In the last post, we talked about the concept of the proportionate share of the value of a going concern that has deep roots in Delaware statutory fair value case law. In Delaware, where the discounted cash flow method is the favored valuation method, the proportionate interest in a going concern is defined by the net present value of the expected future cash flows of a business.
A 2007 article, “The Short and Puzzling Life of the ‘Implicit Minority Discount’ in Delaware Appraisal Law appearing in the University of Pennsylvania Law Review” (written by two professors, Lawrence Hamermesh and Michael Wachter) points out the second problem (with respect to the traditional levels of value).
Recall that the first problem is that of a proportionate interest in a going concern and the third is the marketability discount that appears relative to otherwise controlling interest values in New York case law.
The article notes:
As sometimes happens in rapidly developing bodies of law, however, a doctrinal weed sprung up in the late 1990s in what was otherwise a largely harmonious, well-tended garden of finance and law. In a rapid succession of cases over a period of less than ten years, there developed what is now known in the Delaware case law as the “implicit minority discount,” or “IMD”…
The Hamermesh/Wachter article then describes the IMD:
The financial/empirical assertion of the IMD is quite simple: no matter how liquid and informed the financial markets may be, all publicly traded shares persistently and continuously trade in the market at a substantial discount relative to their proportionate share of the value of the corporation. This discount, it is said, arises because the stock prices on national securities markets represent “minority” positions, and minority positions trade at a discount to the value of the company’s equity. The consequence of the IMD in appraisal proceedings is limited in scope, but substantial in scale: in applying a valuation technique (known as “comparable company analysis, or “CCA”) that estimates subject company value by reference to market trading multiples observed in shares of comparable publicly traded firms, the result must be adjusted upward by adding a premium to offset the “implicit minority discount” asserted to exist in the comparable companies’ share prices. In the last several years, the size of this upward adjustment (and the supposed discount that it “corrects”) has been routinely fixed, even without supporting expert testimony, at 30%.
Interestingly, the Delaware chancellors have relied primarily on works of Dr. Shannon P. Pratt and, believe it or not, me, in reaching their conclusions regarding the IMD. The primary texts relied upon have been the third edition of Pratt’s Valuing a Business, published in 1996, and on my 1992 text, Valuing Financial Institutions.
Never mind that both Shannon and I have modified our positions on the routine application of control premiums when using the comparable company method (actually, the appropriate name is the Guideline Public Company Method).
Gilbert Matthews, a business appraiser with extensive experience in statutory fair value matters, addressed this fact in his 2008 article in the Business Valuation Review (fee to download), “Misuse of Control Premiums in Delaware Appraisals.” Matthews wrote about Pratt:
In 2001, Pratt further clarified his position in Business Valuaiton Discounts and Premiums. After an extensive discussion of various articles and seminars regarding the issue of whether market prices reflect control value, Pratt quoted extensively from [Mark] Lee’s incisive 2001 article and then concluded, “In any case, it is obvious that, given the current state of the debate, one must be extremely cautious about applying a control premium to public market values to determine a control level of value.
However, as late as 2005 in the Andaloro decision, the Court continued to cite Pratt’s 1996 book in support of an adjustment for IMD…
And now, it gets personal. Matthews continued:
Mercer was also coming to the conclusion that market prices are often close to control value. He addressed the issue directly in 2004 [and long before that in speeches] in the important 1st Edition of The Integrated Theory of Business Valuation. After having disagreed with [Eric] Nath in the early 1990s, he conceded that Nath had been right, and that the financial control premium (the difference between Financial Control Value and Marketable Minority Value) could be zero. Mercer’s 2004 book included a modified levels-of-value diagram (see Figure 2) that showed Marketable Minority Value overlapping Financial Control Value. He uses that model to make the point that unless there are cash flow-driven differences between the enterprise’s financial control value and its marketable minority value, there will no (or very little) minority interest discounts.
The Figure 2 referred to in the quote is the updated (or modified) level of value chart on the right side of the included chart.
It should be clear that if economic reality is best described by the modified (four levels) chart on the right, then it would be difficult to address the issue of the implicit minority interest discount with the traditional (three levels) chart. Also, a 30% swing in value is a pretty large difference in any statutory fair value price determination.
Matthews is correct in noting that I refer to the need to discuss cash flow-driven differences to discuss the levels of value. That is the linchpin concept behind the first book cited and also Business Valuation: An Integrated Theory Second Edition, which is the second edition of the 2004 book cited by Matthews (and co-authored by Travis Harms).
As this series on statutory fair value continues, we will specifically address the cash flow-driven differences that underlie the integrated theory of business valuation. We will define each of the levels of value in terms of expected cash flow, risk and growth, just as we concluded in the second post on the discounted cash flow method.