Control Premiums

When appraising the value of a controlling interest, analysts sometimes apply what is known as a control premium to the value otherwise indicated by minority interest discount rates and the value of public guideline firms. Although often justified on the basis of public firm acquisition premiums, the size of a control premium should reflect expected company-level performance improvements and the relative position of the minority shareholders (whose share values are used as a base from which the control premium is applied).

We offer two basic frameworks for analyzing the value of control. One framework commonly used to assess control premiums is based on an assessment of relative control rights. A second framework, described in the March, 1995 issue of the Business Valuation Review, is based on a subjective analysis of the economic advantages expected with control.

1. CONTROL PREMIUMS BASED ON POWER

To analyze control value in terms of power, Pratt and others have suggested that certain rights enhance control value. Among those most commonly identified are the following control prerogatives:

Elect directors and appoint management Determine management compensation and perquisites Set policy and change the course of business Acquire or liquidate assets Select people with whom to do business and award contracts Make acquisitions Liquidate, dissolve, sell out or recapitalize the company Sell or acquire treasury shares Register the company's stock for public offering Declare and pay dividends Change the articles of incorporation or bylaws

2. CONTROL PREMIUM BASED ON ECONOMIC VARIABLES

A second method for analyzing control premiums is to assess the economic benefits of control. For analytical purposes, these benefits fall into categories of company-level operating performance and relative shareholder-level advantages. Many of the economic benefits within the two broad categories are listed below. While not all economic variables are relevant to all appraisals, an analyst must weigh, if only subjectively, those variables judged to be most relevant.

To properly assess the size of any control premium, a careful analysis should be performed by a knowledgeable and experienced business appraiser.

Minority Discounts

Mirroring the control premium, a discount for lack of control is commonly applied as an amount or percentage deducted from a pro rata share of the value of 100 percent of an equity interest in a business, to reflect the absence of some or all of the powers of control." When applied to a minority interest, the discount for lack of control is often called a minority discount. Minority discounts can be assessed in terms of the same variables as those involving the control premium.

MINORITY DISCOUNTS RELATED TO LACK OF POWER

• Discount Related To Absence of Control Prerogatives

One framework for estimating a minority discount considers the relative absence of control prerogatives such as those described above. While helpful to understand the missing prerogatives, a simple identification of missing control prerogatives may not be an adequate basis for estimating the size of a minority discount.

• Discounts Based on Hierarchy of Control

A second framework for estimating a minority discount is a hierarchy of conditions that are believed to lead to greater or lesser impairment in value. Using such a framework, it would be helpful if certain combinations of control prerogatives and other variables could be scaled according to their impact on value.

DISCOUNTS BASED ON ECONOMIC VARIABLES

Mirroring the analysis of control premiums, minority discounts can be analyzed in terms of the diminished economic benefits related to lost flexibility, adverse wealth transfers and risk. Although the impact of lessened liquidity can also be considered, it is commonly applied as a separate part of the discount for lack of marketability.

Marketability Discounts

A proper appraisal requires a second-stage adjustment known as a discount for lack of marketability (DLOM). Commonly expressed as a percent of the value of an interest with greater marketability, a DLOM is defined as the impairment in value due to the risk and cost of being unable to quickly convert an investment into cash, expressed as a percentage of the value of a marketable equity interest.

Base From Which Marketability Discount is Taken:

• Discounts from Marketable-Minority Value The most common and least controversial DLOM is that taken from the value of marketable-minority shares, representing the impairment in value due to the absence of marketability of the minority shares. Absent a willingness of the control shareholder to buy their stock, minority shareholders may find themselves locked into their investment until the control shareholder(s) interests are sold.
• Gradiations of Marketability - An alternative framework for assessing a marketability discount is a hierarchy of conditions believed to lead to greater or lesser impairment in value. Like Simpson's model assessed minority interest discounts, it would be helpful to scale certain combinations of marketability variables in terms of their relative impact on value.

Economic Factors Justifying Marketability Discounts:

Among the most persuasive economic arguments for recognizing a DLOM is the risk of being locked into a position and transaction costs subsequent to the purchase.

