We started our discussion of statutory fair value with an introduction (#1 Introduction) and followed that with a discussion of the DCF valuation method (#2 Discounted Cash Flow (DCF) Method). We now turn to the levels of value charts that are at the heart of every valuation decision made in statutory fair value determinations, either by judicially or by appraisers.
The “Traditional” Levels of Value Chart
The “traditional” levels of value chart has three levels: the control level, the marketable minority (or “as-if freely traded”) level, and the nonmarketable minority level. As we will see, there are two key valuation discounts and one premium that enable “movement” between levels on the chart.
While the valuation concepts of control, freely traded and nonmarketable minority have been around for several decades, they were notformally published in a chart until 1990. Since the publication of the original charts, appraisers have worked on the concepts and attempted to refine them. Interestingly, it is this process of learning and refinement that has contributed to confusion over what “fair value” means in the statutory fair value world.
The three-level chart shows the three conceptual levels of value noted above. It also shows conceptual premiums and discounts that enable appraisers (and courts) to move from one level to another.
The Marketable Minority Level of Value is the Benchmark Level
The benchmark level is the marketable minority level of value, or the middle level in the chart above. Conceptually, it represents the pricing of the equity of an enterprise if (for a public company) or as if (for a nonpublic company) there were a free and active public market for the shares.
In Statutory Fair Value: #2 Discounted Cash Flow Method, we indicated the Gordon Model is a single equation representation of public securities pricing. We’ll come back to this as our discussion progresses. For now, note the following:
- Many large, high market capitalization public companies have free and active markets for their shares.
- Other public companies have less active markets.
- Privately owned companies lack markets.
Nevertheless, we use the conceptual marketable minority level of value when attempting to provide value indications for all three: large-cap publics, smaller, more thinly traded publics, as well as private companies.
Note that the term, marketable minority level of value implies that this valuation concept is a minority concept, i.e., one that lacks control. However, public companies are “valued” at this level. For example, it is routine to refer to the market price of a public company multiplied by its shares outstanding as the market capitalization of its equity.
Said another way, the market cap of equity is an indication of the value of a business enterprise, and not merely of a small minority interest in the enterprise. For that reason, I (and others) refer to the marketable minority level of value as an enterprise level of value. This distinction will become important as we proceed with the discussion of the underpinnings of statutory fair value.
The Control Level of Value
The conceptual level of value above the benchmark marketable minority level is the control level of value. We will learn that “control” has multiple meanings (including financial, synergistic, and strategic), but for now, we stick with the single term. The control level of value represents pricing as if entire companies (or controlling interests in them) are sold.
We move from the marketable minority level of value to the control level of value through the application of a conceptual control premium. When public companies are sold, “control premiums” are typically paid by the acquirers. A control premium represents the percentage difference between the price actually paid for a company, say $14 per share, and the price at which it was trading prior to the announcement of an acquisition, say $10 per share. In this case, the control premium would be 40% ($14/$10 minus 1.0).
Market participants have been studying control premiums for years. The Factset Mergerstat® /BVR Control Premium Study™ is the most prominent such study at this time.
Sometimes, the control level of value can be observed directly, as when public companies and private companies are acquired and valuation metrics become available. So the levels of value chart provides for moving from the observable control level back down to the marketable minority level. As seen in the chart above, the conceptual minority interest discount has been used to facilitate this movement.
The minority interest discount eliminates the so-called value of control (as reflected in the control premium) by deflating a control price by the amount of the actual or conceptual control premium. So in the example above, the minority interest discount, as measured in the movement from the $14 per share control price to the $10 per share marketable minority price, is 28.6% (or 1 – (1/(1+40%)).
The 40% control premium in our example is the numerical equivalent of the 28.6% minority interest discount. Historically, control premium data (averages and medians) have been used by appraisers as a basis to estimate minority interest discounts. There is now substantial agreement among business appraisers that control premiums measure, in addition to any value that may be directly attributable to control, the added benefits of expected acquirer synergies or other strategic benefits.
This evolution in thinking regarding valuation premiums and discounts (and the levels of value) has created growing confusion in the statutory fair value arena.
The Nonmarketable Minority Level of Value
The lowest level on the traditional levels of value chart is called the nonmarketable minority level of value. This level of value represents the conceptual value of illiquid (nonmarketable) minority interests of private companies (i.e., entities that lack markets for their shares).
It has long been accepted that minority interests in private companies are worth less, perhaps even substantially less, than controlling interests. What have not been clearly understood are the reasons for differences in value between minority and controlling interests of businesses.
Appraisers have typically moved from the marketable minority level of value to the nonmarketable minority level of value through the application of a conceptual discount called the marketability discount. That has been my term of preference for many years, but others refer to the same discount as the discount for lack of marketability (DLOM).
If, as in our example above, the marketable minority level of value is $10 per share for a company, and a transaction in a minority block occurs at $7.50 per share, then the marketability discount is 25% (1 – ($7.50/$10)).
The concept of valuation discounts related to lack of marketability has been studied in the public securities markets since the 1960s. A good overview of available market evidence (i.e., restricted stock studies and pre-IPO studies) is found in my book, Business Valuation: An Integrated Theory Second Edition (with Travis Harms). These studies of market evidence fall into two categories, restricted stock studies and pre-IPO studies.
Appraisers and courts have used and misused these studies for years. The misuse of available evidence has contributed to confusion in the statutory fair value arena.
In our next post on Statutory Fair Value, we will dispel some of the confusion regarding the traditional levels of value chart as we proceed with our discussion of statutory fair value in the context of modern business valuation theory and practice.