CHAPTER 16 CONTROL PREMIUMS, MINORITY DISCOUNTS, AND MARKETABILITY DISCOUNTS* by Philip Saunders, Jr., Ph.D. The value of the company can be estimated, as described in Chapters 14 and 15, but cases are usually not about the value of a company but about the value of shareholdings in a company. Shares may be subject to premium or discounts, depending upon whether they represent controlling or minority interests. All shares are equal, but some are more equal than others, to borrow from George Orwell. 16.1 Control Premium 16.1(a) Reasons for Control Premium Control confers value. Stockholders holding a controlling interest in a company can determine the nature of the business; select management; enter into contracts; buy, sell, and pledge assets; borrow money; issue and repurchase stock; register stock for public offering; and liquidate, sell, or merge the company. The controlling party can also set management compensation and perquisites, declare (or not declare) dividends, make capital distributions, and control contracts and payments to third parties. In privately held companies the ability to set compensation is critical, for owner/managers frequently distribute proceeds as compensation rather than dividends in order to avoid double taxation. Minority stockholders often have minimal influence on these important activities. 16.1(b) Amount of Control Premium Whether anyone will pay a premium for a controlling interest (a control premium) depends largely upon whether the potential buyer believes he or she can enhance the value of the company. If the company is being run satisfactorily by current management and new ownership could neither do better nor create synergies to increase value, what extra value could be created through acquisition? It is the potential for a new owner to increase value that makes buyers willing to pay a premium for control. Obviously, the size of the premium will depend upon how much incremental value buyers believe can be created. Following the above reasoning, one would expect variation in the sizes of control premiums, depending upon the particular circumstances of the target companies. That is what one finds in practice. Annual median premiums paid over quoted market prices in recent years for acquisition of controlling, sometimes 100%, interests in publicly traded companies, have been in the 30% to 50% range. The full range of premiums has been PHILIP SAUNDERS ASSOCIATES 781 239-0855 Economic and Financial Analysis phil@philipsaunders.com www.philipsaunders.com
anywhere from double or more the market price to zero, and some controlling interests were acquired at discounts from the publicly traded market prices. Acquisition premiums are not only affected by a potential for increasing the value of the acquisition target. A premium may simply reflect a more sanguine view by the buyer of the prospects of the company than the current owners hold. In addition, depending upon the depth of the market for a particular stock, competition from other potential buyers, and the views and financial needs of the existing stockholders, a buyer may not have to pay as much as he or she estimates the company is worth in order to acquire it. Similarly, low or negative acquisition premiums may be the result of specific needs of the seller. In short, the mere fact of control does not lead to any specific premium. Indeed, it does not necessarily lead to any premium at all. Logic and the data support the courts in their position that the existence and size of a control premium depends upon the facts of the specific case. If a substantial premium is to be added in the valuation of the controlling interest in a company, the basis for adding it must lie in some identified potential for increasing value. The size of the premium depends on how much the value can be increased 1 There are several ways that a new owner might enhance value. There may be potential synergies between the company and the buyer's other activities, although these synergies are often overestimated (see Chapter 17 herein). Perhaps the company is mismanaged, and profitability could be increased by new management. If current management is overcompensated, stockholder value can be enhanced by reducing compensation costs. Another possibility is that the sum of the company's parts is worth more than the whole, and the company can be liquidated at a profit. In valuing a company, care must be taken to avoid double counting premiums. In the case of publicly traded companies the market frequently anticipates changes which will enhance value, either because the market expects current management to make the changes or because it expects new management following a buyout. Similarly, in the valuation of private companies, financial statements are routinely adjusted to eliminate revenues or expenses that relate to current ownership but would not exist for a new owner. For example, reported earnings of a company might be $500,000 but the analyst might conclude that the CEO/owner is overpaid and that adjusting the CEO's salary to market would add $100,000 to earnings. The valuation would then be based upon $600,000 of earnings. Suppose the valuation was being done with a price/earnings ratio of 5X. The company would be worth $2,500,000 based upon unadjusted earnings but $3,000,000 based on adjusted earnings. The extra $500,000 would be the value of a control premium but would only be a premium over the $2,500,000. Adding it to the $3,000,000 would be double counting. Any control premium should only reflect those potential enhancements not already taken into account. 1 For a discussion of a case involving the control premium issue, see Bradford Cornell, Corporate Valuation, 242-246 (1993). 2
