Until the mid-1990s, the conceptual levels of value in use was the “traditional” three-level chart introduced in the last post.
The benchmark level in the traditional chart was the marketable minority level of value, or “as-if freely traded” for private companies.
- The top, or control level was reached by applying a control premium to the marketable minority level.
- To move from the control level to the marketable minority level, the minority interest discount was applied.
- Finally, to move from the marketable minority level to the nonmarketable minority level, a marketability discount, also known as discount for lack of marketability (DLOM), was applied.
To review, the traditional levels of value chart is shown below.
This chart, while showing conceptual relationships that appraisers and courts thought or believed they understood, does not capture the underlying valuation economics of the “control” level, and is misleading in that the marketable minority level is seen as a minority level, when, in fact, it is an enterprise level of value.
Issues with the “Traditional” Levels of Value
For years, appraisers considered certain control premium studies, including the Factset Mergerstat/BVR Control Premium Study, as reflecting “the value of control.” Average control premiums tended to be in the range of 40% or so, with wide ranges, of course.
If “the value of control” is a 40% premium to the marketable minority value, then “the value of control” in moving from control down to marketable minority must be the minority interest discount. So control premium studies were used to measure minority interest discounts (MID) and were calculated as follows:
MID = 1 – (1 / (1 + Control Premium))
Assuming that the control premium is 40%, the implied minority interest discount is 28.6%. So, in the traditional view, minority interest discounts were thought to be quite large because “the value of control” was, on average, large, at least as reflected by the control premium studies.
Many appraisers, when looking at the public securities markets, where enterprise cash flows are capitalized and reflected in current market prices, could not believe that minority interest discounts should be so large.
One appraiser, Eric Nath, wrote an article in 1990 suggesting that using the guideline public company method and public multiples yielded a controlling interest level of value. Lots of appraisers, including me, thought he was wrong at the time.
By the mid-1990s, however, a number of appraisers began to realize that the control premium studies were measuring something other than “the value of control.” The great majority of public company acquisitions that the control premium studies capture are strategic, or synergistic, transactions, and therefore measure the benefit of synergies or strategic benefits to the buyer, rather than the value of control. This meant that the use of control premium studies to estimate minority interest discounts, at the very least, widely overstated minority interest discounts.
Nath noted in 1990 that of the thousands of public companies in existence, only a relatively small number, a few hundred, maybe 4% or 5%, are taken over each year. If the other 95% were trading at far less than their “real” values, then, like sharks to blood, there would be many takeovers to eliminate that market inefficiency.
The end result of this logic is that the public market price generally reflects a control value, which is different than the strategic or synergistic control value that is observed when an occasional public company is acquired, usually by another public company.
The market capitalizes 100% of a public company’s expected earnings/cash flow and reflects the result in its current market pricing. When synergistic buyers acquire a company, they capitalize not only its visible cash flows on a stand-alone basis. They also capitalize the expected increment in cash flows from synergistic or strategic benefits. The observed premium reflects that pricing and the fact that from a practical standpoint, buyers must share some of the expected benefits with sellers in order to induce them to sell.
A Modified Levels of Value Chart
This thinking led me in about 1995, to develop a levels of value chart with four levels. I began writing and speaking about an “integrated theory” of business valuation. In 2004, I published a book, The Integrated Theory of Business Valuation (not in print now). The second edition was published in 2007, Business Valuation: An Integrated Theory Second Edition (with Travis Harms).
This theory recognized that the differences in value as one moves up or down the levels of value chart are reflective of different perceptions of value from the important perspectives of expected cash flow, risk and expected growth.
After this conceptual discussion of the levels of value, we will delve into the integrated theory enough to understand which expected cash flows relate to each level of value. After that, we can begin to tackle statutory fair value and have a basis to discuss the sometimes differing interpretations of that term in the interpretive statutory fair value case law in the various states.
The current version of the levels of value chart is shown below:
This revised chart obviously has similarities to the traditional levels of value chart. There are three general levels (with the overlapping of the two middle levels). There is an upper “control” level and a lower nonmarketable minority level. But there are differences, as seen below.
Two Concepts of “Control”
The revised chart has two control concepts. Based on the discussion above, the financial control level of value is separated from the strategic (or synergistic) level of value. Appraisers and courts who do not understand the important conceptual differences between these two control concepts can make faulty interpretations from available valuation and economic evidence.
