When I was a young business appraiser, or well, when I was a new but not so young business appraiser, the valuation of illiquid minority interests involved developing a base value for a business and then applying two big discounts, a minority interest discount (MID), and then, a marketability discount, aka DLOM. This post is about the first, now disappearing, minority interest discount.
The original levels of value chart suggested that the minority interest discount was the equivalent dollar amount as a corresponding control premium from the base marketable minority level of value. That level is named by reference to trading of minority interests in the public securities markets. The levels of value chart had three levels as in the following figure that I first published in 1990.
The chart showed relationships between three “levels” of value, the marketable minority level, which was a base level, or as-if-freely-traded level, from which other levels were determined, a controlling interest level (control of businesses), and a nonmarketable minority level (illiquid minority interests). The “adjustment factors” in the chart are two discounts and one premium.
- Control Premium (CP). The control premium was an adjustment from the marketable minority level to the control level. Control premiums were observable in the market for change-of-control transactions involving public companies. If a public company traded at $10 per share and sold for $14 per share, the control premium was $4 per share, or the difference between the transaction price and the pre-announcement public price. The control premium in this example is 40% if expressed as a percentage ($14/$10 – 1). Control premiums were analyzed and transactional data was published in predecessors to the current studies available at Business Valuation Resources. Appraisers used control premium studies to estimate minority interest discounts.
- Minority Interest Discount (MID). As is clear from the levels of value chart above, the MID was a mirror image of the control premium. In the example just noted, the control premium was $4 per share. The corresponding MID would therefore be $4 per share. We address the percentage MID shortly.
- Marketability Discount (DLOM). The marketability discount was the difference between the marketable minority value and the nonmarketable minority value. The DLOM was observed in studies called restricted stock studies that public companies issuing restricted stock (under rules of the Securities and Exchange Commission) tended to sell the restricted shares at prices less than their otherwise identical publicly traded prices. For example, a restricted stock offering might be for $7 per share compared to a $10 per share public price. The dollar discount is $3 per share, or 30% of the public price for the freely traded shares. Appraisers used restricted stock studies as a basis to estimate marketability discounts.
I’ll have to say that in the 1980s and 1990s, business appraisers were not focused too keenly on the marketable minority level of value. Many appraisers developed indications of value for 100% of a business, and then, almost automatically, applied both minority interest and marketability discounts.
With this background, we can look at what I am calling the disappearing minority interest discount.
The Minority Interest Discount
The math of the minority interest discount was fairly straightforward. To eliminate the control premium of 40% from the example above, we engage in a bit of basic algebra:
The minority interest discount calculated from the 40% control premium in our example above is 28.6% [1 – (1/(1+0.40))]. The averages of control premium studies tended to be in the 35% to 40% (or more) range, so implied minority interest discounts tended to be in the range of 25% to 30% or so. Those were big minority interest discounts!
The reduction in value was often attributed to certain prerogatives of control, like the ability to run a company, to pick who to do business with, to determine dividend policy, and more. The implication was that buyers of companies were paying substantial control premiums to obtain these prerogatives of control. The minority interest discount accounted for this premium by taking it away, since minority shares lack control.
Then, of course, appraisers applied marketability discounts based on averages of restricted stock discounts in the range of 30% to 35%, plus or minus a bit, and some minority interest valuations got almost ridiculously low. For today, we focus only on the minority interest discount.
Step 1 for the Disappearing Minority Interest Discount
In 1990, Eric Nath wrote an article for the Business Valuation Review of the American Society of Appraisers titled “Control Premiums and Minority Interest Discounts in Private Companies.” The core idea in this article was considered by many appraisers (including me at the time) as heresy.
It took some time for Nath’s novel idea to catch on, but it did begin to resonate with some appraisers (including me) during the 1990s. Nath’s article suggested the following reasoning, which, with the benefit of hindsight I now fully endorse:
- The markets for public securities are massive and market participants are looking to maximize their returns from investments there.
- In a given year, only a relatively small number of public companies are taken over by other companies. The companies that are taken over are acquired on the basis of expected synergistic and strategic benefits, or because their trading prices are sufficiently “undervalued” that they can be purchased with the acquirer benefiting from the expected enhancement in value.