A controlling interest, where no extra value can be added by assuming control, presumably serves only as an insurance policy. Control confers power to make changes in the future, should changes be necessary. Most owners would pay something for such insurance, but maybe not a lot, implying a modest control premium purely for the fact of control. 16.2 Minority Discount While a premium may be appropriate in valuing a controlling block of shares in either a public or private company, a minority discount will only be relevant when valuing shares in a closely held company. Publicly traded shares are already priced as minority holdings, requiring no discount from the quoted value of the stock. This is not so for minority shares in a private company. 16.2(a) Reasons for Minority Discount For all the reasons that a controlling stockholder may enjoy power and economic benefit, the minority stockholder may not. This is not to say that the minority stockholder cannot benefit from the actions of the majority. If the majority sells out at a control premium to a new owner who buys all the stock or succeeds in enhancing the value of the company, the minority owner will share in the gain. However, the minority shareholder in a private company is not generally able to control his or her own destiny, and the value of the minority shareholding is discounted. The depth of the discount will depend on the circumstances. There are two reasons that the discount can vary. First, there are differences in the ability of minority stockholders to fend off majority oppression or exert influence on the company. In some cases, government regulations, indenture restrictions, contractual obligations, the financial condition of the company, and the realities of the competitive marketplace can restrict the freedom of action of those in nominal control. Moreover, the minority may have more power than the size of their holdings would indicate. Statutes, articles of incorporation, or bylaws may require the approval of more than the usual 51% to approve certain actions. A minority shareholding may be enough to constitute a majority when combined with blocks of other shares; having the swing vote can confer power. Cumulative voting for directors can enhance minority power. The second cause of variation in minority discounts is differences in the extent to which the minority stockholders are economically disadvantaged. In circumstances where a company is well run (i.e., management is fairly compensated, financial information is provided, all stockholders receive the same pro rata returns to capital, and in general the minority stockholder enjoys the same benefits as the stockholder in a public company) the minority discount will be less. At the other end of the spectrum, when the minority stockholder has been frozen out, a substantial discount is required. 3
16.2(b) Amount of Minority Discount Usable statistics on the size of minority discounts are scarce. A variety of types of data have been put forward as measuring minority discounts. Some are more credible than others. The difficulty with much of the data is that it is not clear whether they measure minority discounts, or at least minority/lack-of-marketability discounts, as opposed to something else. A common approach is to induce a minority discount from the control premiums observed above. In an acquisition a controlling interest may sell at a premium price per share above the price for publicly traded shares, which are by definition minority interests. The minority discount can be computed as the discount which would reduce the acquisition, controlling interest price to the publicly traded price. While mathematically correct, this approach is not useful for estimating a discount purely attributable to the fact that shares are minority shares. As noted above, the control premiums observed, which are the starting point for the analysis, exist for reasons specific to each transaction which made the buyer believe that the shares were worth more to the buyer than the quoted market price. If, as discussed above, a control premium paid purely for the sake of having control would be modest, then a minority discount, estimated purely to place a number on the reduction in value due to the fact of being in the minority, would be modest. Larger discounts could be warranted, based upon how much the minority shareholders were at a disadvantage in a particular company. It has been argued that the discount from net asset value at which closed end funds typically sell is a minority discount. Such discounts commonly exist in the zero to 20% range, even though the fund assets are publicly traded securities. However, closed end funds sometimes trade at a premium to net asset value. Other reasons for the existence of the discounts have also been put forward. 