text concludes the presentation of this list, which first appears in Chapter 15, “Control and Acquisition Premiums,” with the following comment:
From the above list, it is apparent that the owner of a controlling interest in a business enterprise enjoys some very valuable rights that the owner of a noncontrolling ownership interest does not enjoy.
The authors present two levels of value charts at the same point in the text. The first chart is the three-level one used for several years in editions of Valuing a Business and other publications. The second is the modified and expanded four-level chart presented in this now-familiar figure:
In other words, the control premium in view is the same conceptual premium as the financial control premium indicated in the figure above. (Pratt/Reilly/Schweihs. Citing Jay E. Fishman, Shannon P. Pratt, Guide to Business Valuations, 10th ed. (Fort Worth, TX: Practitioners Publishing Company, 2000). Also, at p. 348, citing Z. Christopher Mercer, “Understanding and Quantifying Control Premiums: The Value of Control vs. Synergies of Strategic Advantages,” The Journal of Business Valuation (Toronto: Carswell Thomson, 1999), p. 51.)
We will see shortly that the statement quoted above may be true as it relates to a controlling owner of a private company and a minority (noncontrolling) shareholder in the same company. It is likely not true (or is not relevant) as it relates to the managements and boards of directors of well-run public companies and the corresponding minority shareholders holding publicly traded shares. Carrying this thought a step further, if the statement about the “rights” of control are not true for well-run public companies (where management and the directorate are expected to do a good job exercising control), then it is also not true for the private company being valued at the marketable minority level of value.
Examination of the conceptual math shown in the figure above reveals no direct consideration of the aforementioned prerogatives of control. What, then, is a control buyer paying for? We observe the following from the equation below, which defines the financial control premium:
- The financial control premium is created by any differential in cash flows or growth that the control buyer is willing to price into a deal. In other words, the conceptual model suggests that a control buyer would pay a financial control price based only on the expectation of greater future cash flows than expected at the marketable minority level.
- Rather than having some inherent value, the value of the various prerogatives of control is manifest in more favorable expectations with respect to expected cash flows, growth, or risk. Control premiums are paid for the right to run the enterprise differently to achieve enhanced cash flow or accelerated growth. The price is paid for the expected cash flow and not for the naked right, or prerogative.
- There is no specific portion of the value of an enterprise that should be allocated solely to the prerogatives of control of control.
We conclude, therefore, that control buyers augment the marketable minority level of cash flow through the exercise of the prerogatives.
Insights. Several insights are appropriate regarding the prerogatives of control:
- I have personally been involved in many transactions involving the change of control of companies and financial institutions. In all of the transactions in which I have participated directly in the negotiations, there has never been a discussion of the so-called prerogatives of control as elements of value. The discussions always revolve around expectations for cash flows and their growth and risks to their realization.
- If I buy a car, I receive the title to it. The title gives me the right to “control” the car and its use. If a company’s assets are purchased, just like my car, title transfers and the new owner has the right to control their use. I did not pay for “control” of the car, but for its use and enjoyment. The company’s assets are not purchased for “control” over them, but for their productive use.
- If the stock of a company is purchased, it is presumed to own or “control” its underlying assets. Acquirers purchase stock for the productive use (i.e., cash flow generation) of the underlying assets. They presume “control” over the company’s assets and their employment.
- The assets of acquired companies are valued for purchase price allocation routinely. I am not aware of an intangible asset called “prerogatives of control” for financial reporting purposes.
We have observed thus far that unless the control buyer expects to achieve augmented levels and growth of cash flows, the financial control premium could be zero, or at least, quite small. Recalling the logic of the economist, if it were not so…In other words, if a substantial premium were paid with no expectation of augmented cash flows, then the control buyer would have to accept a substantially lower return. No rational purchaser would pay extra just for the right to control when control is assumed in the transaction.
The Minority Interest Discount
The conceptual difference between the financial control value and the marketable minority value is the financial control premium, as is seen in the equation above. If that premium is zero (or quite small), it is also true that the minority interest (or lack of control) discount is quite small. Several observations about the relationships between the marketable minority and financial control levels of value are summarized below:
- Minority shareholders of public companies lack control, which is vested with managements and boards of directors. Yet we have observed (practically as with Nath, and conceptually with the Integrated Theory) that the marketable minority value and the financial control value may approximate each other for most public companies. Again, otherwise there would be strong financial incentive for the takeover of many public companies. Absent such a level of activity, it is reasonable to assume that the marketable minority and financial control values for most public companies approximate each other.
- The implication of this line of reasoning is that there is no (or very little) discount for lack of control considered in the pricing of public securities. This makes sense because investors in the public markets are not investing to gain control – they invest in companies and expect managements to run them in the best interests of the shareholders. Otherwise, the shareholders would exercise the control they do have – selling their shares and putting downward pressure on market prices, creating opportunities for takeovers by financial buyers.
- Further, observe that at the marketable minority level, all the cash flows of public enterprises are expected to be distributed to the shareholders in dividends or reinvested in the enterprises at their discount rates. Share prices are not reduced because minority shareholders do not control or have direct access to enterprise cash flows, since minority shareholders have access to the benefit of the market’s capitalization of all expected future cash flows in the current market price. At any time, a minority shareholder in a public enterprise can place a sale order and achieve current market value in three days.