- Given the number of large public companies, private equity investors, and other investors, if there were more opportunities where companies were trading at less than their control values, more would be taken over. The money would find these opportunities “like sharks to blood.” But most companies are not taken over in any year, so they must be trading at something close to their control levels.
- Since some companies are taken over for synergistic or strategic reasons, that kind of control is a higher level of control value than that of the typical public company.
While I initially disagreed with Nath’s suggestion that typical public market pricing yielded (financial) control values, his article marked the first step on the path to the disappearing minority interest discount.
Step 2 for the Disappearing Minority Interest Discount
By the mid-1990s, many business appraisers, including me, had realized that most of the transactions in control premium studies involved strategic (or synergistic) intent, and that control premiums were paid, not for the prerogatives of control, but for the ability to enhance the cash flows of an acquisition through expected operating synergies, enhanced sales, and other expected strategic benefits.
This led to the insertion of a fourth level of value in the chart above, that of financial control, between the marketable minority level and the control level, which was relabeled as strategic control, as seen in the following chart. I published this chart in the latter 1990s, and others published similar charts during this period. For example, the chart below was published in 2000 in Pratt’s (and Reilly and Schweihs) Valuing a Business Fourth Edition (with attribution) along with a similar chart they developed showing four levels of value.
The Control Premium (CP) on the traditional chart on the left represents a single observed premium based on change of control transactions of public companies. That conceptual CP from the left side is broken into two components on the right side, the Financial Control Premium (FCP) and the Strategic Control Premium (SCP), because the combined premiums on the right are identical to those discussed for the left side. In other words, CP (on left) equals (FCP + SCP) (on right).
Appraisers began to figure out that the SCP on the right side, at least, was paid for the ability to enhance cash flows of targets through synergies and strategic benefits. This logic led to the realization that the control premium studies were measuring something other than, and more substantial than the so-called prerogatives of control (to measure the minority interest discount). They were primarily reflecting the value of expected enhancements to cash flows.
The next conclusion was that the use of control premium studies to estimate minority interest discounts would, at the very least, overstate minority interest discounts when applied to control values that did not include the types of strategic cash flow benefits contemplated in strategic transactions. A few appraisers and I wrote and spoke about these insights during the mid-to-latter 1990s. The realization that observed control premiums reflected a combination of financial and strategic premiums was the second step along the path of the disappearing minority interest discount.
Step 3 for the Disappearing Minority Discount
Further evolution of our understanding led to the development of a levels of value chart that suggested that the marketable minority and financial control values were synonymous, or nearly so. That is the logical conclusion reached based on Nath’s observations way back in 1990. The refined levels of value chart is shown here, again in relationship to the traditional three level chart:
Nath’s logic is compelling and is reflected in the chart on the right side immediately above. I introduced the refined chart in the early 2000s in speeches and articles and in the first edition of Business Valuation: An Integrated Theory, which was published in 2004, together with the conceptual math for each level of value in the context of the Gordon Model. Travis Harms and I enhanced the Integrated Theory in the book’s second edition published in 2007. By the way, we are fast at work on the third edition of the book.
In Business Valuation: An Integrated Theory Second Edition, we show that there is no reason for a departure between these two levels of value unless typical financial buyers:
- Expect to run a target company better than existing owners and generate more cash flows from the same assets, or,
- Expect to be able to grow cash flows faster over the long term than existing owners, and/or,
- Are willing to accept a lower than market (marketable minority) rate of return, and,
- And are willing to share these expected benefits with target owners, then...
In short, there is no reason for the financial control value to diverge very far from public pricing for public companies or the marketable minority value for private companies.
There is additional top-down pressure from potential strategic acquirers for managements and directors of public companies to run their companies effectively and for the benefit of all owners. If they do not do so, they become more likely targets for takeover.
I’d like to think that there is a general realization of the appropriateness of this refined levels of value chart among business appraisers. I can say that there is a growing realization among appraisers that it is more descriptive of market reality than any of the previous levels of value charts.
The interesting thing is that many appraisers actually do seem to believe there is a congruence between the financial control level of value and the marketable minority level as shown in the chart at the right above. Virtually all appraisers believe there is a significant conceptual difference between financial control and strategic control values. However, the realization that this relationship impacts the meaning of the minority interest discount does not seem to have sunk in as deeply.
