In Business Valuation: An Integrated Theory Third Edition, we refer to excess owner compensation and the cost of other owner perquisites as agency costs.  According to the Integrated Theory, adjustments for excess owner compensation (or for under-compensation, as well) are appropriate whether the subject interest is a controlling interest or a non-controlling interest.  Why is this so?  Because only by making such adjustments when appropriate can the valuation analyst be assured that the resulting valuation conclusion is at the appropriate base level of value, i.e., the marketable minority value.

If excess owner compensation (or under-compensation) is present, it is appropriate to normalize for these costs to market levels to reach the appropriate marketable minority base / financial control value.  If the subject interest is a non-controlling interest, an appropriate marketability discount can be considered from the base marketable minority value.  If the subject interest is a controlling interest, no marketability discount would be appropriate

Traditional View of Agency Costs – Minority Interests

The traditional view of agency costs relies on the following logic regarding normalization in the valuation of minority interests:

Because the minority shareholder cannot change the excess owner compensation, it may be appropriate not to adjust for it, and value the minority interest based on the reduced cash flows. A “standard” marketability discount would then apply.  According to the traditional view, it is a matter of appraiser judgment regarding whether to normalize or not.

The traditional view provides no guidance on how or when to exercise judgment not to normalize for agency costs.  However, if an appraiser fails to normalize for excess compensation, an undefined base value (i.e., not marketable minority) is derived. The application of a “standard” marketability discount is therefore not appropriate, however, the traditional view suggests that a marketability discount should be applied.

There is a second problem with failing to adjust for excess owner compensation.  Minority interest investments are made for finite expected holding periods.  Businesses are valued under the presumption of perpetuity cash flows.  To the extent that excess owner compensation is not normalized, the understatement of normalized compensation is not capitalized into perpetuity, thereby understating the supposed marketable minority value and penalizing the non-controlling interest for the difference  into perpetuity. Agency costs for minority investors cannot last longer than the expected holding period of the investment.  The issue of not defining the appropriate base value is exacerbated as a result.

Agency Costs and the Integrated Theory

How do we address the concept of control (or lack thereof) in the context of the Integrated Theory. The steps are as follows:

1. Normalize for excess owner compensation and other agency costs, thereby assuring that cash flows to be capitalized or discounted yield the appropriate marketable minority base value for the business.
2. Consider the impact of reduced cash flows to minority shareholders at the shareholder level using a shareholder level discounted cash flow model like the QMDM to examine the expected cash flows to the non-controlling interest being valued over the expected holding period of the investment.
3. Assume a normal exit at the marketable minority value at the end of the expected holding period, thereby modeling the expectation of the investment in the first place.  If that is not a reasonable assumption, the QMDM provides for an alternate assumption regarding exit value.
4. The QMDM calculates the present value of the expected shareholder returns over a range of expected holding periods.
5. From within the range of expected holding periods, the valuation analyst reaches a conclusion for the appropriate implied marketability discount applicable to the “normalized” marketable minority conclusion of value.

In this manner, the Integrated Theory enables the valuation analyst to exercise appropriate valuation judgments regarding normalization of agency costs and then, regarding the assumptions of the QMDM.

A Conceptual View of Agency Cost Treatment

In order to apply a valuation discount or premium, we have to be clear about the base value to which the premium is applied or from which the discount is taken.  The base value in the context of both the traditional view and the Integrated Theory is the marketable minority value.  So any premium or discount should be defined based on differences in valuation characteristics  between a subject interest and the base value to which it is compared.

If valuation analysts do not normalize for excess owner compensation, then the expected cash flow to be capitalized or discounted is understated relative to cash flow at the marketable minority level.  That cash flow would be comparable to a well-run pubic company, which would presume to have management compensation at market levels. We look at the question of normalizing or not first from a conceptual viewpoint.

The left side of the chart above is titled “Integrated Theory Normalize for Agency Costs.”  Here, a valuation analyst has normalized for excess compensation, thereby reducing operating expenses to market levels and increasing capitalizable income by that amount.  The indicated value of equity of the business is based on normalized cash flows.  Therefore, the derived equity indication is at the marketable minority level.  From there, the valuation analyst applies a “standard” DLOM of 35% and achieves a nonmarketable minority indication for the conclusion, which was the goal of the assignment.

A second appraiser was given the same assignment which is conceptually shown on the right side of the chart above as “Traditional View Do Not Normalize.”  He employed the traditional view and did not normalize for excess owner compensation.  As a result, the earnings to be capitalized were understated by the amount of the excess compensation adjustment.  The resulting indication of equity value is therefore below the marketable minority level, and is of indeterminate pedigree.  The second appraiser then applied a “standard” DLOM of 35% and achieved a value that is conceptually lower than the nonmarketable minority value indication of the first appraiser.

A Numerical Example of Agency Cost Treatment

A numerical example of what happens when normalizing for excess owner compensation (or not) can also be instructive.  Two appraisers provided valuation indications for the same illiquid, minority interest of a company as indicated in the following figure.

Based on his analysis, Appraiser 1 adjusted the $1.0 million of reported compensation for the controlling shareholder by $1.5 million, or down to $300 thousand.  This normalizing of excess owner compensation increased adjusted EBITDA by that amount.  Given his concluded adjusted EBITDA of $2.5 million and multiple of 6.0x, the enterprise value is $15.0 million.  Adjusting for debt and cash, equity value is $14.5 million, which is at the marketable minority level.  After applying a “standard” DLOM of 35%, his non-marketable minority value is $9.4 million.

Appraiser 2 concluded that since the valuation subject was a minority interest and could not change owner compensation, there should be no adjustment for excess owner compensation.  Given his unadjusted of $1.0 million and his EBITDA multiple of 6.0x, his enterprise value is therefore $6.0 million, or substantially below the $15 million for Appraiser 1.  After adjusting for cash and debt, his equity value is $5.5 million (of 62% lower than the $14.5 million indication for Appraiser 1.

This much lower equity value does not represent the marketable minority level of value, so it is an undefined base value.  Appraiser 2 then applies a “standard” DLOM of 35%, since there is no guidance in the traditional view regarding how to adjust the DLOM if one does not normalize for excess owner compensation.  The concluded value is $3.6 million at the discounted minority value.  This value does not represent the nonmarketable minority level of value, but rather a value of some indeterminate species.

Conclusion re Agency Costs

Should business appraisers normalize excess owner compensation and perquisites, or agency costs, to market levels for similar services when valuing a non-controlling subject interest?

The answer is “yes” according to the Integrated Theory.

Why is this so?  Normalizing enables the appraiser to develop expected cash flows to derive the appropriate marketable minority (or financial control) value from which an appropriate marketability discount can be considered.

This post will be controversial for some readers.  The logic is discussed in greater detail in Business Valuation: An Integrated Theory Third Edition.  If you think you disagree with me, let me suggest that you obtain your copy of the Third Edition (it is worth it even if you have the Second Edition).  Read the book carefully.  If you do, I believe you will be normalizing for excess owner compensation costs going forward.

If you think you disagree with me and want to comment, please do so in the comment section below.  But please don’t just disagree and talk in terms of opinion.  Speak in terms of valuation theory and valuation concepts.

If you agree with me, please make your voice heard in the comments.  I hope we can bring clarity to this threshold question for so many appraisers.

I look forward to “hearing” your comments.

Until then, be well!

Chris