In the initial post in this series on statutory fair value, we introduced the ideas that fair value is, in part, an equitable concept, and that appraisers are not in a position to make “equitable” decisions.
Appraisers cannot decide matters of equity, but we can provide good and clear valuation evidence to courts in statutory fair value matters. In this post, we will address what appraisers call “levels of value.” Courts are generally familiar with some of the concepts, but I do not believe that most courts are familiar with the growing understanding of the levels of value concept in the appraisal profession. This lack of understanding creates confusion and increases the difficulty of presenting valuation evidence in statutory fair value proceedings.
In this post, we will discuss the “traditional” levels of value chart that forms the basis for most judicial decisions regarding fair value. The concepts in this chart are also the basis for much appraiser and judicial confusion.
In the next post, we will introduce an updated levels of value chart that should begin to eliminate or reduce confusion over important valuation concepts. From there, we will proceed to the valuation concepts that provide the foundation for the levels of value chart. Valuation is a function of expected cash flows, risk and growth. When we understand not only the charts but the underlying cash flows that give rise to them, we will have a chance to reduce judicial and appraiser confusion over these concepts in the context of fair value determinations.
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 not formally published in a chart until 1990. Since then, appraisers have worked on the concepts and have attempted to refine them. Interestingly, it is this process of learning and refinement that has contributed, at least in part, 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 discounts and a premium that enable appraisers (and courts) to move from one level to another.
In the remainder of this post, we will discuss the three conceptual levels of value and the premium and discounts shown on the chart above.
The Marketable Minority Level of Value as Benchmark
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 a public company with an active and freely trading market for its shares. For a private company, it represents that same price as if there were a free and active market for its shares.
For private company valuation, the marketable minority level of value is a construct. Appraisers examine the prices of public companies as similar as possible to a valuation subject (called guideline public companies), and infer appropriate valuation metrics and multiples from the metrics and multiples of the similar public companies.
Traditionally, appraisers would develop value indications at the marketable minority level of value first. If the assignment called for a nonmarketable minority conclusion, they would apply an appropriate marketability discount (as seen in the chart above). If the assignment called for a controlling interest conclusion, they would consider an appropriate control premium (as seen in the chart above).
Note that the term, marketable minority, suggests that this valuation concept is a minority concept, i.e., one without control. Transactions in the public markets for public company shares are minority transactions, so the chart suggests that public company shares may be trading at some “discount” to their control values. Let me make a few foments here.
- The public markets capitalize expected earnings of public companies and reflect their collective valuations in the current market prices of public shares. The markets are looking at 100% of the expected cash flows of public companies, and is therefore an “enterprise” level of value.
- The price of a public company multiplied by its number of shares outstanding is called the market capitalization of its equity. The market capitalization is a reflection of the value of the entire business enterprise, and not merely to a small minority interest of the enterprise.
- In the next post, we will introduce a modified levels of value chart to attempt to reconcile the seeming contradiction between minority and control at the marketable minority level of value.
- While public company transactions are indeed “minority” transactions, owners of public company shares have the “control” to sell all or a portion of their shares at any time and thereby gain liquidity. They are not penalized in value because they hold minority shares. They may not control the operations of the public company, but the collective actions of all minority shareholders control the public company’s price in the market.
In a sense, the marketable minority level of value was the starting point for developing either control value conclusions or nonmarketable minority level conclusions.
The Control Level of Value
The conceptual level of value above the benchmark marketable minority level of value 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 their acquirers. A control premium represents the percentage difference between the price actually paid for a company’s shares and the price at which it was trading prior to the announcement of the acquisition.
Assume that a public company’s shares were trading at $10 per share the day before its announced acquisition. The announced purchase price is $14 per share. The control premium in this example is therefore 40% ($14/$10 – 1). The conceptual premium is shown on the chart above.
Sometimes, the control level of value can be observed directly, as when public companies are acquired and pricing information before and after announcement become available. 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. Other organizations maintain control premium information on specific industries.
Moving down from the control level to the marketable minority level, we see the minority interest discount in the chart. The minority interest discount eliminates the so-called value of control by deflating a control price by the amount of the actual or conceptual control premium.
In our example above, the minority interest discount is measured by the difference between the control price ($14 per share) and the marketable minority price ($10 per share). The minority interest discount in the example is 28.6% (or 1 – (1/(1 + 40%)).
The 40% control premium in the example is the numerical equivalent to a 28.6% minority interest discount. Historically, control premium data (like averages and medians or specific studies) have been used by appraisers as a basis to estimate minority interest discounts.
Since the mid 1990s, there has been a growing consensus among appraisers that control premiums measure, in addition to any value that might be directly attributable to control, the added value of expected acquirer synergies or other strategic benefits.
The 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 represents the conceptual value of illiquid (i.e., nonmarketable) minority interests of private companies, or entities that lack active markets for their shares.
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 (also known as the discount for lack of marketability or DLOM).
To continue our example, the marketable minority value (for a private company now) is $10 per share. A small, minority interest transaction takes place at $7.50 per share. The marketability discount is therefore 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. Market participants observed that when public companies issued restricted shares (under Securities and Exchange Commission Securities Act Rule 144), the prices of the restricted shares tended to be lower than the corresponding public prices for many companies. Appraisers and others have been examining restricted stock studies, which document these restricted stock discounts, fo years.
For a review of available market evidence on restricted studies (and also pre-IPO studies) see my book, Business Valuation: An Integrated Theory Second Edition (with Travis Harms). This book also provides a detailed discussion of the Quantitative Marketability Discount Model (QMDM), which I introduced in an earlier book in 1997.
This discussion of the “traditional” levels of value chart is the beginning point for understanding statutory fair value. Statutory fair value as defined in many states allowed for valuation discounts for a number of years. The trend has been toward eliminating valuation discounts like the minority interest discount and the marketability discount. Nevertheless, discounts are often the topic of discussion and debate in litigated statutory fair value cases.
In the next post, we will introduce an updated levels of value chart that introduces two concepts of control, financial control and strategic (or synergistic) control.
In the meantime, if you have comments, please feel free to post them here. I look forward to the continuing discussion.
As always, be well!