• DLOM Based on Risk of Being Locked Into a Position Perhaps the major element associated with a discount for lack of marketability is the risk associated with being unable to convert an investment into cash in a timely manner. One element of risk is that values may erode pending completion for a sale. Perhaps the ultimate risk is that the owner will never sell his or her interest in the firm.

While minority shareholders may bear a greater risk of being "locked in" a position, control shareholders may bear at least some of the same risk. As observed by Bradley Fowler, "an owner who builds up the value of such a business and wants to sell it, but is unable to do so and watches it deteriorate in value before a buyer can be found, is not comforted by being in control."

• DLOM Based on Transaction Costs In determining the price a buyer is willing to pay, it is useful to estimate the reduced value due to transaction costs subsequent to the initial transaction. Note that, while transaction costs incurred by the seller reduce the net proceeds from a sale, they are not considered to be a component of value. As stated by Allan Lannom, FASA, "willing buyers couldn't care less what the seller has to pay to close the deal."

Transaction costs that are subtracted from value are those incurred subsequent to the acquisition. "While the buyer is not concerned with the seller's brokerage costs, he does have to be concerned with his own brokerage costs when he becomes a seller, and when his buyer becomes a seller, ad infinitum."

Key Person Discount

One company-level adjustment involves a discount for dependence upon a key person responsible for a large part of a firm's success. This so-called "Key Person Discount" is the expected percentage decrease in equity value arising from the loss of a key person. The discount can be affected by a number of factors, including the following:

• Actual dependence on key manager
• Depth and quality of existing management
• Effect of loss of key person on future cash flows Additional risk of operating under new management
• The likelihood of losing the services of the key person
• Prospective loss in value from competition by the key person (not applicable when the key person has died)
• Lost Debt Capacity Made Available By Key Person

Factors which may mitigate the size of any discount include the following:

• Key person life insurance payable to the company
• Covenants restricting a key person's ability to compete with the subject (note that, where a key person is the owner, a covenant not to compete is often implicitly assumed to be part of the terms of sale)
• Availability of quality managers to operate the business

Since a key person discount is driven by economic factors specific to each firm, empirical data on the average size of observed discounts offers only limited insight. To properly assess and defend the appropriate size of any key person discount, the services of an experienced, knowledgeable, competent, certified business appraiser are required.

Portfolio Discount

A company-level valuation adjustment concerns the loss in value due to the ownership of disparate investments. Expressed as the percentage discount from the en bloc equity value in the firm's individual investments, the portfolio discount based on both the difficulty of managing diverse investments within the corporate umbrella and the time, cost and risk of selling the various investments for full value. Factors supporting such discounts are summarized as follows:

The diversity of investments held within the corporate umbrella The difficulty of managing the diverse set investments The expected time needed to sell undesired assets Costs expected to be incurred upon sale of the investments The risk associated with disposal of undesired investments To properly assess and defend the appropriate size of any portfolio discount, the services of an experienced, knowledgeable, competent, certified business appraiser are required.

Discount for Built-in Gains

One controversial discount is the diminution in value associated with built-in gains tax liability on appreciated assets. Although this discount has been consistently disallowed by both the IRS and the courts, it has reappeared since the repeal of the General Utilities doctrine in Tax Reform Act of 1986.

Factors which conceptually justify the recognition of this discount include:

• Diminished cash flow due to lesser amount of depreciation and amortization than that allowed on property subject to a step-up in basis
• Greater potential tax on the eventual sale of the asset
• Potential double tax on the distribution of the asset to the shareholder(s)

Considerations that mitigate the unfavorable tax incidents include the following:

• Possible ability of the buyer to avoid built-in gain tax by converting to an S Corporation for 10 years prior to the sale of the assets
• The potential delay in the payment of tax on the asset appreciation
• Possible lack of basis for assuming that the willing buyer would choose to sell the appreciated assets

Although a likely buyer would pay less for the stock of a company with unfavorable tax incidents, fair market value for estate and gift tax purposes has consistently been defined as if liability for built-in gains does not reduce value. To properly assess and defend the appropriate size of any discount for built-in capital gains, the services of an experienced, knowledgeable, competent, certified business appraiser are required.