The strategic control concept reflects the thinking of acquirers who, when acquiring companies, believe they can increase earnings by running the companies differently. In other words, they expect to enhance observable earnings through synergies of strategic benefits that are unique to each buyer. It is this expectation of increased cash flows, and, as we will see, perhaps a perception of lower risk, that create the strategic (or synergistic) premium in the revised chart above.
The second control level above is the financial control level of value. Note that it sits right on top of the marketable minority level of value. To the extent that buyers believe they can take the observable cash flows of a public company and increase them somewhat by running the company better, then there is some potential for a modest financial control premium.
The flip side of this logic is that any minority interest discount to move from the financial control level to the marketable minority level is nil or quite small. So the strategic (synergistic) control premium should not be used to attempt to estimate the extent of minority interest discounts. The conceptual difference between strategic control and financial control does not reflect “the value of control” but the capitalized value of expected synergistic or strategic benefits.
This logic, which I and many other appraisers believe to be sound, turns some traditional thinking about control premiums and minority interest discounts on end.
So the middle of the revised chart is reflective of financial control and marketable minority levels of value, because both reflect the value of observable or normalized cash flows of an entity that create its equity value.
There are a couple of significant implications from these observations.
- The use of guideline public company valuation metrics, when reasonably employed, should yield value indications at the financial control and marketable minority level of value. So there is no application of an automatic control premium to get to “control” as in the traditional chart. Any financial control premium would be explained in terms of expected benefits of adjusting existing cash flows by running a company better, and would likely be modest in relationship to typical strategic control premiums paid in acquisitions.
- Analysts should be careful when employing the guideline transactions method and developing valuation metrics from such transactions. Some transactions are, arguably or demonstrably, at the financial control level. These transactions would make good guideline transactions for similar companies.
- Some transactions are, however, clearly conducted at the strategic (synergistic) control level. These transactions would embed any strategic (synergistic) premiums considered by the acquirers. These transactions would likely not make for good guideline comparisons unless information is available to adjust multiples for the implied strategic premia.
We now move to the nonmarketable minority level of value.
One (Really) Minority Interest Concept
The lowest conceptual level on the revised chart above is the nonmarketable minority level of value. This level represents the level for illiquid, minority equity interests of business enterprises.
Note one difference between this nonmarketable minority level and that in the traditional chart. There is only one significant discount between the marketable minority/financial control level and the nonmarketable minority level. This is because any minority interest discounts are likely nil or very small, so the only remaining discount is the marketability discount, or DLOM.
The significant discounts observed between the values of marketable and nonmarketable securities is therefore not the result of lack of control in the traditional sense. Significant differences between the values of nonmarketable and otherwise similar marketable securities result from the inability to sell the illiquid investments over sometimes long and uncertain expected holding periods where the interim cash flows (i.e., dividends or distributions) may be low or nonexistent.
Value differences between liquid and otherwise similar illiquid securities are the result of differences in expected cash flows to holders of illiquid shares versus the enterprise cash flows that give rise to marketable minority/financial control values. Lower cash flows relative to the liquid securities, whose cash flows are capitalized in their market prices and available to investors who sell them, also create additional holding period risks. Why is this? Because unlike holders of public securities, holders of illiquid securities cannot receive the capitalized value of enterprise cash flows until there is a terminal sale event (or a purchase on similar terms).
- For a full discussion of this understanding of marketability discounts and the nonmarketable minority level of value, see the QMDM Companion Version 4.0, which includes a full discussion of the Quantitative Marketability Discount Model as well as the QMDM model in Excel, as well.
- I also recommend Business Valuation: An Integrated Theory Second Edition. It explains the integrated theory that we will summarize in future posts in detail.
Conclusions Re Statutory Fair Value
In the last post, we introduced the “traditional” levels of value chart with three distinct levels. In this post, we have compared and contrasted the traditional chart with a revised four-level (really three with the overlapping of marketable minority and financial control) chart.
We can already see that appraisers and courts that consider the top level in the traditional chart as “control value” are really looking at strategic (synergistic) control value, which is a different valuation concept.
Appraisers and courts that consider there is a substantial difference in value between the marketable minority level and the financial control value are really looking at the strategic control level to observe that difference.
And for those few jurisdictions that consider the application of marketability discounts to be appropriate in fair value determinations, we see that, in most cases, it would be taken from the financial control level of value (which overlaps with marketable minority).
We will develop these concepts more fully as we proceed. In the meantime, please do contact me directly or comment on this blog. I welcome the dialogue.