The “Ask the Experts” column in the July 2021 Issue of Business Valuation Update at page 14 (subscription required) posed the following question:
Would it be appropriate to apply a discount for lack of control to [a] minority ownership interest if, assuming the company is well run, all the other owners hold minority noncontrolling interest[s]?
This post quotes a portion of the Answer in bold that is followed by my comments in italics, and then goes to the next part of the Answer and another comment.
Assuming the company is well run, and you wouldn’t be able to make changes that would increase the expected cash flow or decrease the expected risk of the investment, there may not be a significant discount for lack of control that you apply.
There is clear recognition that there would be no discount for lack of control (or minority interest discount) if the company is well run. There is an implicit assumption that the appraiser has made appropriate normalizing adjustments for non-recurring events and for agency costs such as above-market compensation for selected owners (if any). The base value described is at what we call in Business Valuation: An Integrated Theory the marketable minority / financial control level of value. That is the middle level in the levels of value figure below.
We discussed the issue of normalizing for agency costs in more depth in a previous post.
The only reason that there would be a difference between the two levels is if there were an opportunity to increase cash flows or decrease risk between the two levels.
Realistically, in that case, there may not be a difference between a controlling interest and a noncontrolling interest in that company as is on a stand-alone basis.
That is a key tenant of the Integrated Theory. See Appendix 7-A, “A Historical Perspective on the Control Premium and Minority Interest Discount,” Business Valuation: An Integrated Theory Third Edition. In particular, read the section on “The Case for the Disappearing Minority Interest Discount.” That case has been summarized in one of my previous blogs. If appropriate normalizing adjustments have been made, there is seldom any reason for there to be a difference between the middle two levels above.
Both sets of subject interests would have a claim to the same cash flows. If you can’t make changes to increase the cash flow, then what are you really paying for? A buyer would not pay a whole lot more for a controlling interest in that company if it doesn’t really give you anything from an economic standpoint.
There are two controlling interests in the chart above, financial control and strategic control. We find it helpful to refer to the “controlling interest” in the answer above as the “financial control value.” The “minority” value in the answer is the “marketable minority value.” This terminology avoids confusion between financial control and strategic control.
One might ask: “Would it be appropriate to normalize for excess owner compensation if a controlling owner is taking non-pro rata distributions in the form of excess compensation?” The answer is, “Yes.” Some appraisers continue to sing the refrain, “But the minority shareholder cannot change the compensation structure, so it is not appropriate to normalize.” The controlling owner will certainly demand normalizing adjustments if or when she sells the company, and that is the pricing goal for minority owners investing in companies.
If normalizing adjustments are not made, the appraiser has not valued the company, but something else. With normalizing adjustments, the value is at the financial control / marketable minority level. From that level, an appropriate minority interest (or lack of control) discount (none) and an appropriate marketability discount can be considered.
The fact that the controlling owner is taking non-pro rata distributions lowers cash flow available for reinvestment and for pro rata distributions to all shareholders. These lower cash flows (and the risks of an expected holding period) influence (lower) the value of the minority shares and therefore create the marketability discount. The impact of lower growth and/or distributions can be quantified using a quantitative model like the QMDM. As an aside, when the QMDM turned 20 years of age in 2017, I wrote a summary in this post.
The fact is, there would be virtually no or no minority interest discount whether all owners are minority shareholders or there is a controlling shareholder. There is no discount for lack of control. Any marketability discount would be based on differences in expected cash flows, risk and growth in either case.
The Answer is sourced as a webinar Meinhart and Novak conducted for BV Resources on March 31, 2021. Meinhart and Novak got the right answer to the question; however, they seem to treat the question as an exception to some other, unstated rule. The answer is the same whether all the other shareholders are minority owners or there is a controlling owner.
The answer is not an exception based on the facts in the question, but a result of an Integrated Theory of Business Valuation based on expected cash flows, growth and risk. Difference in these value elements at different levels of value create the need for valuation discounts or premiums.
This issue of normalizing or not is a confusing one for many business appraisers. If you have a different view than expressed in this post, feel free to comment with your reasons (in terms of expected cash flow, growth and risk). I look forward to the debate.
The question posed in the Business Valuation Update and many other questions are addressed in Business Valuation: An Integrated Theory Third Edition (Mercer and Harms), which is available on Amazon.com. Get your copy while supplies last.☺ And if you read the book, give it an honest review on Amazon.
Until next time, be well!