16.2(c) Minority Discounts and Case Law A minority discount will be relevant in estate and gift tax cases but usually not in minority buyout cases. In tax cases the objective is to establish fair market value, and the courts have long recognized that "minority stock interests in a 'closed' corporation are usually worth much less than the proportionate share of the assets..." 2 Tax courts have allowed discounts for minority interests. Sometimes it has been difficult or impossible to determine whether the discount was allowed because the shares represented a minority interest, were unmarketable, or both. A survey of selected decisions shows minority discounts in the 10% to 40% range, marketability discounts also in the 10% to 40% range, and combined discounts, where the court only gave a single number, in the 15% to 65% range. 2 Cravens v. Welch, 10 F.Supp., 94, 95 (S.D. Calif., 1935). 4
In minority buyout cases the courts have not tried to determine "market value" or "fair market value" of a minority interest but rather "fair value," which is usually only broadly defined in the statutes. Not surprisingly, there has been substantial variation among courts as to the determination of fair value. In general, the concept of fair value incorporates the notion that the minority shareholder should receive his or her pro rata share of the value of the company. The rationale is that the need for judicially ordered buyout is usually triggered by a situation that cannot otherwise be resolved without dissolution of the corporation or by oppressive behavior on the part of those in control. In the first instance, liquidation and distribution of the proceeds would lead to each stockholder receiving a pro rata share, without any discount; when mandating a buyout the court attempts to leave the minority stockholder in no worse position than he or she would have been had the corporation been dissolved. In the second instance, the oppression of the majority would be rewarded if the minority stockholder did not receive a pro rata share but was subjected to a minority discount instead. Although the courts are not unanimous, minority discounts have not generally been taken in minority stockholder buyout cases. 16.3 Lack of Marketability Discount Minority interests of private companies typically lack marketability. A publicly traded share is in the minority, but it has liquidity. A share in a private company is both in the minority and lacks a ready market. Marketability confers value. People will pay extra for the ability to get out when they want to get out. As compared with an asset for which willing buyers can be found, a non-marketable asset sells at a discount, hence the Lack of Marketability Discount (LOMD). The LOMD is in addition to any minority discount. The two are taken not together but seriatim. For example a 10% minority discount reduces an $100 share value to $90, and a further reduction by a LOMD of 40% reduces the value to $54 ($90 x (1-0.4) = $54). 16.3(a) Reasons for Lack of Marketability Discount (LOMD) The minority shareholder has no ready market for his or her holdings, precisely because prospective buyers do not want to change places with the shareholder and have no control over the company and no way of selling. Usually, the only market for minority shares is other stockholders, who have no incentive to buy, unless they have some ulterior motive, e.g., adding the incremental shares to their own holdings might give the buyers a controlling interest. Many articles of incorporation and by-laws are specifically drafted with the intent of keeping the corporation closely held. The documents can contain such features as waiting periods, rights of first refusal by other shareholders, and arbitration clauses, which serve to chill a potential sale to an outside party. For most minority shareholders, sale must await action by the controlling stockholder, such as sale of the company. 5
16.3(b) Amount of LOMD As opposed to the minority discount, there are substantial data on marketability discounts. The data come from several sources, primarily sales of restricted stock and pre- IPO transactions. Restricted stock (a/k/a unregistered or letter stock) may not be sold in the public markets until after a specific holding period, currently one year. Private transactions occur in restricted securities which have publicly traded counterparts, i.e., registered and publicly trading shares of the same class of stock in the same company. The difference between the prices in a private trade and the publicly traded shares provides a measure of LOMD. Studies of restricted stock sales over the years have for the most part revealed annual mean and/or median discounts in the 20% to 35% range. Registration statements include information on sales of unregistered stock in the three years prior to an IPO. 3 Since the stock is not freely marketable, an implied LOMD can be computed by comparing the transaction price with the eventual IPO price. LOMDs so computed over the years have had annual median