Business appraisers have dealt with concepts related to the levels of value for many years. These levels of value are conceptual in nature and relate to where, on a continuum of value, a particular valuation interest should lie. Does the interest exhibit elements of control? The appropriate level of value should reflect this. Is there no control for a minority interest? The appropriate level of value should reflect this, as well. What about if there is no available market for the interest? The appropriate level of value should reflect this, also. It seems so simple and basic.
The Traditional Levels of Value
However, what seems simple and basic may not necessarily be so simple or basic. The “traditional” levels of value chart was first published in 1990. It reflected a basic understanding of differing levels of value related to control and marketability. The traditional chart had three conceptual levels, as illustrated below. The chart relates the three levels with one premium (the control premium) and two discounts (the minority interest discount and the marketability discount). The chart also describes the market evidence considered by business appraisers in developing value indications at each level.
Moving Between the Levels
The middle level on the chart is the so-called marketable minority level. It is the level that treats private companies “as if” they were freely tradable, like publicly traded companies. Appraisers examine transactions involving public companies, similar in business or nature to private companies, to develop valuation multiples for private companies.
The upper level on the chart is the controlling interest level. This level reflects the value of businesses when they are sold in their entirety. In fact, there was a publication called W.T. Grimm & Co. Mergerstat Review dating back at least to the early 1980s. The first set in Mercer Capital’s library is the 1987 edition. The point is that market analysts have been looking at the relationship between the prices at which public companies sell and their “previously unaffected” (by merger announcements) pricing for many years. The market evidence in these books and subsequent books under different owners relates the control prices or acquisition prices of public companies that sold to their prices before the announcements of their sales. The difference between the two prices was and is called the control premium, which is shown in the upper left of the chart above. The control premium was the analytical tool often applied to marketable minority values to derive controlling interest values.
The same difference between marketable minority and control measured by the control premium (marketable minority to control) is also measured by the minority interest discount (control to marketable minority).
The equations were simple.
1. Control Value (CV) = Marketable Minority Value x (1+ Control Premium)
2. Minority Interest Discount (MID) = 1 – (1 / (1 + Control Premium))
3. Marketable Minority Value = Control Value – MID
Since there was no available market evidence of minority interest discounts, business appraisers used equation #2 above and the Mergerstat market information on control premiums to derive minority interest discounts. Control premiums tended to be large, say 35% to 40% (or more or less), and the implied minority interest discounts were also large. Using equation #2 and control premiums of 35% to 40% and rounding, the implied minority interest discounts were in the range of 25% to 30%. It was neat and tidy.
The bottom level of value in the chart above is the nonmarketable minority level. Interests in public companies with active markets sell on a minority interest basis at their marketable minority levels. That is the price observed when minority interests in public companies trade in a free and active market. Beginning in about the latter 1960s with the SEC Institutional Investor Study (actually published in 1991), a number of observers noted that when public companies offered what were called restricted securities for sale, the prices were often significantly lower for the restricted offerings than for the freely traded securities. Observe that the discounts between the freely traded prices and the restricted stock prices were called restricted stock discounts. On average, these restricted stock discounts tended to be in the range of 30% to 40% (or so). Restricted stock discounts were used (and, unfortunately, still are) by business appraisers as a proxy for the marketability discount to relate the marketable minority level with the nonmarketable minority level of value.
[Brief Aside. Shares in restricted stock offerings were originally restricted from resale for a period of two years under SEC Rule 144. This lengthy required “holding period” for institutional investors had a great deal to do with the amount of required discounts in the offerings. As restrictions under Rule 144 have eased over the years, it is not surprising that average results in the later restricted stock studies are lower than the original studies under the old two year restriction period. This debate is broader than is possible to address in this post.]
We look at the conceptual math of the traditional nonmarketable minority level now.
4. Marketability Discount = Restricted Stock Discount (+/-) as Proxy
5. Nonmarketable Minority Value = Marketable Minority Value x (1 – Marketability Discount)
What we have described thus far is the general state of knowledge of business appraisers regarding the levels of value as of the early 1990s. Unfortunately, that state of knowledge has not improved much on the part of many appraisers since then.
Some appraisers began to ask questions about the validity of control premiums as a basis for estimating the amount or extent of minority interest discounts in the mid-1990s.
The initial questions related to the nature of transactions recorded in the Mergerstat Review publications. It was observed by some (including me) that the great majority of control transactions observed involving the sale of public companies related to strategic or synergistic transactions. Synergies or strategic motivations have nothing to do with minority interest discounts, so it began to be argued that it was inappropriate to use Mergerstat data as a basis for estimating minority interest discounts.
These observations led to a belief that there must be at least two conceptual levels of control. In addition to the strategic control concept of the Mergerstat Review transactions, there must be a concept of financial control, which would lie somewhere between the old control level in the chart above (which should be strategic control) and the marketable minority level.
Finally, we began to ask questions, not about market evidence per se, but about why value might be different at the different levels.
In the next post, we will look at a modified levels of value chart with four levels of value. In future posts, we will examine the conceptual levels of value as influenced by the expected cash flows, risks, and growth attributable to enterprises or interests in them.
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