Nevertheless, the refined levels of value chart above and the growing realization of the congruence between the marketable minority and financial control levels of value mark the third step on the path of the disappearing minority interest discount.
Step 4 for the Disappearing Minority Interest Discount
We have said that there is congruence between the marketable minority and financial control levels of value.
Nevertheless, some would argue, if not further, then repeatedly.
Owners of publicly traded shares hold minority interests. A minority interest simply can’t be worth as much as a control interest, so there should be some minority interest discount. If I can’t take a big minority interest discount, then I can’t get the low nonmarketable minority values that are appropriate for unattractive investments in illiquid interests in private companies.
The problem is that minority investors in public companies do have significant elements of control relative either to financial control owners or owners of illiquid minority interests. Consider the following regarding minority investors in securities of publicly traded companies:
- Each public minority investor controls when he or she invests in particular public companies
- Each investor receives prorata distributions/dividends paid by the public companies they invest in
- Each investor expects to receive the benefit of all reinvested earnings based on future earnings growth (and expected market price appreciation) based on those reinvestments
- Each investor will receive a prorata share of the purchase price if and when a public company is sold
- Each investor controls his or her holding period for every public company investment
- Each investor can sell his or her minority interest in a public company at any time and can expect to receive the capitalized value of all future cash flows (i.e., the current market price, which represents a marketable minority/financial control value) and receive cash in three days in his or her brokerage account
- Collectively, minority investors can express dissatisfaction with management and directors of a public company by selling their shares. Collective selling pressure would depress market pricing, thereby making a particular public company a more attractive takeover target. The threat of this collective power of minority shareholders of public companies acts to encourage management and directors to run companies for the benefit of all shareholders.
Call the pressure from each public minority investor in a public company and the collective pressure they can bring as bottom-up pressure to assure that public market pricing reflects financial control value.
This logic regarding the power held by minority investors in publicly traded companies provides the fourth step along the path of the disappearing minority interest discount.
Is There a Minority Interest Discount?
It is a truism that no valuation premium or discount has any meaning unless the base to which it is applied or taken is specified. Consider the following:
- The base level of value to which any control premium is applied is the marketable minority (or the marketable minority/financial control) level. Control premiums can be observed in the marketplace, as discussed above. We also know from real world experience that strategic control buyers pay prices based on their expectations of enhanced cash flows or growth relative to stand-alone targets. There is economic logic underlying the reasons why strategic control (or financial control) premiums are paid.
- The base level of value from which any marketability discount is taken is the marketable minority (or the marketable minority/financial control) level. Investors in illiquid, minority interests of private companies generally expect to receive less than all of their cash flows each year, anticipate additional risks not faced by public securities holders because of inability to sell quickly, and may suffer from suboptimal reinvestment decisions by controllers. There is economic logic underlying the reasons why less is paid for illiquid interests than for prorata shares of business enterprises. The phenomenon of typically lower prices for restricted (illiquid) shares of public companies relative to their freely trading counterpart shares is observable in the marketplace as an affirmation of the economics underlying the marketability discount for private companies.
The base level from which a minority interest discount would be taken has to be a control base. That base cannot reasonably be that of strategic control, which is not observable except by exception when public companies are sold. It is not observable at all for private companies. The base level could be the financial control level, but if that were the case, any minority interest discount would be zero or minimal.
I am not saying here that there is no such thing as a minority interest discount. We apply minority interest discounts to underlying net asset values when valuing illiquid interests of asset holding companies. We do so because market evidence exists that closed-end funds holding primarily liquid investment assets tend to trade at modest discounts to their underlying net asset values. But for operating companies, the case for the minority discount is more tenuous.
What I am saying is that there is substantial economic evidence that the minority interest discount that I grew up with in the valuation business is disappearing. Apply a large minority discount at your own risk. Don’t apply one by using irrelevant control premium information as a basis for developing it. If you apply a minority interest discount, make sure that the base from which you take it is clearly specified, and be prepared to address the logic in the four steps for the disappearing discount outlined in this post.
As I mentioned, Travis Harms and I are working diligently to complete the third edition of Business Valuation: An Integrated Theory. This post is an offshoot of those efforts. If you would like to be notified when the new book becomes available, please send me an email at:
As always, I welcome comments on this blog. Unless I am mistaken, this post should generate a few comments. I hope so!