values generally in the 40% to 55% range. The pre-ipo discounts have been larger on average than the restricted stock discounts, which is logical, as the pre-ipo purchaser has less certainty of ultimate marketability than the owner of restricted stock. The IPO may not take place, and, even if it does, the pre-ipo stock typically is both subject to underwriters' lockup and not registered at the IPO thereby remaining restricted stock. In terms of marketability, the pre- IPO purchaser is further down the pecking order than the holder of restricted stock. There also have been studies which estimated LOMDs from the drop in share price when a stock or a market became illiquid because of delisting or some external shock or from option prices. Such estimates of mean LOMDs have been in the 10% to 25% range. While the mean and median LOMDs from the restricted stock and pre-ipo studies are interesting, they disguise the fact that the ranges are enormous, varying everywhere from negative, i.e., the stock sold at a premium, to almost 100%, i.e., the unmarketable shares were close to worthless. Not all the reasons for the wide variations are well understood. Relevant factors identified in studies relate to underlying investment risk. Small company size, low profitability, high variability, and low book-to-market ratios, for example, tend to be associated with larger LOMDs. However, not all studies have found all these risk-related factors to be significant. Also important is block size. The larger the ownership block, assuming it is less than 50%, the higher the LOMD is likely to be; other things being equal, a 40% ownership share will sell at a bigger discount than a 10% share. Interestingly, the industry the company is in has not been found to be correlated with size of LOMD. 3 17 CFR 229.701. 6
What is abundantly clear from the data is that the further away in time a security is from potential marketability, other things being equal, the bigger the discount. The data shed light indirectly on a common valuation problem faced by the practicing attorney and the valuation advisor: the LOMD for a minority holding in a closely held company with no publicly traded shares, no reasonable prospect of ever having an IPO, and no prospect of a liquidity event until the majority holders decide to sell the company. The data do suggest that the LOMD in such a case should be substantial. If restricted stocks with a foreseeable degree of marketability within a year, have LOMDs, on average, in the 20% to 35% range, and stocks with a prospect of becoming restricted stocks with publicly traded counterparts following an IPO have LOMDs, on average, in the 40% to 55% range, how much greater must the discount be for shareholdings awaiting a liquidity event sometime between tomorrow and never? A final caveat for the practitioner: courts, particularly the tax court, in recent years have increasingly given short shrift to valuations based upon averages from LOMD studies. The courts are expecting, quite appropriately, that the circumstances of the individual company and stockholding, as they relate to the averages, be examined and taken into account. 16.4 Bottom Up Method In valuing minority interests we have, up to this point, discussed valuing the company first, then calculating the minority discount and the LOMD. An alternative approach is to value the minority interest directly, sometimes referred to as the bottom-up method. In the bottom-up method the analyst looks at the stock simply as another investment. The stock pays a dividend, or not, with some degree of regularity. Capital distributions may or may not be expected in the future. The company is in an industry and has a history, financial condition, assets, management, and other attributes that make one confident, or not, that the dividends and the distributions will be paid. The cash from future dividends and distributions can be estimated, and there is some degree of risk that the estimate may be wrong. The projected cash flow can be discounted back to a present value. The discount rate should reflect the degree of risk associated with the investment and the projections, as well as the facts that the instrument is unmarketable, lacks control, and is issued by a private company. In this manner the minority, non-marketable share is valued by the discounted cash flow method directly as a financial instrument without the need to value the company as a whole or estimate discounts. A variant of the bottom-up method is sometimes referred to as the quantitative marketability discount model. While the method sounds neat and clean, it relies upon financial projections, which often have a large margin of error, and the correct choice of a discount rate, which can be subjective, since, by definition, there is not a market of non-marketable securities from which to derive the relevant discount rate. The estimated values can be sensitive to small variations in either the projections or the discount rate. Nevertheless, the bottom-up method has considerable appeal, especially when the minority gets very little benefit from its shareholdings or is far removed from corporate control. 7