- This reasoning suggests that the public securities markets eliminate most, if not all, of any discount for lack of control.
The logical inference following these observations is that unless there are cash flow-driven differences between the enterprise’s financial control value and its marketable minority value, there will be no (or very little) minority interest discount. The definition of the discount for lack of control (the minority interest discount), as found in the Glossary of the ASA Business Valuation Standards, is:
An amount or percentage deducted from the pro rata share of value of 100 percent of an equity interest in a business to reflect the absence of some or all of the powers of control.
It is important to note that this definition is consistent with the notion that the discount for lack of control might be nil or quite small if the financial control premium is similarly nil or small.
Insight. The capital structure of an enterprise may include voting and nonvoting stock. If the vote is perceived to decrease risk somewhat relative to the nonvoting shares, voting shares may trade at a small premium to nonvoting shares. Stated alternatively, nonvoting shares may trade at a small discount to voting shares. The discount does not reflect merely the lack of vote, but rather, the increased risk perceived to be associated with the lack of the vote.
Market discipline causes most public companies to be run in reasonable fashion, with cash flows being optimized and either reinvested or distributed to achieve appropriate returns to shareholders. The minority interest discount will exist only if the typical control financial buyer can expect to augment cash flows from properly normalized cash flows at the marketable minority level.
Insight. These observations are made in relationship to operating companies. Their relevance for asset holding entities needs to be addressed further. The logic of the Integrated Theory suggests that there is no reason for minority interest discounts related to asset holding entities to be of great magnitude. In practice, I have used minority interest discounts in the range of 0% to 1o% for several years when valuing asset holding entities. The issue of minority interest discounts seldom arises when valuing operating companies, since most valuation methods, other than comparison with guideline transactions of whole companies, yield marketable minority level indications of value.
The financial control premium was defined in the previous post. The related minority interest discount from the financial control value (MIDF) is defined in the following equation:
The conceptual analysis thus far suggests that our levels of value chart should be modified to better reflect the conceptual relationship between the financial control and marketable minority levels of value.
The expanded, modified chart in the figure above depicts the much smaller (or non-existent) difference between the financial control and marketable minority levels of value suggested by our analysis. This is the levels of value chart that I use in valuation reports, speeches, articles, and as found on Mercer Capital’s website as a resource. This chart summarizes in picture form the conceptual math of the Integrated Theory. It also shows the nonmarketable minority level of value, which we will discuss in future posts.
The Minority Interest Discount and Statutory Fair Value
The odyssey to a better understanding of the levels of value began with Eric Nath’s 1990 article. Appraisers began questioning the use of (strategic) control premium data as the basis for estimating minority interest discounts in the mid-1990s. I began speaking about an integrated theory of business valuation in the early 2000s, and published The Integrated Theory of Business Valuation (out of print) in 2004. Business Valuation: An Integrated Theory Second Edition (with Travis Harms) was published in 2007.
My experiences in testifying regarding statutory fair value have convinced me that an understanding of the Integrated Theory will assist appraisers and courts in future statutory fair value determinations. With the vocabulary we are building, we will turn to discussions of specific statutory fair value cases and examine their valuation economics in light of the Integrated Theory.
The strategic control value will be developed to round out the enterprise levels before proceeding to the shareholder level (nonmarketable minority value). However, we do pause to observe that what can be large differences between the enterprise and shareholder levels of value is not attributable to the familiar prerogatives of control, but rather the lack of marketability.
 Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business, 4th ed (New York: McGraw-Hill, 2000), pp. 347-348. The list is growing with succeeding editions.
 Ibid, p. 349.
 Ibid, p. 347. Citing Jay E. Fishman, Shannon P. Pratt, Guide to Business Valuations, 10th ed. (Fort Worth, TX: Practitioners Publishing Company, 2000). Also, at p. 348, citing Z. Christopher Mercer, “Understanding and Quantifying Control Premiums: The Value of Control vs. Synergies of Strategic Advantages,” The Journal of Business Valuation (Toronto: Carswell Thomson, 1999), p. 51.
 “Definitions,” Business Valuation Standards (Washington, D.C.: American Society of Appraisers, June 2005), pp. 21-31. This lack of control discount is theoretically consistent with eliminating a financial control premium.
 The capital structure of an enterprise may include voting and nonvoting stock. If the vote is perceived to decrease risk somewhat relative to the nonvoting shares, voting shares may trade at a small premium to nonvoting shares. Stated alternatively, nonvoting shares may trade at a small discount to voting shares.
 These observations are made in relationship to operating companies. Their relevance for asset holding entities needs to be addressed further. The logic of the Integrated Theory suggests that there is no reason for minority interest discounts related to asset holding entities to be of great magnitude. In practice, we have used minority interest discounts in the range of 0% to 15% for several years when valuing asset holding entities. The issue of minority interest discounts seldom arises when valuing operating companies, since most valuation methods, other than comparison with guideline transactions of whole companies, yield marketable minority level indications of value.