16.5 Example A simplified example to illustrate the application of control premiums, minority discounts, and LOMDs may be instructive. Fred Founder owns 60% of Intergalactic Enterprises, Inc. Cousins Larry and Liz own 20% each but don't work for the company. The company is efficiently run and pays reasonable dividends. When Larry dies, Intergalactic is valued at $10,000,000 for estate tax purposes. Company value $10,000,000 Larry's share value: pro rata $2,000,000 Minority discount 5% After minority discount $1,900,000 LOMD 20% After LOMD $1,520,000 Note: The minority discount is relatively modest because the company is efficiently run and Larry is not particularly disadvantaged by being a minority shareholder. The LOMD is also modest because the minority stock has an investment value based upon yield. The company starts conserving cash and stops paying dividends. Soon thereafter Liz dies of unrelated causes, and her shares are valued for estate tax purposes. Company value $10,000,000 Liz's share value: pro rata $2,000,000 Minority discount 10% minority discount $1,800,000 LOMD 60% After LOMD $720,000 Note: The minority discount increases, as Liz's inability to control the dividend flow becomes an issue. The shares no longer have a yield-based investment value. They are minority shares with no foreseeable liquidity event and a substantial LOMD. Heirs Larry II and Liz II and Fred Founder are now stockholders. Fred sells his 60% to AcquisitionCo. AcquisitionCo is an independent third party, the price is set in arms length negotiation, and Fred receives no consideration other than payment for his shares. AcquisitionCo pays a premium because it can enhance value 20% by making operations more efficient. AcquisitionCo anticipates only arms length intercorporate transactions and, thus, has no means of capturing the entire increase in value for AcquisitionCo; the gain in value will be shared with Intergalactic minority stockholders. 8
Consequently, AcquisitionCo only pays a premium based upon Founder's shares (i.e., the shares it will actually own), not on the whole company. Old company value $10,000,000 Increase (20%) in values Control premium paid to Fred $1,200,000 Larry II s pro rata share $400,000 Liz II s pro rata share $400,000 New company value $12,000,000 AcquisitionCo s share $7,200,000 Larry II s share value Pro rata $2,400,000 Minority discount 10% After minority discount $2,160,000 LOMD 60% After LOMD $864,000 Liz II s share value Pro rata $2,400,000 Minority discount 10% After minority discount $2,160,000 LOMD 60% After LOMD $864,000 Note: The minority shareholder values increase with the value of the company and thus benefit from the acquisition, even though they do not share directly in the control premium and still suffer the same percentage minority and marketability discounts. Had AcquisitionCo been able to siphon off all the gain in value for itself, there would have been no gain for Larry II and Liz II, and AcquisitionCo could have paid a higher premium for Fred's controlling block. On this different set of facts, however, AcquisitionCo and Fred Founder might have been open to charges of looting, and Larry II and Liz II might have had grounds for suit. AcquisitionCo brings in Larry II and Liz II to manage the company, which they do for several years, but then Larry II and AcquisitionCo have a falling out. AcquisitionCo fires Larry II, whereupon Larry II sues. The court finds AcquisitionCo breached its fiduciary duty to a minority stockholder and orders AcquisitionCo to buy Larry II's stock at "fair value" as opposed to "fair market value," i.e., with no discount. Company value $12,000,000 Larry II s share value Pro rata $2,400,000 Minority discount 0% After minority discount $2,400,000 LOMD 0% After LOMD $2,400,000 9
If it wasn't obvious before the example, it should be now: control premiums and minority discounts depend upon the purpose for which the premium or discount is being calculated and the facts of the specific situation. As with so many things in life and the law, God and the devil are in the details. 16.6 Summary Implications for Counsel 1. If the issue at stake is the value of shares in a company, valuing the company is only the first step. The market value of the specific shares may vary widely from their pro-rata value, depending upon the amount of control they do, or not exercise, and their marketability. Frequently, the amount of a control premium, minority discount, or marketability discount is the biggest single valuation issue in dispute in a case. 2. Although minority discounts and, to a lesser extent, control premiums are difficult to quantify, there is substantial evidence on marketability discounts which can be large. 3. Historical studies form the basis for quantification of discounts. It is necessary to examine the circumstances of particular shares to see how they compare with the shares in the studies and to determine appropriate adjustments from the averages in the studies. Relying on the averages alone is a good way to lose cases. * First published in Robert B. Dickie, Financial Statement Analysis and Business Valuation for the Practical Lawyer (Section of Business Law, American Bar Association, 2nd ed., 2006). 10